India macro-economic review: Pre-monetary policy

 

Covid economy: Lockdown, Transition to Normalization & setback

More than a year ago, EGROW research paper discussed the economics of lockdown[1] and the transition to normalcy. The transition played out as we had envisaged and normalisation had occurred by March 2021 as anticipated.

Second Covid wave started in April and we were back into another transition period, characterised by regional, better targeted restrictions in terms of services and selected district lockdowns. In the last meeting we had pointed that public forecasts were following the covid waves, but our analysis of the second wave allowed us to see through it.

The available forecasts were much too affected by short term developments resulting in a high correlation between covid cycle and GDP forecasting cycle. Our analysis of the delta variant, in EGROW foundation research paper, clearly showed that the new variant is not part of the old wave which is more or less over. Based on our dual S curve model, we predicted that the covid variant would spread very rapidly and then decline just as rapidly as it grew. This is what happened by end of July.

The key point to note is that people were focussing on the wrong issue. It was not the incompetence of the government or the carelessness of the public which was critical in the second wave, but the high transmissibility and severity of the new variant(s). This has been proved by the spread of the Delta variant in the UK, Indonesia, other SE Asian countries, US and China.

Based on the second wave model, published in May 2021[2], we had concluded that FY22, Q1 GDP would be much worse than predicted by anyone and Q2 GDP would bounce back much faster that anyone was expecting. Consequently, Q2 GDP would make-up most, but not all of the losses during Q1. With H2 growth recovery still on track, the full year growth would remain within our six month earlier forecast of 10% +/- 1 percent, with a downside risk. That is how the economic recovery has played out so far.

In our 2020 paper on fiscal policy during the transition[3] emphasis was on logistics disruptions, and supply chain disruptions during the transition period. Logistics problems were much severe in other parts of the world than India. There were problems of sudden stops and sudden starts. The logistic costs of Indian exports went up by only 20 percent, compared to the logistic cost of exports from China to the US, which went up by 100 percent or more.

In the USA this was aggravated by a shift in demand, from services to goods. Demand for manufactured products and imports of the same shot up. This resulted in unexpected pressure on logistic chain.  The logistics of delivering commodities are completely different from services and there was a shortage of ships and containers, and those costs went up. As covid wave dies down, we will see a reverse shift, the demand will shift back to services. Disruptions in the supply chain are an important factor to keep in mind. E.g. semiconductor disruptions, the natural resource commodity disruptions, etc.

As our analysis indicated, inflationary pressures from logistics and supply chain disruptions would have a large temporary component in India, USA and worldwide, because of its origin in the supply chain disruptions. However in the case of India inflation is also strongly affected by global petroleum oil and edible oil prices, both of which have increased substantially during the last six months.

Macroeconomics of Indian economy: Exports, Investment and private consumption

There has been a surge in exports from India especially in the Q1 and till July. The macroeconomic issue is to determine how much of this is temporary and permanent. There have been many indications in the data and personal observations that supply chain shifts are occurring. Most of the surge seems to be due to the shift in supply chains. This has two elements- incremental demand and diversification and risk reduction. There is increasing willingness to pay 10-20 percent higher cost of imports from India, to reduce China risk. This willingness is increasing with the unpredictable behaviour of Chinese authorities, ranging from random actions with respect to capital markets and tech companies and severe lockdowns in many cities purportedly based on a few Covid Delta cases numbering in the tens.

The government must make sure, with the help of industry associations, that any new bottlenecks are identified and solved expeditiously, to ensure that this great opportunity is translated into permanent increase in World export shares.

The government’s provision for Capital expenditure was increased by 30-34 percent in the budget. This will finance construction intensive infrastructure in FY22. The momentum was somewhat disrupted by the second wave but will pick up in Q2 FY22 and stimulate complementary private investment. We expect the Digital economy to lead private investment during FY22. However, much of this investment comes under intangibles and will not be visible in the usual indicators of fixed investment. 

Doubts remain about the speed of recovery of private investments because of the depletion of private saving/increase in indebtedness of those affected by Covid infections and those with employment/income losses during lockdowns. EGROW’s research paper in 2020 had pointed to the importance of distinguishing between Contact Services, goods and their related services, and non-contact services. The key new element is the dynamics of the shift in relative demand for goods and services. The shift from savings to goods consumption took place during the lockdown and transition period was when fears of contagion were high. As vaccination drives proceed and fears of Covid contagion subside, there will be a gradual shift back to services and a reduction in the pressure on the demand for goods. This will translate into reduced pressure on logistics chain, logistics costs and inflationary pressure on commodities.

