Thursday, March 01, 2007

Views on Budget 2007

As usual, the Indian media has excellent budget commentary, e.g. Suman Bery, S. Narayan, Ila Patnaik, M. Govinda Rao. A spreadsheet with some minor value added on the budget-at-a-glance is useful in thinking about what happened. In it, I have removed the SBI transaction of Rs.40,000 crore which is just accounting entries between MOF and RBI. I like to use the `best available estimates' in comparing the three recent years, which involves using actuals for 2005-06, revised estimates for 2006-07 and budget estimates for 2007-08.

Political backdrop

Feb 2007 is a bad time for economic policy. The UPA is worried about its political future, thanks to high inflation and two lost state elections. This stress is generating an interest in going back to the economic thinking of the garibi hatao days in the minds of many MPs of many parties. Business Standard had an excellent editorial setting this stage on the 28th morning.

My Business Standard piece says:

The most depressing feature of the budget speech was right at the outset. The speech began by punching the viewer in the nose in para 8A (a last minute insertion) with a ban on futures trading on wheat and rice. It was a jarring reminder that India may be an IT superpower with a $1 trillion GDP, but there are many people at the top who are still thinking in the 1970s mentality of blaming futures traders, hoarders, profiteers and speculators for an economy-wide mismatch between supply and demand.

For more on banning commodity futures trading, see link, link.

Progress on the deficit

The situation on the (central) fiscal deficit is:

Unit 2005-06 (A) 2006-07 (R) 2007-08 (B)
Rs. crore 146,435 152,328 150,948
Percent to GDP 4.11 3.68 3.23

In 2007-08, bond issuance of Rs.150,948 crore is proposed. This involves a low growth in nominal terms when compared with 2005-06. If this target is met, it would imply that the central government has expenditures of 3.23% of GDP which are not covered by revenues. When bond issuance is flat in nominal terms, the growth of GDP and the growth of the savings rate gives increased space for private investment and thus an opportunity for accelerating Indian GDP growth. This is good news for achieving high GDP growth.

If the existing FRBM Act and Rules are treated as a given, and if a deficit of 3.23% of GDP is achieved, we're pretty much done on the job of getting the central GFD down to the target of 3% of GDP. Hence, the gains which were obtained in recent years, of a sharply dropping fiscal deficit, will not be repeated in the future.

There were two reasons to shoot for a fiscal deficit of roughly 2% this year:

  1. From a business cycle perspective, these are the best of times. A fiscal stance that is roughly achieving the FRBM target of 3% in these best-of-times involves acute fiscal stress when there is a business cycle downturn. A fiscal deficit of 2% for 2007-08 would have meant a fiscal stance that was basically FRBM-compatible.
  2. Rapid deficit reduction could have been a contractionary device to help check inflation [link].

But this policy option, of getting down to a 2% fiscal deficit, was not taken. Good times were used, instead, to sharply grow `plan' expenditure. Roughly speaking, a percent of GDP is Rs.40,000 crore. Instead of devoting that last Rs.40,000 crore to deficit reduction, it has been tossed into `plan' expenditure.

Tax reforms

The peak customs rate and many other customs rates were dropped a bit. This will reduce local prices; improve the competitiveness of exports; increase the trade/GDP ratio; improve resource allocation locally; induce GDP growth. I should remind the reader that the "peak" customs rate is not the peak: many, many products are above it. It's probably more like "the rate we'll use if we don't have any special thoughts on our minds".

Apart from this, there was no progress on tax reforms. E.g. on the GST, there was just a pious phrase, but not the kind of brick-and-stone implementation that is required. I have blogged separately on a mistake that has been made on the tax treatment of venture capital. In my mind, UPA politics does not particularly impede such areas of progress, so the daunting political backdrop does not explain the lack of progress [see article by Bibek Debroy].

Size of the State

The situation on growth of the State is as follows (all numbers as percent of GDP):

Element 2005-06 (A) 2006-07 (R) 2007-08 (B)
Non-plan non-interest 5.48 5.21 4.81
Interest 3.723.533.40
Plan 3.95 4.17 4.39
Total 14.21 14.03 13.72

Interest payments reflect a combination of the debt/GDP ratio and the cost of financing public debt. They have dropped slowly, primarily responding to lower interest rates on incremental debt issuance.

`Plan' expenditure is money spent on major programs such as the National Rural Health Mission or Sarva Shiksha Abhiyan. This is where the UPA has dramatically increased outlays, going from 3.95% of GDP to 4.39% of GDP over a two year period.

`Non-plan' expenditure is the remaining expenditure of government. In my understanding, all the expenditure on genuine public goods, such as judges and policemen lies here. It has been shrinking.

The overall picture adds up to a central expenditure/GDP that dropped slightly from 14.21% to 14.03% to 13.72% of GDP.

There is a lot to be dissatisfied about about this game plan. One could have argued for a bigger reorientation in favour of expenditures on public goods. One could have argued in favour of using the fiscal space of a business cycle upturn to achieve deficit reduction. But broadly, despite these difficulties, it is not an alarming situation where the expenditure/GDP is growing. At worst, if projections go wrong, we might endup with an expenditure/GDP for 2007-08 which is flat at 14.03; if things go right, we will endup at 13.72. The numbers are not as dangerous as the welfare-program rhetoric.

