Building bridges

When India sought a loan from the International Monetary Fund in the midst of a severe foreign exchange crisis in 1991, the IMF insisted that the country cut down its fiscal deficit as part of the loan conditions. Though India has come out of that crisis and now has abundant foreign exchange reserves, the insistence on cutting down fiscal deficit continues.

The pressure from the IMF and the World Bank can be resisted since instead of borrowing we are actually repaying part of the foreign loan ahead of schedule. Currently, the pressure is more from economists who think it imperative that we cut down on our fiscal deficit in the interest of the economic health of the nation.

But is a fiscal deficit necessarily bad? Fiscal deficit is the gap between government expenditures and government income from tax and other sources. This is the amount which the government has to borrow from the market or the Reserve Bank of India to meet its obligations.

Despite all the talk about the need for fiscal discipline, the combined fiscal deficits of the Central and state governments has been hovering at around 10 per cent of the gross domestic product ever since 1990.

What is wrong with the government borrowing to meet its fiscal deficit? In fact, some private companies prosper with borrowed money while some others go bust. The question is: what does the borrower do with the loan? If used to create income-generating assets for the future, then there is no problem. So, people who are critical of high fiscal deficits believe that governments use money less productively than the private sector. Hence, a fiscal deficit is bad.

The most common argument is that if the government corners a higher share of the resources, then there would be less for the private sector. As the government borrows more from the market, interest rates would go up. The cost of capital for private investors would rise and some private investment projects would become less profitable. But, this chain of logic may break down at several points.

First, in a recessionary situation with a lot of idle productive capacity, government expenditure, funded by borrowing, can grow without affecting the availability of resources or raising costs for the private sector. Further, increased government expenditure would generate more income and demand for goods and services produced by the private sector.

This complementarity would further increase if the government spends more money on infrastructure projects in which private investment is not forthcoming in any case. With better infrastructure, private business may feel induced to invest more in areas where infrastructural bottlenecks are the major constraint limiting investment.

Second, the chances of a rise in interest rate or a fall in availability of funds would be less in an open economy. Any hike in domestic interest rates would attract more foreign funds. One reason why high fiscal deficits have not resulted in a rise in interest rates or a balance of payment problem in India is the large capital inflows from abroad, particularly from non-resident Indians and foreign institutional investors.

Another argument against fiscal deficit is that it would lead to inflation, especially if the deficit is financed by printing money. Again, this may not be the case in a recession when supply can expand together with demand, without requiring a rise in prices. Moreover, in India the inflation rate depends more on the weather gods (a good or bad harvest) and the situation in west Asia (a rise or fall in oil prices).

The real problem with running a fiscal deficit is that it would add to the debt and lead to a debt-servicing burden. Again, this would not be a problem if the return from the projects funded by borrowing is more than the interest lost. Can this be guaranteed in India where, an increasing proportion of government revenues is being used to pay salaries and pensions without any corresponding rise in the productivity of government employees?

The share of interest payments in government expenditure has also been going up, though there has been a small let-up recently as a result of a fall in interest rates. But there is a limit beyond which the interest rate will not fall and may go up again.

All these mean that the percentage of government revenues available for building physical infrastructure (roads, power, transport, communication, irrigation, and so on) and social infrastructure (education, health, drinking water, social safety net) is going down over the years.

This would have serious long-term consequences as the productive capacity of the country would not expand and even existing infrastructure would not be maintained, while the pressure of population and the proportion of retired people would go on rising. The problem is even more serious with external borrowing which have to be serviced in foreign exchange.

To sum up, the real problem is not the size of the fiscal deficit but the composition of government expenditure. A better index of fiscal health could be the size of revenue deficit — the gap between the government’s current expenditure and current revenue. This is broadly analogous to the gap between the government’s consumption expenditure and income.

The problem is that in India, we not only have a revenue deficit but this has also been going up as a percentage of the GDP. So, the government is borrowing even to meet its consumption expenditure. This is a recipe for long-term disaster.

The practical solution lies in the government restricting itself to areas where the private sector is not forthcoming. Also, such public sector projects (in steel, cars and so on) should yield a commercial return comparable to what competing private companies are getting.

For projects in social sectors, the relevant parameter is not commercial profits but the social rate of return. But it is nearly impossible to calculate it with any precision. So, in those areas attempts must be made to cut down wastage and improve the administration and delivery systems to ensure that the benefits reach the targets. And that is the real challenge, not a reduction in the fiscal deficit.