Terrorism, meltdown and fiscal chastity
S. S. Tarapore, BUSINESS LINE, 5 12 08
India must fight the wars on terrorism and financial meltdown, effectively and expeditiously. The government needs to undertake selective and focused pump-priming and generalised payouts should be avoided, says S. S. TARAPORE.
Let there be no mistake about it. India is a country at war — a war on terrorism and a war dealing with the global financial meltdown. These wars have to be fought effectively and expeditiously and there are unavoidable costs as also collateral damages. At the control room of these insidious wars is the Indian fisc. If we are to maintain strict fiscal rectitude, the country may face serious damage and if we resort to skilled financial engineering to skirt around the costs, we would lose the other vital war against inflation. There are no soft options.
The war on terrorism has to be fought without any cringing on the financial costs. The expenditure on countering terrorism should not be kept on a tight leash, though there should no doubt be proper accountability, Let us not believe that a few coppers would suffice.
This is priority No.1 today and we should be prepared to meet whatever cost it takes to effectively combat terrorism. The costs of an effective response could be colossal and while earmarking is not a good principle in public finance, there should be a special tax/cess earmarked for this purpose; the citizens of this country would be willing to bear this burden. The words of Bob Dylan would surely ring in our ears:
“Yes ‘ n’ how many deaths will it take till he knows
That too many people have died.”
The backwash effect of the global meltdown on the Indian economy would be lagged and long drawn out. Monetary policy is not an efficient tool for handling such emergencies. The appropriate instrument is fiscal policy: Fiscal surpluses must be built up during the upturn of the cycle and fiscal deficits resorted to during the downturn. In the Indian case, however, there are large fiscal deficits at all times, irrespective of the stage of the cycle and this poses a constraint when an expansionary fiscal policy is warranted.
It has been “Such a Long Journey” as Rohinton Mistry would put it, from Dr C. Rangarajan’s Indian Economic Association Presidential Address in 1988, calling for an Accord between government and the RBI, followed by the two Supplemental Agreements between the RBI and government in 1994 and 1997; the E. A. S. Sarma-Y. V. Reddy Report in 2001 and, finally, the Fiscal Responsibility and Budget Management (FRBM) Act, 2003.
Under this Act, the revenue deficit was to be wiped out and the gross fiscal deficit (GFD) reduced to 3 per cent of GDP; this target has been successively moved forward to March 2010. Furthermore, RBI’s support to the market borrowing of the government was also phased out.
Surplus to deficit
While there is a general perception that a revenue deficit was all along part of the system for the past 60 years, it bears mentioning that up to 1978-79, there was a revenue surplus. There should be a reversion to the earlier practice of a small revenue surplus. It would appear that, in 2008-09, fiscal expenditures are lurching out of control. In the current financial year, up to October 2008, the revenue deficit was 57.7 per cent above the full year’s target, while the gross fiscal deficit (GFD) was already 87.8 per cent of the full year budget estimate.
What is more alarming is that the quasi fiscal deficit (the deficit kept outside the budget) in the current financial year has been estimated at 5 per cent of GDP and even if it is eventually lower because of the reduction in the international crude oil price, the overall GFD, in effective terms, would be way above the 3 per cent envisaged in the FRBM.
All signs point to an economic slump in the industrial countries. Paul Krugman calls it a “nasty brutish and long” recession which could be a euphemism for the forbidden dirty word “depression”.
While in countries where there is reasonable monetary-fiscal control, it makes sense to undertake a large fiscal stimulus, in India, there is a dilemma in that the fisc has been out of control even before the global financial meltdown. The global meltdown would impact India in two ways. First, the international slowdown would inevitably impact exports. Second, a number of industries and financial institutions are fragile and need some fiscal relief.
There are vocal advocates for a large and quick fiscal stimulus but this would have a crowding-out effect. In some ways, the government is damned if it did and damned if it does not. What should the authorities do? The government needs to undertake selective and focused pump-priming; generalised payouts should be avoided.