In India, a nationwide third wave is highly unlikely unless there is a new mutation similar to the delta variant. But, regional variations in the number of cases will be observed.

The overall GDP is expected to be 10% -/+ 1 percent, with downside risk higher because of the second wave. Though the second wave is over on a nation-wide level, we may continue to see regional flare ups as have happened in Kerala, Maharashtra and the Northeast. However, given the learnings from the first two waves (Govt, business, public), the increase in Sero-positivity (2/3^rd of population) and the higher vaccination levels (1/3 of adults), a nationwide third wave can only happen if there is new Covid variant comparable in transmissibility and severity as the delta variant. Nobody can predict this, but the medical community can ensure that any such variant is detected quickly and contained before it becomes another wave!

The interest rate should, and is likely to, remain unchanged. So too the future guidance on monetary policy.

Capital depletion, capacity destruction!

The government and RBI must be alert to any, “Capacity destruction” and “capital depletion in informal enterprises” that has taken place under the radar of regular data collection. The formal sector, particularly the corporate sector is flush with cash and have reduced their demand for credit. The medium-large firms in the MSME sector will also have sufficient access to credit once their demand revives. My concern is for the self-employed and the micro & small enterprises which have exhausted their personal and family sources of working capital and may have difficulty obtaining the capital needed to restart their enterprises. The government and RBI must be on the look-out out for sectors/industries/services where capital depletion has happened and ensure that help is provided for restarting their business.

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[1] https://egrowfoundation.org/research/policy-for-post-lockdown-indian-economy/

[2] https://egrowfoundation.org/research/indias-second-covid-wave/

[3] https://egrowfoundation.org/research/lockdown-economics-fiscal-policy-during-pandemic-crises/

 

Budget 2015-16: Some Suggestions

Introduction

    This note makes suggestions on issues that either come directly under the purview of the Ministry of Finance or are closely related to it.  These include Fiscal Deficits, Taxation, Expenditures and Subsidies and Financial Sector.  Though “Big Bang budgets”  have sometimes had policy announcements outside these areas, this is only successful if there is a great deal of confidence that the policy announcements will reach fruition & implementation. Otherwise they can do more harm than good.

Fiscal Deficit & Revenue Deficit

    The budget needs to stick to the Fiscal deficit targets (glide path for reducing FD) outlined by FM Arun Jaitly in his maiden budget, or risk losing credibility. It is equally, if not more, important however to achieve the original FRBM target of zero Revenue Deficit by 2016-7. These two together imply an improvement in the quality of central government expenditures with a shift from subsidies and current expenditures to investment-capital expenditures: In other words the reduction in revenue expenditures can provide room to increase investment in infrastructure while meeting the old fiscal deficit targets.[1]

    This will also create the confidence in the RBI to move aggressively on Repo rate reductions an easing of monetary policy to complete the “Macro Pivot” that the Indian economy desperately needs to stimulate demand for consumer durables (like automobiles, housing & home goods).[2]

   As a reduction in the revenue deficit represents an increase in public savings, this will help increase national savings and thus help slow down the rapid accumulation of foreign liabilities [increasingly negative Net international Asset (NIA) position of India] that has occurred since 2010 and minimize the probability of sudden stops in capital inflows.

New FRBM & Credit Rating

  India’s high fiscal deficit has been the major reason for its marginal credit rating (lowest investment grade: Moodys Baa3/S&P’s BBB-). Government may consider targeting a further reduction in the Fiscal deficit to zero by 2019-20 with the objective of raising India’s global credit rating. FM could announce his objective of raising India’s global rating by three notches to upper medium investment grade [Moodys A3 or S&P’s A-] over the next five years or so.  This would also need to be supported by a new FRBM with new FRBM targets to establish credibility and ensure a credit rating upgrade of this magnitude.

Tax reform

Administration, Appeal & Settlement

       What has been called “Tax Terrorism” by some and “harassment” by others, has been one of the contributors to the collapse of economic growth from 2011 to 2014. There is an urgent necessity for a dramatic overhaul of the entire system of tax administration, tax procedures and tax rules and of the review, appeal and rectification mechanisms. Based on the recommendations of previous committees on tax administration reform and the Government’s  E-Governance ideas, the FM’s budget speech could outline a credible road map for reform of the revenue administration and speeding up of the appeallate system. For instance recording of every decision of each tax officer, including those relating to tax demands, success of legal cases and years spent, would help analysis of outcomes of these decisions with a view to continuous improvement.  It is important to demonstrate quick, fair & effective tax justice for all actual & potential tax payers.

