Fiscal Deficit & The Quality Of Government Expenditure

INTRODUCTION
With the Fiscal Responsibility Bill stalled, the pre-budget time is apposite for taking another look at this issue. Fiscal sustainability has three aspects. One is the trend in the debt GDP ratio as determined by the primary surplus/deficit and the growth rate relative to the real interest rate, second the quality of government expenditure and third the efficiency of the tax system. In this article we focus on the quality of government expenditure. One of the most important implications of the fiscal problem in India is that the government has no money to spend on essentials. The basic problem is therefore of identifying and eliminating wasteful and unproductive expenditures so that the fiscal deficit can be eliminated and more money spent on essential government functions.
INTEREST EXPENDITURE
Interest payments are a major item of expenditure, with about half of total Central government revenue spent on interest payments. They thus “crowd out” other potentially more productive items of government expenditure.
In drawing implications for the present and future it is important to look back into the past. Interest on accumulated debt is the embodiment, as it were, of past sins. That is borrowing to finance past government expenditure. In the past few decades such expenditures consisted of both government consumption (or revenue expenditure) and unproductive investment (or capital expenditure). Thus concern about interest payments is implicitly a concern about the volume and/or quality of expenditures in the past. Some of these past government consumption and unproductive government investments are rightly viewed as crowding out present government expenditures.
One implication of this line of reasoning is that to the extent that this debt was incurred in financing investment or capital it should be allocated and assigned to these investments and the concerned organizations (e.g. PSUs, PSBs, DPEs or administrative departments). A substantial part of the indirect subsidies are the cost to the government of servicing the debt assigned to each of these organizations (organized by sub-sectors & budget heads instead of by organisations). The rest is the depreciation of these assets and their quality because of lack of replacement investment. The net value of these organizations to the government (family silver or copper as it may turn out to be) is therefore the gross value of assets or equity owned by the government in each organization minus the debt incurred by government in setting them up.
The major policy implication is that, if we are concerned about government debt and interest payments, we should sell all units producing “private goods & services” and use the proceeds to repay the debt. Operationally this could be done by creating an independent dis-investment organization and assigning to it both the ownership of the equity and an equivalent amount of debt obligation and giving it the mandate to eliminate both in an efficient way over a fixed period of time. This would reduce government interest payments over time, eliminate the crowding out of current expenditures by interest payment and allow government to focus on essential expenditures.
PUBLIC GOODS
The next question that arises is what are these “essential” government expenditures that have a higher claim on government revenues? One important category consists of Public Goods & Services. Public goods are characterized by an element of non-excludability (e.g. defence, police) or very high transaction costs for pricing (e.g. local roads) so that they cannot be charged for on an individual basis. They (public goods & services) are almost by definition items that must be paid for out of tax revenues.
They include,
i) Roads [excluding major, high density highways] & Water ways [river navigability, drainage systems, flood control]
ii) Legal System [laws, courts, judges]
iii) Public security system [police, prosecutors, jails]
iv) Public Health systems [Communicable diseases, epidemic monitoring & control, Public drinking water, sewerage & sanitation systems]
v) R&D on socially beneficial areas, including tropical diseases, agriculture (e.g. appropriate crops & rotation patterns for different agro-climatic regions), pollution.
vi) Public Education [rights, responsibilities, civic & democratic virtues, public morality, productive knowledge (e.g. agricultural extension), preventive health & population restraint, pollution abatement, water conservation]
vii) Environment & Pollution, forests, parks.

