Business Daily from THE HINDU group of publications
Monday, Sep 18, 2006
Money & Banking - Insight
Concern on the dilution of FRBM guidelines
The RBI Annual report expresses concern that dilution of the goals set in the FRBM Act may not be conducive to economic growth in the long run. It also makes the point that the concessions of tax proposed for SEZs may work against the appropriate regional distribution of investments. The RBI and the Government should look at the suggestions of the planners positively and consider different options for regulating fiscal deficit.
THE CENTRAL bank's annual report highlights the need to preserve the fiscal deficit-GDP ratio within the limits laid down by the FRBM Act.
The Annual Report of the RBI for 2005-06 has been "crowded out" by other documents emerging from the central bank, in particular the Tarapore Committee (II) Report on fuller capital account convertibility. But when the Annual Report reached the media, it did give rise to some concern of a possible rift between the Government and the central bank because of certain comments it makes on fiscal responsibility and Special Economic Zones (SEZ).
On fiscal responsibility, the report makes the characteristic point that fiscal discipline is correlated, in general, with economic growth. Fiscal responsibility amounts to preserving the fiscal deficit/GDP ratio within the limits laid down by the FRBM Act. The RBI report expresses concern, albeit in a muted fashion, that dilution of these goals, as hinted at in the Budget speech, may not be conducive to growth in the long run. The report makes special reference to the perception that low fiscal deficit enables a lower interest rate environment, encourages savings and enables the Government to undertake investments in necessary sectors. In the apex bank's view, reduced fiscal deficit also makes the debt more sustainable as the present ratio of public debt to GDP is quite high.
Adverting to SEZs, the RBI report makes the point that the concessions of tax proposed for the SEZs may work against more appropriate regional distribution of investments. It seems to share the conventional wisdom that tax concessions for exports may not evoke the necessary response of increased exports. But China's successful experience in establishing the SEZ as an engine of export growth would give the lie to the RBI's point of view.
One may argue that the RBI is exceeding its jurisdiction in making comments on specific reforms, such as SEZs. Obviously, the Government is in a better position to choose from a menu of options to encourage exports than the RBI is. Even as the central bank is zealous in its attempt to protect its turf on monetary policy, details of export incentives and related tax policy should legitimately be the concern of the North Block rather than Mint Street.
Should limits be relaxed?
While on the subject of fiscal responsibility the RBI is entitled to its conservative view, the Planning Commission too has its legitimate point of view. In its recent Approach Paper, it has expressed the view that FRBM limits may have to be relaxed if investment targets have to be attained. The debate is still on.
During the last decade or so, India has consistently been violating the 3 per cent norm laid down in the FRBM Act. Fiscal purists have been claiming that such violations could lead to lower savings, lower growth and indirectly increase the current account deficit. But, in the last five to six years, during which the fiscal deficit/GDP ratio has been in the region of 7-8 per cent, the growth rates have been robust, the current account deficit has remained low, inflation expectations have been managed in spite of high crude prices and interest rates have remained benign.
Conventional economic thinking argues that debt becomes unsustainable if interest rates are higher than the rate of growth in the economy. Over the entire recent period, India has maintained its interest rates lower than the rate of growth, among one of the highest in the world. The enthusiasm for fiscal purity is obviously outrunning the evidence of ground reality, which does not show such adverse consequences.
We have, however, to concede a point to the purists. It is obviously necessary to rein in revenue deficit, which is ostensibly not incurred for creation of assets. There is, however, every justification for allowing fiscal deficit financed by Government borrowals through bonds (not from the RBI) to implement investments in infrastructure. The argument that such investments will lead to crowding out of corporate credit needs is not borne out by what has happened in India, at least in the last few years.
The banking system has been ready and able to meet all the legitimate credit needs of the business sector. There is no great danger of interest rates creeping up too high either, given the abundant liquidity. It, therefore, stands to reason that the RBI should put on its thinking cap to explore why there is an obvious disconnect between the theoretical concerns of fiscal purism about the consequences of higher than 3 per cent fiscal deficit/GDP ratio and the economy's actual robust behaviour in the last few years, both in terms of growth and inflation.
The debate regarding fiscal deficit, initiated by the planners, is centred on the Procrustean-bed approach of constraining investments of the Government qua the Government, though the local bond market permits borrowals at a reasonable rate of interest. There has to be space for fiscal deficit to the extent it is used for financing profitable and necessary investments, which yield returns. (This is, of course, not an argument for external borrowing).
The validity of a limit, such as 3 per cent of GDP is also not clearly established in India's case. I, however, concur with the fiscal purists in their argument for limiting revenue deficits. Perhaps, the Finance Minister's pressing the pause button in respect of revenue deficit reduction is a bow in the direction of populism.
The RBI and the Government should look at the suggestions of the planners positively and consider different options for regulating fiscal deficit. Particularly it is important to focus on primary deficit, bearing in mind India's experience and international practice.
Low returns on forex
I now turn to the RBI's accounts for 2005-06. As is to be expected, substantial accretion of foreign exchange reserves has enabled an increase in the income of the central bank from the deployment of foreign exchange resources.
However, the return on foreign exchange assets for 2005-06 was only 4.1 per cent, against 8.2 per cent in 2004-05.
This compares unfavourably with the far more substantial returns earned by the Singapore Government on a similar order of foreign assets.
This difference arises because, with the Indian model, the reserves are invested effectually in developed countries' government securities. While this reduces the risk and volatility in earnings, it also means that India has to be content with a much lower return than the Singapore Government gets.
I had an occasion to refer in these columns to the comment of Mr Lee Kuan Yew, Senior Minister of Singapore, who had been Chairman of Temasek and Chairman of the Government Investment Corporation of Singapore, which manages its reserves, for nearly 25 years.
He had pointed out that the Singapore model had found followers in Taiwan and South Korea. What prevents the RBI from adopting the model, with its prospects of higher returns? The disposition of income received by the RBI is on conventional lines. Against a total income of Rs 26,000 crore from both domestic and foreign sources, the central bank allocates nearly Rs 12,000 crore to Contingency and Other Reserves.
The balance left after meeting an expenditure of Rs 5,800 crore leaves a surplus of Rs 8,400 crore, which is transferred to the Government. This sum is a substantial increase over the Rs 5,400 crore transferred in 2004-05.
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