Kautilya: Jalan needs to Start Worrying

India Today
October 19, 1998

KAUTILYA
Jalan Needs to Start Worrying

India's high fiscal deficit is a cause for great concern

Jairam Ramesh

Bimal Jalan, the affable governor of the Reserve Bank of India (RBI), is most careful about what he says and does. That is why his reported statement in Washington dc that India's fiscal deficit should not be a cause for external worry is most puzzling. This is not what the RBI as an institution has said in the past or is saying now. Jalan was addressing foreign investors. He told them to worry more about the current account deficit than the fiscal deficit. A current account deficit means the country is borrowing from abroad. The current account deficit, projected to be 2 per cent of GDP in 1998-99, is still well below the danger level because of lower economic growth. But the fiscal deficit is already at unsustainable levels.

India's crisis of 1990-91 was characterised by the highest overall fiscal deficit of 12.3 per cent of GDP and the highest current account deficit of 3.2 per cent of GDP. But in actual practice the relationship has not been direct and unidirectional. Countries like Malaysia, South Korea and Thailand and Indonesia were destroyed by unmanageable current account deficits, even as they ran very low fiscal deficits. A high fiscal deficit will result in a high current account deficit. But no fiscal deficit does not necessarily mean no current account deficit.

If we want short-term funds, then the Government is right in highlighting the importance of the current account deficit. But Kautilya thought our objective was to discourage short-term investors and attract long-term ones. If this is still the goal, then the fiscal deficit is crucial.

Kautilya is putting himself in Jalan's place and trying to think like him in order to make sense of his statement. If the argument is that the fiscal deficit is not important at all, then the governor is wrong. The fiscal deficit matters. The sustainable level of deficit in the country as a whole is around 7 per cent of GDP, whereas today the combined deficit of the Centre, states and public enterprises is 9-10 per cent of GDP.

But let us assume this isn't what Jalan meant. What he wanted to say was not that fiscal deficit didn't matter but that the nature of financing the deficit mattered more. True, but how do we judge this, specially since this year the governor himself-aided by the chief economic adviser-has convinced the finance minister not to indicate the level of monetisation of the deficit in the budget?

Let us also assume the governor did not wish to convey that the fiscal deficit is unimportant but that what is more crucial is the use the fiscal deficit is put to. Surely, here India has a huge problem. Half its fiscal deficit finances the revenue deficit-the gap between current receipts and current expenditures like interest payments, subsidies and establishment costs. As long as this situation persists, the ability of the Government to invest more in physical and social infrastructure is going to remain severely constrained. This should worry all investors.

Another argument Jalan may have had in mind is that fiscal deficits should matter more when savings rates are low. When the savings rate is, say, 10 per cent of GDP-as in much of the West-then a fiscal deficit of 3 per cent of GDP is a recipe for disaster. Jalan may feel that since India's savings rate is 26 per cent of GDP, the country can sustain a higher level of fiscal deficit.

The flaw in this argument is simply that in the developed countries of the West almost all the savings are financial savings. In India, household savings comprise 20.3 per cent of GDP and are made up of both financial and physical savings. Financial savings alone are 11.4 per cent of GDP. If from this figure, 9-10 per cent of GDP is being pre-empted by the Centre and the state governments to meet their deficits, then clearly our capacity to increase productive investments is limited.

Actually, this whole external-internal distinction that is implicit in the governor's remarks is untenable. Imbalances in the domestic account manifest themselves in imbalances in the external account. Among key policies that discriminated against India's agricultural sector in the pre-1991 era were the overvalued exchange rate and high import duties on industrial products.

Often, external liberalisation has lower start-up costs and energises internal liberalisation. Also, all investors look at the same macro-economic and micro-economic indicators before taking a decision. East Asia was killed externally by the fragility of its internal banking system.

A top economic administrator told Kautilya that the correct version of the governor's point may well be that the fiscal deficit is not a cause for external worry provided monetary policy is tight. In that case, interest rates will shoot up, spending will be reduced and imports will come down. Apart from its impact on growth, this is a purely short-term, ad hoc view.

Kautilya would suggest that the governor forget his firefighting mandarin years in Delhi, where he had to be sensitive to the political economy. Instead, he should follow in the footsteps of his distinguished predecessor who had declared intellectual autonomy from his friends and colleagues in Delhi.

The author is secretary of the AICC's Economic Affairs Department. The views expressed here are his own.

Issue Contents | Write to us | Subscriptions | Syndication