Central and state governments have spread their limited resources too thinly over too many areas and items of expenditure. As a result many of these essentials have suffered from a lack of resources and attention, and the availability and quality of these public goods has deteriorated dramatically. The time taken in court cases is legendary. Those of us who believe that Bihar and Eastern UP is hundreds of miles away may be surprised to know how badly the local/ground level police systems have deteriorated in the heart of the capital of Delhi. In this era of severe fiscal problems it is in my view essential for government to go, “Back to Basics” and refocus its attention on public goods & services.
As most of these public goods will continue to be produced or supplied by government to large extent for quite some time it is essential to improve the efficiency of production in terms of cost & quality. This is considered below
EXTERNALITIES & SUBSIDIES
Degree of Externality
The second essential area of government expenditure is on subsidies for those goods and services that have large externalities. In principle all private (non-public) goods & services can be assigned to three categories: Those with high, medium and low or no externalities. Elementary education, rural water supply, adult literacy, rural secondary education and development of markets in remote, hilly & backward areas have high externalities.
Policy Implications
Two policy implications follow:
a) Phase out subsidies on goods & services with low or no externality such as Industry, power, shipping, road transport, other transport, coal & lignite.
The phase-out schedule must however give sufficient time for,
(i) Developing a clear, transparent and positive framework for private production & supply,
(ii) An independent regulatory framework for natural monopoly segments and
(iii) Consumers to adjust to higher cost-based prices (excluding X-inefficiency costs of monopoly & corruption).
b) Align the actual subsidy ordering with the ordering of degree of externality.
This is implicit in the calculation of financial gains of phasing out subsidy.
PRODUCTION EFFICIENCY
Relative Inefficiency of Public Production & Supply
Even if there is a need for government subsidy, it does not follow that the good or service must be produced and/or supplied by the government. Government should only produce and supply such a good or service if its efficiency is higher than that of the private (individual, co-operative or corporate) sector and non-profit organisations (NPOs).
There are inherent problems in government production and supply of private goods & services. The CAG & other government auditing procedures are not conducive to commercial production and supply, particularly in a highly complex economy subject to myriad risks and shocks. The principle agent problem means that public employees and their overlords have a strong incentive to first create rents & then appropriate these rents for themselves. As a result corruption has gradually become endemic and there is much evidence that government production is less efficient than private. The only profitable government entities are either ones in which resource rents (the difference between world price and the full cost of extraction) can be disguised as profits, or government created monopolies (created by banning private production or investment for decades) with no private benchmarks for comparison.
The production, supply & maintenance of most of the subsidized goods produced by the public sector can and should be progressively opened to the non-profit organisations, co-operatives and private providers. The first step would be to develop a supportive policy framework for private entry. A modern regulatory framework must also be created for social sectors where quality is difficult to judge before purchase but is critical to the future of individuals.
Solution
There are many detailed issues involved in improving the efficiency of government programs. From a broad (macro) perspective, this requires improvement in two areas through dramatic changes:
Public Accountability
The key to public accountability of government agencies supplying goods & services and government servants and political masters overseeing them is the citizens’ right to information. A “Right to Information Act” must be enacted to return this right to the public. The poor in whose name all expenditures are justified must have the right to know all the facts relating to expenditures made/justified in their name. The information needed to be made publicly available includes the names of those who have authorized or spent the money, the purpose for which the money was spent, the names of the companies or individuals who received this money and what they have produced/done for receiving this money.
Issue specific user groups must be empowered to share with Panchayti raj & other government institutions the responsibility for monitoring public activity at the village and local level. For instance, all parents of school age children in the village (or set of villages) must be part of a user group for monitoring the activities of the village primary school, its teacher and the government supplies allocated to it. Similar user groups should be set up for all local public goods and services provided by the government.
Modern Management Practices
A complete and thorough modernization of the systems and procedures for production, supply and procurement of goods & services is needed. Perhaps not more than 25% of government projects use PERT/CPM a technique of project management, a technique that was developed in World War II and taught in US engineering colleges since the sixties. According to an informal survey only a few progressive organisations like NTPC use these techniques. Modern inventory control is a subject I recall discussing with the Navy chief over a decade ago, only to read in the newspaper recently that the armed forces still do not have modern inventory management systems.
INCOME TRANSFERS
Many government expenditure programs are hypothetically directed at the transfer of income to the poor, while several subsidies are justified by such reasons even if the externality is low. An additional consideration enters the picture in this case: The (transaction) cost of direct vs. indirect transfers. Indirect transfers have some self–selecting features but higher transaction costs. We must start experimenting with the use of new smart card technology for providing income transfers to the poor, in place of the plethora of poverty alleviation programs with enormous administrative cost and notorious leakages.

Capital Account Convertibility: Looking Back and Ahead- Lessons from the Asian Crises

