An open letter to the finance minister

Sir,

It is true that we live in exceptional times and every government in the world is running high deficits to stimulate its economy. However, to assume that India has no choice but to imitate the West or China is too simplistic a view, possibly an excuse based on political convenience. Is not our economic and demographic cycle very different from that of most of the large economies? Are we not a supply-constrained economy rather than a demand-constrained one?

While others need to stimulate demand, we need to stimulate supply. We need more roads, more power supply for people to buy cars and electric gadgets to use them, for example. Say's law will thereafter automatically come into play, as supply will create its own demand.

India is rather fortunate and blessed to be in that unique position. A concerted effort to remove supply-side bottlenecks will drive us on to a path of sustainable and high growth, enabling us to tap the latent demand.

To do that, all you need to do is to remove barriers to capital flows, help bring down the cost of capital, improve access to all forms of competitive resources, and put in place a favourable framework for entrepreneurship to flourish.

The fiscal stimulus that you had to undertake in December 2008 and January 2009 was understandable, given the political exigencies in an election year and, of course, the immediate need to slow down the speed with which the economy was hurtling down. It was an instantaneous response to the global economic tsunami that hit us; an exercise to manage an unforeseen crisis.

Your party had much less strength within the erstwhile UPA, and thus, pushing through tougher reforms was anyway politically inexpedient. Regardless, the government acted in the hour of need, helped by the reserves and ammunition built during the preceding four years of prosperity. That ammunition is now being used up at a very rapid pace.

But after having been returned with a much stronger mandate and that too in the early stages of your government, if you do not muster the political will to take the structural problems head on, bring in innovation and boldness to usher in the required reforms, bring down deficit to levels that can keep the cost and availability of capital at desirable levels, then we run the risk of relapsing to an era of sub-par growth.

It is axiomatic that high growth is the cure for India's two issues of concern: high public debt and high poverty levels. The question that begs to be raised is whether the therapy that is being administered to re-accelerate growth is the right one. Are we being myopic, focusing too much on short-term gain and failing to address the structural deficiencies that need urgent redress? In the process, will we end up creating problems that will get even more difficult to manage later? Does this not raise the risk of a demographic advantage turning into a disadvantage?

All you need to look at is what Manmohan Singh had done when he took over as finance minister in 1991. The challenges that he faced to usher in economic reforms were far bigger than the ones we face today. Singh took all the steps it took to reduce structural irritants to growth: removing quantitative and qualitative restrictions on domestic and foreign trade; bringing down direct and indirect tax rates; abolishing controls on exchange rates; starting disinvestment of PSUs; and reducing barriers to competition and capital flows, to name a few.

He untiringly led the process through his thought, application, energy, innovation and passion, and that helped alter the economic landscape of this country. We would have been much worse off, possibly many years behind, if India had not been lucky enough to get him as the finance minister.

Since then, we have had all kinds of political combinations in power. We have no doubt progressed much further. Yet, the gap between what could and should have been done, and what has been done, only widened.

It is in this context, that the return of a stronger coalition led by your party in May 2009 gave us all a glimmer of hope that the loss of pace in ushering in reforms and the appalling lapses in execution will possibly get reversed soon. We wonder why such a hope does not have a logical basis. Your colleague Kamal Nath, the Union surface transport minister, for example, is already talking about building 20km of road a day.

Optimists believe that the budget is not the only forum for ushering in reforms and that the more radical changes will be done outside the budget. We hope so. We are, however, limiting the focus of this letter to the high fiscal deficit, its crowding-out effect, the consequent impact on cost of capital and the potential enervating follow-on impact it has on private-sector activity.

We would like to draw your attention to the following data points:

• By end-FY10, combined public debt will vault up to around $1 trillion, 80% of GDP. Combined debt of central and state governments would have tripled over FY01-10.

Many years of high growth have done little to bring down this ratio, because of sudden and rapid deterioration in government finances over the past two years.

• FY10 combined fiscal deficit, at about $127 billion, will be roughly about 59% of the aggregate incremental growth in bank deposits, insurance savings, postal savings and employees’ provident fund.

Once risk-free rates start rising, cost of capital across the borrowing chain will start rising. By definition, this is bad for equity and bond markets.

A possible sovereign rating downgrade, whether justified or not, will add to our woes. If conditions in capital and currency markets are not conducive, raising risk and debt capital may not only be expensive, but also difficult.

Foreign portfolio flows chase growth and if markets start worrying about risks to growth, that may slow down with attendant repercussions.

The acceleration in FY03-08 real growth to 8.9% (from 5.4% during FY98-03) was led by three key factors:

1) Normal monsoons, with average 4.9% CAGR in agricultural GDP;

2) A surge in private corporate sector capex, which contributed 33% of incremental GDP; and

3) A more-than-doubling of bank loans.

At this stage of the global economic cycle, private corporate sector capex may remain muted any way (and this can only worsen if capital becomes expensive). To that extent, this has to be replaced by infrastructure spend and there again, the higher cost of capital will be a major drag. If the investment cycle does not reaccelerate, then growth will falter.

Slower growth will lead to a further rise in the fiscal deficit as a percentage of GDP and slow down poverty alleviation; and we run the risk of getting caught in a vicious cycle, as there will be even more pressure to raise allocations to social sector schemes.

It is in your hands to mitigate this risk and possibly turn it into a virtuous cycle. A lot of foreign capital will hit our shores, if confidence in growth and the rupee rise.

A larger part of domestic savings will be available to stoke private sector investment activity, which will be needed to push up capital output ratio.

All of that will accelerate growth, buoy up sentiment, and have a benign impact on capital markets. That will help you to disinvest not only more, but at better prices as well, further helping the nation’s cause.

Akin to the first wave of economic prosperity ushered in by Manmohan Singh’s reforms in 1990s, the decisions you take or fail to take today will decide whether we capitalise on the opportunity staring at us, or lose it.

The economic survey lays down a number of prescriptions that can help address the issues that have been raised in this note, and administering just a few of them will be good enough to put us back into a road of high growth.

Yours faithfully...

Nemkumar and Datar are with institutional brokerage IIFL.