Less Fanfare, Better Sense

<?xml version="1.0" encoding="UTF-8"?><root available-locales="en_US," default-locale="en_US"><static-content language-id="en_US"><![CDATA[The Indian economy has been on its way to integration with the world at large. Thus, our economy&rsquo;s vicissitudes no longer stand isolated from world events. Do these developments have a bearing on our expectations from the upcoming Central budget? What are the economic principles that should guide us? With India opting for the globalisation drive, there have been two major changes in the economy. The first concerns our move from the fixed to the flexible exchange rate regime, and the second surrounds a gradual acceptance of capital account convertibility. Economic theory teaches us that these two policies, when adopted without compromise, render a third government policy, commonly called fiscal policy, ineffective. The Central budget, on the other hand, is primarily an exercise in fiscal policy, consisting as it does, of a statement of the government&rsquo;s tax-expenditure proposals. When the government succeeds in raising outputs and incomes across the economy by spending out of its tax revenues, the general level of demand for commodities rises. With the public wishing to spend more, demand for usable monetary resources rises too. There is a complex process through which this latter rise manifests itself. To over-simplify, however, the banks end up with more demand for their loanable funds. At the same time, there is a tendency for commodity prices to shoot upwards as demand chases supply. If the price rise is sustained, one faces what is known as a rise in the rate of inflation. Inflation is an evil that most governments attempt to avoid, since it hurts the poor and benefits the rich. The rich are benefited either because they are the suppliers of commodities which rise in price or because their incomes are protected through pay commissions whose recommendations the organized labour force enjoys. To keep inflation in check, the central bank adopts a tighter monetary policy, which amounts essentially to raising the rate of interest prevailing in the markets. To be precise, it raises the bank rate, the repo rate and so on, which are the rates of interest it charges commercial banks for their borrowings from the central bank. With money becoming more expensive for the commercial banks, they in turn increase the rate of interest for their customers. It is at this stage that the economy experiences the impact of a convertible capital account. If interest rates are lower elsewhere in the world, then financial capital, in pursuit of higher rates of return, flows into economies where the rates of interest are higher. Normally, this is reflected in booming stock markets. A stock market boom reflects, however, that foreigners&rsquo; demand for domestic currency is rising. And now, with a flexible exchange rate, the domestic currency appreciates vis-&agrave;-vis world currencies, thereby making domestic commodities more expensive to the foreigners and foreign commodities cheaper to domestic residents. This causes a dent in the initial rise in demand for commodities within the economy. Recall now that we had started out with an increase in domestic demand following successful fiscal policy. This led, as we saw, to a crowding out of the private sector producers. Needless to say, there may not occur an exact cancellation, but one should be less than euphoric about successful fiscal policy in the face of flexible exchange rates and convertible capital accounts. In the course of the financial year following the last budget, we have witnessed three significant events. One, the phenomenally booming stock market till the recent downturn; two, the claimed buoyancy of tax collections; and three, the recent admissions, albeit sotto voce, that the Indian economy has failed to sustain its much advertised rate of growth in the neighbourhood of 9 per cent. The simultaneous occurrence of the second and the third of the listed events would appear to support the predictions of economic theory, since larger tax revenues suggest healthy perusal of fiscal policy. Does this mean that the Indian economy qualifies as a textbook example of the economic proposition outlined? Literally, no economy in the world, leave alone ours, fits the textbook model exactly. Amongst other things, textbooks predict instantaneous adjustments of exchange rates and capital inflows. Economies across the world differ in terms of these rates. Further, even when the interest rate in a given economy exceeds the average world rate, capital may not flow in immediately. Investor expectations play a major role here. When foreign institutional investors expect the interest rate to fall in the near future, they could well withdraw their funds despite the immediate advantage of parking their funds in India. For example, one wonders if the recent injury sustained by the sensitive index was related to expectations that the Reserve Bank of India was about to lower interest rates in response to American action. And there are a host of other institutional constraints too, which may not lead to an exact fulfilment of theoretical predictions. Be that as it may, the central bank governor has now announced that the bank rate is unlikely to be lowered. This reflects concern for the inflationary propensities exhibited by this economy. On the other hand, the American economy, by slashing its interests down, has created a wedge between the Indian and the American rate, thereby opening up the doors for foreign capital inflow. If these policies are sustained, the Sensex will be back on course. Simultaneously, the RBI governor has advised the commercial banks to lower interest rates if they so wish. This advice would seem to reflect a possible concern for the adverse effect that foreign capital inflow could have on the already appreciated value of the Indian rupee against dollars. Even if the rupee appreciates, lower commercial bank loan rates would keep the domestic demand alive, thereby boosting the growth rate of the economy. Whether the commercial banks will follow the advice is unclear, since the bank rate continues to be high. The finance minister will have to face the charge that, despite greater tax collections and hence vigorous doses of fiscal stimuli, the rate of economic growth has sustained a jolt. The fall in the growth rate, if correctly reported, must force either or both of two measures. First, one might expect even greater government expenditure proposals in the forthcoming budget. One hears that similar policies will be undertaken by the American economy too. The second measure could well be a reversal in the interest rate policy announced by the RBI. True enough, this has no direct link with the finance ministry&rsquo;s policy measures. But both organisations are presumably concerned with the welfare of the economy and it would only be in the fitness of things that they work in tandem rather than end up at cross-purposes. In fact, as the Indian economy opens up more and more to the world at large, one hopes to see a reduction in the size of the government. The present government, as well as its predecessor, made proclamations that this is the direction in which we are planning to move. Yet, the promise has not been adhered to &mdash; for obvious reasons. The greed for political power supersedes pious avowals. In a democratic society, votes count and the need to satisfy specific groups of citizens cannot be ignored. As in the past, therefore, the government is expected to pay scant attention to economic doctrines in the forthcoming budget. If it were serious about following economic laws strictly, there would be less fanfare surrounding the budgetary circus. A poor democratic country trying to parade itself as a world-class market society is a contradiction in terms. Especially, with the general elections looming large in the horizon, the finance minister will be sprinkling fiscal favours on the populace, as we sit glued to our television sets next week. Exchange rates and capital account considerations are likely to occupy a back seat. The author is former professor of economics, Indian Statistical Institute, Calcutta Courtesy: The Telegraph &nbsp;