IntroductionThe Asian crises has come and gone. The period in which forecasts of its negative effects were continuously revised upwards was followed by constant downward revision of these effects. The current consensus is that, even though the initial severity of the crisis was surprising (given that it occurred in economies thought to be “miracles”) the recovery was as quick as in other previous crisis. As in the case of our own BOP crisis of 1991 the “Asian crisis” was due to a mix of underlying Structural Problems, increasing Macro-economic Imbalances and Triggering Factors or Events. In a few countries like S. Korea recovery has been as fast as (or faster than) in India, while in others like Indonesia it is likely to be much slower. The speed of recovery has depended on the vigor with which some of the critical structural and macro problems have been tackled. Both the problems and the solutions are by now reasonably well understood.
It is therefore time to put aside some of the irrational fears unleashed by the “Asian Crisis” and resume the process of moving towards capital account convertibility. As has been our practice so far, this should be done with “all deliberate speed,” that is at a speed which is reasonably fast but does not involve excessive risks.
Lessons from Crises: Old & New
Though the Asian crisis has come and gone, the processes of separating the right lessons from the wrong ones, is not complete. More important, the lessons for the crisis countries may differ in important respects from those for India. It is necessary to be clear about the lessons for India, before we start applying them to the issue of Capital Account Convertibility for India.
We had already learned several lessons from our own crisis of 1991 and the Latin American crisis of the previous decade. The Eighth Plan working group on Balance of Payments (1989) had analysed India’s debt profile and suggested two fundamental changes:
a) A decrease in the ratio of short term to total debt as the former was dangerously high.
b) A strong effort to attract Direct Foreign Investment so as to decrease the external debt-equity ratio of the country.
A Planning Commission paper [1989] showed that the Fiscal Deficit had risen in tandem with the current account deficit. It subsequently became clear that the former was a major cause of the latter and several government economists were internally warning about the dangerously rising Fiscal Deficit (before the crisis).
The fixed overvalued exchange rate was also recognised as a major cause of the sharp rise in the current account deficit and the 1991 crisis. Opening of the current account over the next two years was therefore accompanied by a flexible exchange rate policy. Post-crisis it was also recognised that the regulatory system for banks as well as stock markets had to be modernised and strengthened. Efforts in this direction started in 1992 and have continued steadily (though not very fast in some sub-sectors) since then [PC working paper 2001/4].
The Asian crisis did reinforce (and make widely known) the importance of flexible exchange rates and Banking de-control & regulatory reform. It is now more widely recognised that the banking regulations have to be brought up to international standards.
There were, also, a few more specific lessons, which are of relevance to our move toward capital account convertibility. In each of the affected Asian countries the crisis lasted about a year and recovery has taken place in two to three years after onset. Even in Indonesia the basic crisis lasted for about the same time and continuing uncertainty is largely due to political violence and constitutional upheavals. This pattern of crisis and recovery is very similar to the Mexican crisis of 1994. Fixed exchange rates and excessive external short-term borrowing (defined as less than one year) were the two most common macroeconomic culprits. The obverse of this proposition is that external loans with residual maturity of over one year did not add at all to the crisis, as the crisis was over within a year. Portfolio flows proved to be somewhat more volatile than expected, partly because of the fixed exchange rate; nominal exchange rate had not been allowed to appreciate in the preceding period of large inflows. As expected, however, stock market declines from panic sale of foreign portfolio equity proved to be self-correcting. The problem of declining stock prices and capital flight was limited to less than a year, as net inflows re-started as soon as the bottom had been reached. Further there is a strong suspicion that as in the Tequila crisis, capital flight originated from domestic investors and not foreign ones. Conversely FDI again proved to be much more stable with reductions in net inflows but no net outflow even during the crisis year. Overall lessons, namely the need for flexible exchange rates, flexible interest rates, competitive stock markets and open forward markets are both helpful in avoiding crisis and in ending them rapidly.
On the structural side, the greatest underlying problem was the control mentality and subversion of markets by the government, alone or in tacit or open collusion with business and financial institutions. More specifically, excessive lending for real estate, which may have been part of the problem in some countries, represented bad lending practices and poor regulatory systems. The problem was not equity investment (domestic, FDI or portfolio) in real estate firms per se, but excessively risky lending to firms (high debt-equity ratios). This was part of a more general problem of highly leveraged firms obtaining further loans from banks, which modern prudential regulations could perhaps have identified as excessively risky for the financial system as whole.
Capital Account Convertibility Reform
Formally we became convertible on the current account in 1994. There is a need to eliminate the gap between the theoretical position and the reality. All import controls (QRs) imposed on protection grounds were eliminated by April 1st 2001. The lifting or easing of exchange controls has however been very limited. Use & purchase of foreign exchange by individuals to import goods and services into India should be made virtually free by April 1 2003. This can be effectively achieved by allowing individuals to use international credit cards or bank cheques (FE denominated accounts) for purchasing goods & services up to a value of $100,000 per annum. This limit could be phased in over the next year, in two steps, starting with an immediate announcement of a $50,000 per annum (per resident) limit (R1). The credit card records would be available to RBI (as well as to the Income Tax department) and any violation of the provision would attract penalties under FEMA. The limit could be raised to $100,000 within the next 13 months (R1b).
Asset Purchase: Residents
A significant step towards capital account convertibility could be made, by simultaneously allowing individuals, businesses and Corporations to make capital transfers abroad, including for opening current accounts (R2). This would be up to a limit of US $100,000 per annum per resident, to be phased in the same manner as the limit for purchases. Within this limit employees of Indian companies could also invest in the ESOPs of foreign companies. The resident entity would however be required to keep a record of all such transactions and the assets so purchased, for showing to RBI or other designated authority when required to do so. In fact there could be a single overall limit of $100,000 that includes both current and capital account transfers.
These two recommendations can be combined together into the following single one:
Recommendation 1: Every resident individual should be allowed to use up to $50,000 per annum to purchase goods or services abroad, to open a bank account abroad or to purchase assets abroad.