There is talk about a large fiscal stimulus akin to that in the industrial countries. There is, however, a major difference. The industrial countries have witnessed a recession (defined as two successive quarters of negative growth). In contrast, the most pessimistic estimates of growth in India is 7 per cent in 2008-09 and 6 per cent in 2009-10. Thus, it is not feasible for India to ape the industrial countries and undertake a large fiscal stimulus to deal with the fallout of the financial meltdown in the industrial countries.
Furthermore, in India, we face two separate problems. One, the war on terrorism could conceivably require large outlays of expenditure. While it is difficult to put any precise number to this requirement, whatever be it, the nation cannot afford to stint on providing the necessary resources. Two, the global meltdown should not be an excuse for acceding to the general clamour for subventions; nonetheless, a select fiscal stimulus may be necessary.
How should the total additional expenditure be financed? First, there should be an across-the-board Security Tax Surcharge on all taxes — direct and indirect. Second, there should be a carefully crafted reduction in the plethora of exemptions for both individuals and corporates.
Third, any reduction in the petroleum prices should be deferred for the time being. Fourth, subsidies should be gradually reduced. Fifth, an increase in the borrowing programme may be necessary and this would entail higher costs of borrowing. Sixth, there should be no further monetary stimulus at this stage.
Per contra, there may be a need for some balancing assistance on a select basis for sectors affected by the global financial meltdown. Again, to the extent some investment is deemed necessary, the government should undertake labour-intensive projects with substantial backward and forward linkages.
There are some intemperate thoughts being floated suggesting that the RBI balance-sheet should be made part of the Consolidated Fund of India. While this would be a disastrous gimmick to cover the fiscal deficit, it is a serious matter and needs separate treatment.
It would be imprudent to relax or abrogate the FRBM. To quote Dr Isher Ahluwalia, “The FRBM is like a chastity belt, don’t loosen it without a better alternative”.
3 European Central Banks Cut Rates
Top of Form
Bottom of Form
By CARTER DOUGHERTY December 4, 2008, BRUSSELS
Interest rates fell at a historic pace across the globe Thursday as central banks sliced borrowing costs in a bid to stimulate stagnating economies and revitalize credit markets still idling despite huge government rescue packages.
The European Central Bank knocked down its benchmark interest rate by three-quarters of a percentage point, to 2.5 percent. The reduction is the largest in the bank’s 10-year history, capping a furious end to 2008, a span in which the bank nearly halved its key rate and provided ever-easier credit to ailing banks.
The magnitude of the bank’s efforts has made clear that it is worried about an economic downturn that is becoming broader and deeper by the day. The central bank was mapping out a strategy that is, in word and deed, less drastic than that of the Federal Reserve, at the epicenter of the crisis in the United States, but nonetheless precedent-setting.
The bank’s rates have not reached their lowest levels ever, but most economists expect they will do so early next year. The central bank president, Jean-Claude Trichet, made clear that the bank was considering that and more.
“If new decisions are needed, we will take new decisions,” Mr. Trichet said after a policy meeting in Brussels, later adding, “I exclude nothing.”
The Bank of England did its part as well Thursday, cutting rates by a full percentage point, to 2 percent, the lowest level in 50 years. When it next reduces rates, as most economists expect early next year, it will have brought borrowing costs to their lowest level in the institution’s 314-year history.
The European Central Bank accelerated its rate reductions as new projections from its staff suggested the economy of the 15-nation euro zone would be lucky to emerge from its current contraction in the second half of 2009.
Inflation, only six months ago a source of angst for the European Central Bank, will undershoot the bank’s goal of close to 2 percent in 2009, according to the forecasts.
“Price stability is important,” said Erik Nielsen, chief Europe economist at Goldman Sachs. “But what they have done over the past two months is huge for them.”
Across the English Channel, the Bank of England looked close to tossing out the rule book entirely, as it faced an economic crisis led by a free fall in the country’s flagship industry, financial services, where sweeping layoffs are underscoring how bad it could get.
Heavily indebted consumers who are now curbing spending are prompting a sharp rise in British unemployment, and the British central bank now seems ready to deploy its financial firepower unsparingly.
