For years, the World Bank, IMF and Indian observers (including me) have warned that India’s fiscal deficit is too high and will soon lead to disaster. So too did Martin Wolf and Ed Luce in a recent article in The Financial Times.
Yet disaster has stubbornly refused to arrive for so long that it seems a case of crying wolf. How droll, a Wolf crying wolf.
When oil prices shot up during the 1991 Gulf war, it proved the last straw for an Indian economy burdened by a 10% combined fiscal deficit for the Centre and states. Today, another Gulf war has raised oil prices, and India’s fiscal deficit is back to 10% of GDP after dipping briefly in the mid-1990s. But today India has a current account surplus, forex reserves of $75 billion, low inflation and low interest rates.
Now, fiscal deficits of even 5% of GDP have bankrupted countries like Argentina. How does India survive, indeed thrive? What makes India different from other countries, and even from the India of 1991? The main reason is the flood of invisibles in the 1990s. That makes India really different.
High fiscal deficits typically cause three problems — a balance of payments crisis, high interest rates (because of crowding out) and high inflation (with currency depreciation being a key contributor). India suffered all three problems in 1991.
The big difference now lies not in the invisible hand of Adam Smith but in trade invisibles. Net invisibles have shot up from under $2 billion a year in the 1980s to $11.7 billion in 200-01 and $14.0 billion in 2001-02. They totalled $8.6 billion in the first half of 2002-03, and I expect the inflow to be a whopping $19-20 billion for the full year, over 4% of GDP.
A closer look at invisibles shows that miscellaneous services amounted to $14.7 billion in 2001-02, of which software accounted for $7.2 billion. In the first half of 2002-03, miscellaneous services yielded $9.2 billion of which software exports were $4.1 billion. We need more information on what the other miscellaneous services are. Remittances from Indians abroad were $12.19 billion in 2001-02, and accelerated to $7.3 billion in the first half of 2002-03. Possibly this includes some panic remittance of accumulated savings by Indians in the Gulf in anticipation of war.
The influx has more than offset the impact of a high fiscal deficit. Such deficits typically cause a balance of payments problem, high interest rates through crowding out, and high inflation because of currency depreciation. Let us examine each of these three in India’s current context.
India’s high fiscal deficit has indeed created a huge trade deficit as conventionally measured. India’s merchandise trade deficits in the 1990s have been 3 to 4% of GDP, often higher than the 3.2% that emptied India’s forex reserves in 1991. But an influx of net invisibles of 4% of GDP has converted a record trade deficit into a current account surplus. Instead of a crisis we have equanimity.
Next, consider the impact of the fiscal deficit on interest rates. A high deficit should crowd out private investment and so raise interest rates. This is exactly what happened in the investment boom of the mid-1990s, when corporate bond rates soared to over 20%. This was unsustainable, led to uncompetitive production, and was followed by an investment bust that cooled interest rates. These were then pushed down even further by the flood of invisibles. The flood greatly increased money supply, despite the RBI’s sterilisation efforts. The Economic Survey says that forex reserves now exceed 100% of currency. The inflow of invisibles has been augmented by FDI and FII investment. The net effect is that corporates today can float 5-year bonds at 7%, the lowest rate for decades. Reliance, which once borrowed abroad to save on interest costs, now finds Indian borrowing cheaper. As Surjit Bhalla has remarked, globalisation has forced down Indian interest rates via invisibles.
What about inflation? Typically, high fiscal deficits drive down the real effective exchange rate. Currency depreciation plus high interest rates typically cause high inflation. But in India invisibles have kept the rupee steady, and steady import prices have meant low inflation. As India opens up, domestic inflation is increasingly determined by global inflation. Many people think the rupee was weak in the late 1990s because it depreciated against the dollar. In fact other currencies depreciated even more, and India’s real effective exchange rate was pretty steady. Ever since the Asian financial crisis, global inflation has been modest. So too has Indian inflation.
Can the situation suddenly change? Maybe, but I see no sign of it. Mckinsey expects India’s software exports to boom from $9.5 billion last year to $58 billion by 2008.
In sum, the fiscal deficit should not be criticised for threatening an imminent crisis. Rather, it should be criticised for funnelling precious resources (invisibles) to finance the fiscal deficit instead of accelerating GDP growth. That is a less stringent criticism, but a more accurate one.