Goods & Services Tax

  The FM can spell out a road map for GST and set in motion any changes in administrative structures/systems that will be required for the GST. He could also start modifying Central Excise/ VAT/ Service tax rates to close the gap with rates that will be required under GST.

Customs Tariffs & Duties

     Inverted duty structures arise whenever selected products are allowed below the average/median rate which is currently close to the general peak tariff rate of 10%. The IT zero agreement reduced tariffs on many electronics final goods to 0% and therefore created an inverted structure in electronics. To the extent it is legally possible an effort must be made in the budget to move to a uniform 10% tariff rate by raising import tariffs that are below this rate and lowering those which are higher than this rate. This is the best structure for the “Make in India objective”

    Textiles and Agriculture are two major sectors of the economy, for which customs duty reforms lagged far behind the others. Textiles still has a complex mix of Specific and Ad valorem import tariffs that is a source of enormous corruption. This undermines/defeats any objectives that such a complex structure was designed to achieve. It would be far better to drastically simplify these rates. The ideal solution would be to eliminate specific duties and unify Ad velorem rates at 10% (which is the general peak rate). The second best solution would be a uniform rate of 15% to be reduced to 10% in a few years. The third best would be to reduce the specific rates to 2-3 at most and eliminate them in next few years.

Agriculture is the only sector subject to Ad hoc bans on import and exports. I know from experience that these bans and their removal always come too late to benefit the farmer. These Ad Hoc changes usually benefit some favored intermediary. The consumer is usually saved from the worst excesses. The farmer can only benefit if there is a stable regime of import tariffs and export duties on the basis of which he can plan future crop patterns and investments for productivity improvement. The FM could announce his intention to eschew import-export bans (in future) and announce a committee to work out a structure of import tariffs & export duties that would balance the interests of farmers and consumers. If some reports/studies exist in the Ministry he could even announce some rationalization of tariffs & duties, for instance a move to reduce tariffs on all agricultural inputs (cotton, wool, silk etc) into manufacturing to 10%.

Income Taxes

   The Income tax law and rules are a ramshackle structure built over decades with new extensions added every year.  The original version of the new Direct Taxes Code, which I saw in 2009 as CEA, came fairly close to a simplified structure based on sound economic principles. There were a few minor items which could have easily been corrected. I understand it has lost some of its economic soundness and simplicity as it went through Parliament. However, the need for a new Income Tax law and simplified rules remains.  Some effort needs to be made to simplify the income tax on the basis of the principle of reducing ‘exemptions and deductions” and reducing marginal rates to produce revenue neutral change. 

The complexity and harassment is even greater with respect to business and corporate taxation, and a good budget must show some effort at simplification, particularly with respect to cross border entities and transactions.

One uniquely Indian anti-entrepreneur tax rule introduced in the last 3 years needs to be eliminated: That is to treat issue of shares of Start-ups to funders at a price above the face value (at which they are held by the start up entrepreneur) as short term capital gains on which a tax must be paid at time of issue.

Non-Tax Revenues

  Finance Ministry must continue to pursue the change in system for leasing national assets like spectrum, minerals, and land is done through transparent, competitive auctions. In the case of spectrum, this requires removal of artificial stipulations of minimum price (price of rural spectrum in many states is zero), freedom to trade or sub-let the spectrum to other qualified bidders and to ensure open access in areas where spectrum is surplus (e.g. many rural areas)

Expenditures

    With the abolition of National Planning and the Finance Commission recommended transfer of higher share of gross taxes, the Central Government should increasingly focus on subjects in the Central list and on public goods(& service) aspects of those in the Concurrent list. The division of expenditure into Plan & non-Plan should be re-classified into the economic categories of “consumption” and “investment”. These overlap broadly with the budgetary categories of “current” & “capital” with the major exception of expenditure on maintenance and repair of capital assets(which is a form of capital formation).  A serious effort must be made in this budget to change the expenditure mix from current to capital and thus reduce the revenue deficit.

Investment Expenditures

    The Central Government must focus its limited resources on classic “Public goods infrastructure”. These are parts of infrastructure in which social benefits far exceed private benefits or from which it is difficult or impossible to collect user or service charges on a sustained basis. Highways and roads, carefully selected rail lines & related signaling equipment and critical bottlenecks in Ports and waterways are already identified focus areas on which greater budgetary emphasis is needed. However, to successfully bring in complementary or supplementary private investment in “private goods infrastructure” the policy & regulatory environment must simultaneously be made more transparent and free of policy and regulatory risks.