This policy would at one stroke introduce virtually complete convertibility for 99% of our population, without giving rise to a significant increase in either capital outflows or import of goods and services. That is for those operating with tax paid income and assets. Capital account convertibility has already effectively exists and has existed for decades for those operating with so called ‘black money.’
Recommendation 2: Corporations and Businesses be allowed to make financial capital transfers abroad (including opening bank accounts with check facility) up to a limit of $50,000 per annum.
They would be subject to certain transparency requirements such as credit card payment, cheque payment from FE account and record keeping.
GDR/ADR: Resident Companies
Issue of GDRs or ADRs is the least risky form of equity issue from the issuing country’s perspective. It is dollar denominated and trading occurs between non-resident. There is therefore no direct effect on the country’s foreign exchange or equity market at the time of a crisis.

Recommendation 3: Issue of ADRs or GDRs by resident companies (Public or Private limited) should be completely de-controlled.
No prior approval would be required from government (or RBI), but the issue would have to be reported to RBI within a reasonable period after it has been made.
FDI & ESOPs
Foreign Employees should be allowed to participate in the Employee Stock Option Plan (ESOP) of an Indian Company with full repatriation benefits, subject to the FDI rules on aggregate foreign equity holding. Such ESOPs are going to be very important in the development of Knowledge based Industries & Services such as IT and Drugs & Pharmaceuticals. The automatic route would also apply to such ESOPs. For instance a company, in a sector in which automatic 100% foreign equity is allowed as per FDI policy, can issue any amount of ESOPs to foreigners by going through the automatic route to RBI.

Recommendation 4: Indian companies should be allowed to issue ESOPs to foreign employees on the same basis as the FDI policy applicable to the sector in which they are operating.
External Commercial Borrowing
As our analysis of the Asian crisis showed there is little risk to the country in external borrowing of maturity above one year. The only thing to be watched carefully is the amount of loans with residual maturity of less than one year. The two together should be kept well within the foreign exchange reserves. It therefore follows that ECB policy can be drastically liberalised without excessive risk. At present ECB of maturity greater than 10 years is outside the ECB limits (i.e. de-controlled). We should plan for complete de-control of ECB and FCCB of maturity greater than one year by 2003-4. These should be phased in starting with immediate de-control of ECB of average maturity greater than 5 years and above, followed by,

Recommendation 5: De-control of ECB (and FCCB) of average maturity of three years or more by resident companies.
Indian Direct Investment Abroad
True Globalisation requires that Indian companies should go out into the world and compete across the globe. This is the most effective way of learning and developing competitive skills. It is difficult enough for companies that have been protected for long to do so without us creating restrictions and hurdles for them.

Recommendation 6: De-control the flow of Indian Direct Investment Abroad by Indian Companies up to a limit of $50 million per annum. Remove the conditions on repatriation of earning by way of dividends etc.

Recommendation 7: As a corollary to the above policies, a coupling of FDI and Indian Direct Investment Abroad in the form of Swap of Equity between an Indian and a Foreign Company would also be permitted (freed) within the allowed FDI ceilings.
Portfolio Investment
One of the lessons of the Asian crisis is that foreign equity investors can display a herd instinct, when they are confronted with extreme uncertainty and lack of information. This creates volatility in portfolio flows. It is a standard principle of financial markets that the more diverse the set of owners of financial assets the less likely it is that they will have the same expectations and act in the same way. Any decrease in controls on portfolio investment in India by foreign residents, that results in a more diverse set of foreign equity holders, is therefore highly desirable. Thus within the prescribed aggregate equity limits for FIIs , we should encourage all non-residents to invest in the Indian equity market.

Recommendation 8: All non-residents (venture capital funds, insurance companies, pension funds, endowments, wealthy individuals etc.) should be encouraged to make portfolio investment in India through a SEBI registered intermediary (portfolio manager, mutual fund etc.). The direct holding of any non-resident should not exceed 5% of the total shares of any given company.

Recommendation 9: NRI’s, FII’s and other non-residents should be allowed to hold equity up to 100% in listed companies, venture fund companies and in the IPOs of venture fund assisted companies. In the case of listed companies, this will be subject to a board resolution.