Mechanisms for provision of public goods

The main game plan of the UPA for winning the coming elections seems to be: exuberant spending on the `flagship schemes' such as NRHM, SSA, NREG, etc. There is limited evidence that these schemes work well. The right area to focus on would have been to look for more bang for the buck. The UPA seems to be content with just more buck.

There are some signs of fresh thinking in education. On one hand, FM announced an excellent `scholarship' program (para 20) where 100k children will be given Rs.6,000 a year in class 9,10,11,12. The entry of 100k children every year means that within four years, there will be nearly half a million children in this program.

There will be an exam that filters entry into this. But it won't be like many other ridiculous Indian competitive examinations, like (say) the NTS which in my time was awarded to 250 students in the country. A full 100,000 children all over the country will get through, and then get a decent scholarship of Rs.6,000 per year which is big enough to be attractive to most families. Assuming roughly everyone who finishes class 7 will take this exam, it will also throw up wonderful data on learning attainments at class 8.

I think this is an excellent strategy for addressing the bulge of children coming out at class 8. For more on this subject, see this article from February 2006. While this effort is very, very good, it remains vulnerable to the weaknesses of curriculum and examinations of CBSE and other 12th standard level coursework in India.

The speech has a host of other scholarship programs - for SC/ST/minorities. It makes a lot of sense for the State to provide such politically targeted scholarships, rather than fundamentally distort the educational system through quotas or other interference in the mechanisms of how schools and colleges work. The big picture should be one where if there is a political reason to gift someone some cash, that is okay, but this should be done without contaminating the overall resource allocation and growth.

Finally, the speech has a plan for shifting 1396 ITIs into public-private-partnership. The devil is in the details, but if (in principle), 1396 ITIs could be transformed, that would be pretty cool.

So my broad sense about Budget 2007 is that primarily it's the UPA trying to throw money at their `flagship schemes' in the hope that some of this will generate votes, with a small layer of clever thinking layered on top of it.

Structural reforms

The establishment of the Debt Management Office (DMO) is, in my opinion, a truly big deal. It links up to larger questions of RBI reform [link]. But even viewed in isolation, I think it's the biggest milestone in Indian monetary reform after the 1997 ways and means agreement. Economic Times has an edit on this, and I say in my piece in Business Standard:

Perhaps the most important announcement of the budget speech, in terms of long-term structural economic reforms, concerns the establishment of an independent debt management office (DMO). For all these years, India has burdened the RBI with the task of being the investment banker for the government. This is an onerous burden for the RBI, for there is a severe conflict of interest between setting the short interest rate (i.e. the task of monetary policy) and selling bonds for the government. If RBI tries to do a good job of discharging the responsibility of selling bonds, this involves selling bonds at high prices, i.e. keeping interest rates low. This leads to an inflationary bias in monetary policy.

An additional conflict of interest is caused by RBI being the regulator of banks also. If RBI tries to do a good job of discharging its responsibility of selling bonds, it has a bias in favour of forcing banks to buy government bonds. This generates a bias in favour of flawed banking regulation and supervision, so as to induce banks to buy government bonds and particularly long-dated government bonds. This has hurt the safety and soundness of banks in India.

In addition to these core problems of conflicts of interest, Indian debt management has many other weaknesses. There is no one place in the country where there is a full database of all the liabilities of GOI. This information is, hence, not used for risk management and optimisation of the financial burden of GOI. There is a big gap between the way mature market economies apply sophisticated financial economics for the purpose of devising optimal strategies for debt management, and the state of play in India.

As far as the mechanics of implementation are concerned, the budget speech says `in the first phase, a Middle Office will be setup'. A mid-office would constitute a single comprehensive database about all liabilities and guarantees of GOI, and a risk management overlay which improves the risk profile of the overall portfolio. It is the logical starting point for the construction of DMO. If MOF is able to get key staffpersons with experience in state-of-the-art debt management in public sector settings, it is possible to setup the mid office in 9 months, and have the DMO fully running in 18 months.

In 1997, RBI and MOF signed the `ways and means agreement', which was the first milestone in modernising Indian monetary policy. The separation of government's investment banking function from monetary policy, ten years later, marks the second important milestone in Indian monetary reform.

2 comments:

  1. Dear Dr.Ajay,
    Let me first introduce myself. I am A.V.Raman and I remember your talk even now.
    Long back I had the pleasure of your company in Deolali in the year 2000 I think when I was doing my BA in Christ College Bangalore, in a Liberty and Civil Society seminar organized by the Centre for Civil Society.

    I chanced to see your blog in the internet. I moved on from there to do my MA and MPhil in Sociology from my University of Hyderabad with Industrial Relations and Sociology of Work being my areas of interest. Currently I am in the Department of Sociology, University of Warwick, Coventry UK. pursuing my full time PhD in Industrial Relations intending to become a full time academic!
    Best Regards
    A.V.Raman

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