Consumption Expenditures

        On the consumption side the focus has to be on the subsidy and other reforms already identified by the government should be pushed along by this budget: Drastic reform of Food Corporation of India and the entire procurement-PDS system can reduce wastage & corruption and make more funds available for investment. Initial steps could also be taken for shifting all metros/urban areas (given competitive supply of food grains) from physical supply to cash subsidies for food grain purchase.  Similarly, NREGA reforms to increase capital component and pay wages directly through Aadhar linked accounts could also change the mix.

        In Education and Health, Central Government should focus on preparing and propagating E-education and E-health systems and platforms that can be used in any/every State, it should focus on educating the educators, teaching the teachers, training the trainers and managers of (public & private) education and health systems across the country. It should focus much more on “Public health” & eradication of Communicable diseases and on “Public Education,” than on personal health & education. The “Swach Bharat” and “Beti Padhao, Beti Bacha” campaigns are good examples of this approach. The Skill Development Mission, including the need for Standardization and Certification of the thousands of certifiable skills, is another initiative that requires a much greater urgency and thrust to be imparted to it.

Subsidies

   The decision of the Govt. to increasingly transfer subsidies directly to intended recipients (without distorting prices of products and services) by linking them to the UID/Aadhar number is a very good one. Government has also accepted the advice to make the (cash) transfer payments through bank accounts.  If all subsidies including kerosene to the poor & fertilizer/Urea subsidies to farmers can be given directly, it will be a signal achievement of the government. The funds saved through reduced administrative costs and elimination of corruption can be used for job creating, productivity enhancing, infrastructure development.

The Aadhar authority needs to start analyzing all its records to eliminate duplicates and identify incomplete coverage. For the latter, one way is to compare with the digitized electoral roles with Election Commission. Second way is to aggregate UID Nos issued, by blocks and compare with population records from the last census, to identify areas that need special effort.

There are two non-conventional ideas that are worth considering & adopting. First is the use of cell phone based subsidy/transfer payment systems for reaching the poorest of the poor, given that 80-90% of the population has cell phones. In fact it would probably be cheaper to give all the ultra-poor a free cell phone than to ensure that they have usable bank accounts.[3]

Second, adopt a UID linked multi-application smart card (MASC) as a single unified platform for all subsidies, welfare and social schemes. Such a card can easily have slots for the poor’s entitlement to public education and government healthcare facilities or Govt. funded credit/debit limits for use in private facilities.[4]

Financial Sector

          The rise of NPAs in Public sector Banks (due to forced lending for infrastructure projects subject to Govt policy & regulatory risk) and the imminent necessity of introducing Basel III capital adequacy norms, makes capitalization of PSBs an urgent problem. The funding required has to be raised from the market. One possible solution is to set a dual limit: 51% for SBI and a few of the strongest & most profitable PSBs and 26% for the rest. Then sell shares in the latter to capatilise all PSBs to required levels (Many years ago a committee headed by Dr. Bimal Jalan had recommended lowering the limit for Govt. shareholding in PSBs to 26%).

Conclusion

    In his speech to the ET Global summit, the PM has laid out the elements of a New Development Paradigm, of Employment Generation and Empowerment of the Poor and Middle Classes.  The forthcoming budget should flesh this out and give it a more concrete shape.[5]

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A version of this article appeared in ET Blogs at http://blogs.economictimes.indiatimes.com/PolicyAnalysis/budget-2015-16-some-suggestions/

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[1] During 2005-2008  an argument was made that subsidies for health & education should be classified as “capital expenditures” (as “human capital”) contrary to the accepted budgetary practice all over the World. The result of this exercise was not better health & education but a large increase in consumption expenditures that helped create the 2010-11 bubble and subsequent bust in economic growth.

[2]  http://dravirmani.blogspot.in/2013/02/macro-pivot-rebalancing-of-indian.html & http://dravirmani.blogspot.in/2013/08/managing-indian-macro-pivot-twist.html

[3]  http://dravirmani.blogspot.in/2014/04/mobile-banking-vs-mobile-access-to-bank.html & http://dravirmani.blogspot.in/2014/09/financial-inclusion-bank-account-jan.html

[4]Please see http://dravirmani.blogspot.in/2012/12/the-unique-identification-uid-number.html and references therein.