Universal Primary Education and the Spurious issue of “Privatisation”

The bold move of the Delhi government to hand over about 30 of the worst MCD run schools to “private parties” has raised a storm of opposition. These schools are in slums and peripheral areas, where the need for education is the greatest and the quality of education provided is the worst. Sadly even well-meaning comments reveal a lack of knowledge of basic facts. This article tries to clear the fog of confusion, and goes on to addresses the broader issue of how to ensure universal education in the current environment of fiscal stringency.
The Indian constitution enjoins upon the government to ensure education for all its citizens. The courts have interpreted this provision to say that private commercial schools are not allowed. So how can the Delhi government handover its schools to the “private” sector? What about all those “private” and “government aided private schools” that we read about. The confusion arises from the definition of “private.”
Strictly there are only two types of schools “government schools” and “non-government schools.” In common parlance most of us refer to the latter as “private” schools. The flaw lies in equating “private” with “profit making.” Non-governmental schools can only be set up by non-profit organisations (NPOs) such as societies or trusts under the societies act or relevant trust act. The law as it stands today does not allow the setting up of commercial for-profit organisations to provide schooling, so the question of any school being driven by the “profit motive” does not arise.
The Delhi govt proposes to hand over some schools to non-profit organisations who can run them much better than the governments of the last fifty years have been able to do. It is extremely hypocritical of those who can afford to send their children to good quality “private” schools to rail against this effort to improve the quality of education to poor children on the specious and totally mis-leading charge of “privatisation.”
6.4.1 Universal Primary Education
The union government recently decided to make elementary/primary education a fundamental right, with the operational goal of making it universal and compulsory. Is this merely “pie in the sky” rhetoric or is it a realistic goal. The objective cannot be met by a business as usual approach that pumps more funds into existing systems of government education - namely more funds for more government run school buildings and for hiring more government teachers (who don’t show up to teach). What can a new approach consist of?
Rashmi Sharma has shown that teachers are absent from their work for 14 days a month for officially recognised reasons. Unofficial absence, when added to this, would mean, particularly in rural areas, that teachers are seldom available to do any teaching. Add to this the poor quality of teachers and you may begin to comprehend how uninteresting school is for students in government schools. In fact the teachers themselves are aware of this low quality as demonstrated by the experience of my 17- year old son in a slum in the heart of Delhi last summer. The government teacher there requested him to give her own son lessons.
And all this costs the government upwards of Rs 1000/child /year. Compare this with the cost to NPOs/NGOs of Rs 50 to 65 per child/month. There are now NPOs who have offered to take on the task of teaching at 1/10th the cost incurred by government, with a guaranteed and measurable quality of output (i.e. testable levels of reading, writing and arithmetic ability). One can now begin to get an idea of what can be achieved by a radical new approach.
6.4.2 Rural Schools
In modern economies schooling constitutes one of the most important functions of local government. Primary schooling should be completely de-centralised to Panchayats over the next five years. Each Panchayat should however be required to set up a user group consisting of mothers of young children along with Panchayat officials, the local teacher and a representative of the State education department to monitor and supervise the functioning of the school so as to ensure quality. The funds currently being spent on the primary school system should be devolved to the Panchayats along with the authority to hire and fire teachers. In the transition period the pool of teachers could consist of the currently employed teachers.
Govt should provide a capital grant to any NPO/NGO that wants to set up and run a secondary school in any rural area not currently serviced by a secondary school. Special focus should be on schools for girls so that they do not have to walk unreasonable distance from home (larger grant could be provided in such cases). I understand that the UP education authorities have successfully used this approach to provide a secondary school for girls in every single district of the State. Such an approach is even more important in the poor, badly governed States.
All existing urban primary school facilities should be handed over to Non-Profit Organisations/NGOs on an as is basis. This should be done over a five-year period (say) starting with the worst run schools. The government could provide a one-time grant to those NPOs wanting to set up schools in underserved/slum areas. This would be done on the clear understanding that they would not be entitled to any further subsidies. It would also be made clear that they have to follow some simple basic norms like free education for all those living in the neighbourhood who cannot afford to pay.
The government would focus on training of local teachers (using innovative techniques and communication facilities), and in providing regulatory oversight The laws, rules and regulations relating to setting up and running of non-profit schools must be simplified. This requires a change in attitude from control to modern regulation. Govt. should focus on ensuring transparency to parents of enrolled students and ensure that there is no financial fraud or misleading advertisement of quality of the schooling provided. These changes can transform the educational picture of the country within the next 5 to 10 years.