“They are pretty much signaling that they will go as low as zero,” said Jacques Cailloux, chief Europe economist in London at Royal Bank of Scotland. “They will do anything they can to prevent any sort of vicious spiral through the economy.”
The Swedish central bank delivered much the same message on Thursday.
It reduced its key lending rate by 1.75 percentage points, to 2 percent. Earlier in the day, the New Zealand central bank also lowered rates, underscoring the rapidly unfolding global easing of monetary conditions. Indonesia, which had not been expected to move, made a surprise cut Thursday in its main rate, by a quarter-point, to 9.25 percent.
Mr. Trichet distanced the European Central Bank from the Federal Reserve’s policy of “quantitative easing,” or pumping cash into the economy to pressure banks to lend.
“We are all doing what we trust is appropriate,” Mr. Trichet said. “We are not all in the same situation.”
Instead, what is shaping up in Europe is a policy that combines very low interest rates with less orthodox methods of persuading banks to step up lending to the rest of the economy. For example, the European Central Bank is considering changes to its deposit facility, which many banks are using to hoard their cash.
The European bank is reluctant to cut rates more quickly and promise to keep them there, as the Fed has effectively done, because it ties the bank’s hands in tightening credit later when the crisis has passed. Previous promises of easy money are commonly blamed for creating the housing boom whose collapse is at the core of the current crisis.
“The E.C.B. has no intention of inflating its way out of a debt bubble as the Fed is preparing to do,” said Elga Bartsch, chief Europe economist in London for Morgan Stanley.
Mr. Trichet also emphasized that central banks could not fight the crisis alone.
He criticized governments and the European Commission, the executive arm of the 27-member European Union, for not moving quickly enough to put in place the bank recapitalization and guarantee plans that were rushed through legislatures in October.
European antitrust authorities have come under fire for not approving the programs more quickly, and the central bankers pressured a top commission official at their meeting Thursday to accelerate the process.
The European Central Bank’s reluctance to outline a more forceful strategy for the future exposes it to the charge that it is underestimating the severity of the downturn, and that it is passing on opportunities to get ahead of it, analysts said.
Kenneth Rogoff, a former chief economist at the International Monetary Fund, said the bank was finding the shift difficult “after years of fighting the old battle” against inflation, but urged it to act more quickly.
“You build up anti-inflation credibility precisely so you can use it in an emergency,” Mr. Rogoff said. “This is an emergency.”
David Jolly contributed reporting from Paris, and Bettina Wassener from Hong Kong.
Rate cut in the offing
Our Bureau Business Line, Mumbai, Dec. 4
The Reserve Bank of India is expected to announce another set of measures, including a rate cut, on Saturday, as part of its efforts to boost demand in the economy.
The central bank has called a press conference on December 6 which will be addressed by the Governor, Dr D. Subbarao.
The market has been expecting a sharp cut in reverse repo by the RBI to prevent banks from parking their surplus funds with it or invest in government securities, instead of lending.
Banks have been deploying huge surpluses, almost to the tune of around Rs 50,000 crore, since the last few days at the RBI’s reverse repo window. This is a clear sign that banks are more comfortable earning 6 per cent interest by parking funds with RBI than lending. Another sign of banks’ risk aversion is that, off late, the government securities market has been recording a robust turnover, averaging around Rs 10,000-Rs 15,000 crore daily.
Inflation has also eased to a seven-month low. The Wholesale Price Index (WPI) based inflation has come off to 8.40 per cent in the week ended November 22 as compared to 8.84 per cent noted in the previous week. Softer inflation will give the central bank headroom to pare signal rates. “We expect the RBI to cut the reverse repo and repo by around 100 basis points each. The cut in reverse repo rate will force the banks to go back to their core function of lending. It is unlikely that the RBI will tinker with CRR and SLR,” said a dealer with a public sector.
The government securities market has already discounted the rate cut by the RBI with prices going up by almost two rupees on Wednesday. On Thursday, profit booking resulted in prices coming off by 50 paise to a rupee.