[5] A New Development Paradigm: Employment, Entitlement and Empowerment, Economic and Political Weekly, Vol. XXXVII No. 22, June 1-7, 2002, pp. 2145-2154. https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnxkcmFydmluZHZpcm1hbml8Z3g6MjQ4ODc3YWI2ZDcxZmE5NQ

India Budget 2013-14: Pre-budget Q&A

1.      Q: What do you believe are the most critical issues that the FM should be focusing on when he delivers the budget?

A: The critical issue is to restore economic growth. To do this, two central problems have to be addressed in the budget.  One is the Fiscal deficit and the other is revival of private investment.
 

2.      Q: This is the last full year budget before next year’s general elections. Do you worry about populist measures being announced?

 A: There is still time for another pre-election budget in 2014.  The 2013-14 budget should focus on the revival of investment and growth, leaving any “populist” measures to the next budget. 

3.      Q: The government finances are a mess. We’d be lucky if the fiscal deficit comes in at 5.3 per cent as the FM has promised it will.  The CAD is set to end this year at a record high. But would you say the progress made by the FM in the months since he took charge give you reason to believe that we are on the path to recovery?

A: The administered price changes announced by the government during the last four months are a good beginning, but they are just that a beginning.  The next critical step is the budget.  More important than the precise number for the current year (5.3% or 5.4% of GDP) will be the steps taken to put government consumption, subsidies and transfers on a firm trend to fiscal deficit reduction.  Further action will also need to be taken to reassure tax paying investors that a simple, broad based tax structure that promotes voluntary compliance is still the objective of the finance minister, and not “revenues at any cost.”

       For instance, measures introduced in the last budget to tax equity investment in new entrepreneurial ventures as hypothetical unrealized capital gains is against the logic and practice of capital gains taxation.  This should be completely and unambiguously removed for young, small scale entrepreneurs who are trying to obtain funding from venture capitalists.

4.      Q: High fiscal deficit has supported consumption but crowded out investment. Isn’t this growth composition a self-defeating one?

 A: Yes. The rate of growth of investment during 2008-9 has fallen dramatically from that attained during 2003-4 to 2007-8.  At the same time government consumption and government transfers and subsidies for private consumption have increased during 2008-09 to 2011-12.  Though the objective of the government was to promote inclusive growth and poverty alleviation the collateral damage caused to growth was insufficiently understood and appreciated by policy advisors, policy makers and even private industry (till 2011-12). The focus of expenditure needs to be reversed.

5.      Q: Has enough been done on addressing supply-side bottlenecks? What would you like to see as first steps by the government?

 A: Much more needs to be done to address supply-demand gaps in Agriculture (APMC, ExIm regime), Energy (pricing, subsidy), Minerals (Exploration, auctions), Land – Rural (LAA, R&R), Urban (land use, market) and skills (certification, training of trainers, rural youth).

6.      Q: What should be the more immediate priority – revenue enhancement or quality of expenditure?

A: Expenditure reduction has to be the immediate priority. It will allow an equivalent easing of monetary policy and thus support investment and growth.  In contrast revenue enhancement will add to and worsen the dis-incentives for investment.  This is particularly true of short term, “revenue at any cost” measures that have additional negative effects on sentiments and “animal spirits.” An improvement in the quality of both taxes and expenditures would enhance efficiency and growth, but the macro economic situation requires a sharp reduction in expenditures coupled with a dramatic easing of monetary policy.

7.      Q: India’s fiscal deficit one of the highest among high growth economies. Would you put this down to high government spending or weak revenues, especially our low tax base?

 A: India’s fiscal deficit has historically been among the highest in the world, not to speak of high growth economies.  However, by 2007-8, t he central (national) fiscal deficit was reduced to 2.5% (4%) of GDP in 2007-8, a highly creditable performance, even in a global perspective.  The global financial crisis of 2008, changed this trajectory, by necessitating a fiscal stimulus (of 2.5%) to offset the dramatic fall in private demand. 

      The V shaped recovery of growth to 8.2% in 2009-10 justified this stimulus but was also an argument for cutting back the deficit over the next two years to the 3% prescribed by the FRBM.  Unfortunately, the fiscal stimulus was increased, with little protest from economic experts by an additional 0.5% of GDP (to 6.5 % of GDP) in 2009-10, so it became impossible to bring it back to 3% by 2010-11.  This was driven by 2.2% of GDP increase in revenue expenditure and a 0.8% of GDP increase in subsidies. Restoring subsidies and other revenue expenditure -GDP ratios to those achieved in 2007-8 will help bring down the fiscal deficit and restore growth and tax revenues to earlier levels.