The growth rate has come down and the authorities are seeking to promote growth by reducing interest rates. But this growth is funded almost entirely by government investment using created money. The external funding required to import machinery and equipment may be carried out by project funding through Chinese loans. But it would appear that even China no longer depends only on the Sovereign standing of the Government as security for its loans but wants hypothecation of the project assets they will build. According to Acemoglu and James Robinson investment alone is not enough. The institutional capacity must also be built up and here we see institutional collapse instead.
Development through money creation
But growth funded by money creation to tide over a fiscal deficit will worsen the current account of the balance of payments. Then the knee jerk reaction of the Treasury is to clamp down imports through imposition of higher tariffs and domestic taxes. But then it finds that the government tax revenue goes down and suddenly decides to reduce the tariffs and taxes as it happened in the case of the import of vehicles. But such tariff and tax increases, whether to protect import substitutes produced domestically or to protect the rupee, also reduce growth and worsen exports. 50% of the inputs of our exports is from imports. Further when the prices of tradables increase, the real value of the rupee falls while the government maintains the nominal value making our exports uncompetitive.
The Central Bank liberalized foreign currency borrowing by firms and banks. Despite the exchange risk and even higher cost of funds, the banks (particularly those controlled by the authorities) have gone in for such borrowing. But meanwhile the rupee depreciates in the foreign exchange market as the demand for dollars exceeds the supply of rupees. The Central Bank is bullying the forex dealers not to quote high for the dollar. But how long can it do so? How will those who need dollars obtain them? These tactics work only in the here and now, that too not without cost. The banks merely reflect the demand for dollars by the public. Those who earn the dollars by exporting will feel less inclined to bring them back.
The Central Bank also suppressed the shorter end of the Treasury Bill market because the lenders were asking for higher yields. It is due to reduction in liquidity and expectation of higher inflation in the future.
What is required is to take necessary measures to reduce the current account deficit in the balance of payments and that means the fiscal deficit must be reduced in absolute numbers without harping on the Debt/GDP ratio where the GDP in money terms includes inflation. This ratio is 80% and the authorities are arguing that it has come down over the past when it was over 90-100%. Two economists, Reinhart and Rogoff, published a research paper showing that when the ratio exceeds 90% there will be a steep fall in economic growth (we had negative 1.5% growth rate in 20001 with debt ratio of 95%). But subsequent studies showed some errors in their data and the consensus now is that instead of a steep fall there will be a slow decline in growth as the level of debt rises.
The government’s fiscal deficit is now increasingly funded by domestic bank borrowings. This pre-empts resources from the private sector. In the first quarter of this year 82% of the bank credit went to fund the public sector. This quarter is better but unless there is sufficient credit growth to the private sector, its growth will slacken as it seems to be happening.
Financially over-leveraged companies
The private sector, particularly some finance companies and stock broker firms are over-leveraged. They also carry bad debts which are not being written off and their capital replenished since they live in the vain hope that the market will once again take off to save them from bankruptcy. Unless the debt overhang in the form of bad debts is cleared, the stock market is unable to regain normal turnover. Shares which are acquired by foreigners keep rising pushing up the All Share and S&P Price indices. But with the uncertainty in the exchange rate foreigners are being cautious. Those who have already invested will be on the look out to see if a steep fall in the rupee will wipe out their capital gains. Those who expect the rupee to depreciate more will hold back their purchases.
There was a Stock Exchange rule which required a company to have a three year profit record before it could qualify for listing in the stock market. But this rule was flouted and doddering finance companies with dodgy loans have been listed exposing both equity holders and depositors.
It is in the above scenario that the Central Bank wants to reduce interest rates. It has reduced the deposit rates by fiat and also reduced the yields on government bonds. This is a time when the rupee is weak and the current account deficit is large. Orthodox economics doesn’t justify lowering interest rates in such circumstances. Some foreign investors and the government bet on an economic recovery but there is no one to provide the extra capital required for such higher investment. Local firms can borrow from abroad only if they have strong balance sheets. There is a new unease expressed by the rating agencies about the Sovereign Debt. In the last five years the government went for such bonds but doesn’t seem to have the stomach to do so now.
The government is still able to borrow foreign currency particularly from China. As for the government investment program, it is not possible to curb projects which are on-going. But new projects should be subject to rigorous cost/benefit analysis so that they produce a return to at least pay back the foreign loan and interest charge to service them. The UDA is running a program to beautify the city. Yes it will help in attracting tourists. But who is going to pay the costs? Shouldn’t the beneficiaries not pay the cost? Or should the costs be recovered from the poor taxpayers in the country by way of indirect taxes on goods and services?
If the costs are not paid directly by those who benefit as in the case of road tolls, it will be the public at large who have to pay for the investments. This will reduce their real disposable incomes. According t a Household Survey of Expenditure the households are already spending more than what they earn as incomes. They will either run down their savings or get into debt. This is at a time when the country is running a current account deficit in the balance of payments. It’s time the government adopt frugal public expenditure by cutting down on the costs of the political establishment as the new Chinese President Xi Jin Peng has announced.
If economic growth is to be sustainable, it must be based on profitable growth by all economic agents both in the public and the private sector, where the companies are making profits and investing for the future. But subsidies distort the cost of resources and prevent the business firms from making proper business plans. If no fare increase is granted, the private bus operators will at a minimum reduce the number of buses they ply and this will make the government unpopular.
The minister in charge of private passenger transport appears on television and vows that he would not allow the private bus operators to increase bus fares from next month. The private operators say that costs of diesel have gone up and they cannot run at a loss. The government never seems to learn that businesses cannot be run at a loss and will have to be closed down if they are losing.
The ministers don’t seem to understand that like the government the private bus operators cannot run at a loss. For years the government subsidized the consumers of electricity and petroleum products. Ultimately it had to change the pricing policy and recover the costs. The government was able to do so only because the state owned banks funded the losses. At last the government accepted the IMF recommendation and raised the prices to reduce the subsidy. There is no economic logic in selling products below cost. Socialist rhetoric over the years argued for subsidies for the poor. Yes there may be a case for subsidies to the deserving poor although even in such a case economists say it is better to give them cash grants instead of subsidized goods.
When the price of something falls or is held at a low level the demand for it rises, but supply does not. If you tell oil companies what they can charge for petrol and impose price control on petrol they will reduce the amount they sell, creating shortages. If you impose price control on any commodity be it bread or petrol which are supplied by private sector enterprises there will emerge shortages and a black market. Likewise, if you put a price ceiling on bread and milk, or shirts and shoes, consumers will buy more of them, but stores will stock less of them or, if the price is low enough, none. Didn't the CTB go into bankruptcy because of inability to raise fares while having to accommodate politicians who wanted it to employ their supporters pushing up costs unnecessarily? When will these politicians learn?