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A RETURN OF BAD TIMES

- An unusual paper on India and the global economic situation

The budget season is here again. The finance minister is in the ministry for the third time. His earlier ventures were not covered with glory, but there is always hope that the longer he holds the post, the less error-prone he will become. The times are difficult: the growth rate is plummeting, the balance of payments is deeply in deficit, and the fiscal deficit as a proportion of GDP in April-September was the highest in at least six years. P. Chidambaram also has a new chief economic advisor, Raghuram Rajan, one of the best he could get, though the ministry website con- tinues to show Kaushik Basu in that post. The mid-term survey, which is supposed to review April-September performance, is still to come out. So we do not have the ministry’s view of how the economy is doing. But we do have an unusual paper from the ministry on the global economic situation and its implications for India. Kanika Bhatnagar is obviously a maverick, for she gives us a shock right at the outset: she begins with the following quotation from Tolstoy’s War and Peace: “At the approach of danger there are always two voices that speak with equal force in the heart of man: one very reasonably tells the man to consider the nature of the danger and the means of avoiding it; the other even more reasonably says that it is too painful and harassing to think of the danger, since it is not in a man’s power to provide for everything and escape from the general march of events; and that it is therefore better to turn aside from the painful subject till it has come, and to think of what is pleasant. In solitude a man generally yields to the first voice, in society to the second.” Quite apart from its relevance, what beautiful language! How unusual for a finance ministry paper! But then, Kanika was just a summer intern, and is probably thinking of something or someone pleasant under some tree by a university canteen.

Kanika began by quoting José Manuel Barroso, president of the European Commission, who reacted indignantly to a reporter’s question at the last G20 summit: “Frankly, we are not here to receive lessons in terms of democracy or in terms of how to handle the economy. This crisis was not originated in Europe… seeing as you mention North America, this crisis originated in North America and much of our financial sector was contaminated by, how can I put it, unorthodox practices, from some sectors of the financial market.” In other words, the crisis was none of Europe’s fault, but was due to infection by American toxins. Kanika proved, to my satisfaction at least, that Barroso was plain wrong.

Kanika began the story with the Lehman Brothers crisis of 2008. Just before it happened, the value of American mortgage-backed securities was $6.5 trillion — even bigger than the corporate bond market ($5.4 trillion) and the government bond market ($4.3 trillion). When lenders lose confidence and begin to withdraw loans to asset-based security holders, holders sell the securities, the issuers of the securities start selling the assets, asset prices crash, and the entire chain of borrowers and lenders goes bankrupt. That is the essence of a credit crisis. Kanika pointed out that European banks had considerable exposure to American asset-backed securities and hence shared in the losses. Not that they needed America to get them into trouble; Europe had its own ABS market worth 2 trillion euros. But European banks had to hold cash reserves of 4-8 per cent against mortgage loans, while American banks did not. As a result, American loans were seen to be more risky and carried higher interest rates. That is what made American ABSs more attractive. But actually, American banks’ loans were indirectly guaranteed by the US government and were less risky.

The European sovereign debt crisis was also linked to the fall in asset prices, especially property prices, resulting from the European banks’ problems, but came a bit later, in 2009. On 16 October, Georgieu Papandreou, Greek prime minister, gave out a figure of 12.7 per cent of GDP for Greek fiscal deficit; the European statistical office found in January 2010 that Greece had been falsifying budget figures. That led to a collapse in confidence, and blocked Greece’s access to the financial markets. Lenders and credit rating agencies began to look anew at the finances of other European countries; interest rates on their debt began to go up, and one by one, Spain, Portugal and Italy were downgraded. These European countries did not all have high debt-GDP ratios; but they were more vulnerable because they lacked a policy instrument, namely currency issue, that countries outside the European Union had. Even with a single currency, balance of payments adjustment could have taken place in Europe if relative wages had fallen in the southern countries. But Germany is extremely allergic to inflation; it kept wage increases close to productivity increases and kept real wages constant. Other European countries simply could not compete with it.

The troubles in the US and the EU had an impact on India: its export growth slowed down rapidly. But the impact was “moderated”, to use the Reserve Bank’s favourite word, by a rise in inflows of foreign direct investment: as investment prospects in the Western world deteriorated, capital started moving to India, which was still showing respectable growth. When FDI inflows slackened, the Reserve Bank, always reluctant to spend foreign exchange reserves, let the Rupee depreciate massively. Kanika concluded that India is highly vulnerable to global storms.

She did not go into policy measures required to meet those storms. The exchange rate is the only one the government has been using; so the Rupee will continue to go down. But expectations of Rupee depreciation discourage capital inflows; they are likely to slacken. The only policy instrument available to the government to prepare for the gathering storm is fiscal balance. If he has the country’s interests at heart, P. Chidambaram should bring down the fiscal deficit drastically in the next budget. It is unlikely that he would do so by reducing growth of expenditure; the Congress is a spendthrift party, and the looming general election will tempt it even more. If he cannot discipline his party, the only option left to him is higher taxes. He may well calculate that only 35 or 40 million people pay income tax. They are insignificant as electors; he may be tempted to raise income tax. Or he may consult one of his fiscal advisors, and may get ideas for some new taxes. New taxes do not generally yield much; they require new administrative arrangements, which take time to build up. But meanwhile, they make taxpayers’ lives miserable. Let us see which of Tolstoy’s two ways Chidambaram chooses: whether he turns aside from the painful subject and does what is pleasurable, namely run another huge deficit, or whether he faces the danger squarely and acts to avoid or at least alleviate it. There is also a third way, one that his predecessor usually took, namely do nothing and trust god.