New Delhi: The finance ministry’s chief economic adviser Arvind Virmani was in a combative mood on Thursday when he defended the government’s fiscal policy, after stand-in finance minister Pranab Mukherjee’s budget speech on Monday showed the biggest fiscal deficit overrun in recent history. He also maintained in an interview that recent developments showed an urgent need to get started on financial sector reforms. Edited excerpts:
Is the worst over for the Indian economy?
What I can say at this point is the crisis hit in October. Not the crisis, the meltdown. Broadly, my view is that if you look at it in terms of quarters, weak quarters are third quarter (October-December), fourth quarter, first quarter (of 2009-10) and second quarter. There’s no data yet, it is all speculation right now.
Expert view: Virmani says India must find and remove the bottlenecks quickly to get back to high growth. Harikrishna Katragadda / Mint
In this budget, there is a candid admission by the government on the fiscal overrun. Is it a major concern?
I have been questioning the very basis of that question. Everybody is writing about an overrun and its implications. That is completely the wrong place to start. The place to start is, what is the crisis? The crisis is a demand shock through various means.
It is very clear that export demand and private investment are going to slow down because of these events that are going to happen. So we have a shock to demand, and we have to use monetary and fiscal policy to counter that. It’s a demand shock, that is the key issue we are addressing.
We come to fiscal policy. There is a decline in demand for private investment. The fiscal objective is (to) provide a stimulus to counter this. One way to do that is to substitute private investment by public investment, and that is where the infrastructure investment comes in.
Now the key point which is being missed is that demand for funds is going to be lower. When you are substituting public investment, you are also substituting the borrowing. Fiscal deficit is the change in net debt. There is no crowding out. The basic point I am making is that the fiscal thing you should be looking at is the increase in fiscal deficit.
Last year (2007-08), it was about 2.7% of the GDP (gross domestic product). This year it is estimated at about 6% of the GDP. There are two ways to look at it. One way is to say the fiscal stimulus provided this year is over 3%. The other way to look at it is there was an FRBM (Fiscal Responsibility and Budget Management Act) target. If there had been no crisis, we would have attempted to make sure the 3% is met. The real stimulus is 3%.
On top of that, there was also an oil shock. So, you issued extra bonds, which is also like a stimulus except that it is countering a different problem. So you have, in my way of looking at it, a fiscal stimulus of 3-4% of GDP. This is one of the highest stimulus in the world. I do not understand when somebody says the stimulus is not enough. They are using some benchmark which is not a correct benchmark.
Is the fiscal deficit sustainable?
There are four components of fiscal deficit. One...is Pay Commission arrears and loan waiver. Both those will be over next year. The second part of it is what used to be called automatic stabilizers. The fall in profit which is reducing revenue at existing rates, that is called automatic stabilizer. Third one is where there is conscious reduction in taxes; they are all policy measures which can be reversed. The fourth part is package(s). By definition, if it is a package it is reversed. Yes, I think it is sustainable. Personally, my target would be 2010. We should go back to FRBM targets and we can...
Doesn’t the fallout of the fiscal deficit run counter to your monetary policy?
If you actually believe investment demand is falling, the demand for credit is also falling. So, all you are doing is substituting. There is no crowding out.
There is a separate issue of monetary policy. I don’t think they are directly linked. The monetary policy is normally the first line of defence.
There are different indicators of monetary policy and they are giving different signals. RBI (Reserve Bank of India) has rightly said credit flow has increased since the September shock. Government security interest rates had fallen. If they are rising now that is an indicator to the contrary.
It is not an issue of government because government is an issue of crowding out. This is an issue of monetary policy in my way of looking at it. If government security interest rates are rising, to me it is one indicator that money supply is too tight. I don’t want to call it supply, it is the monetary conditions.
If RBI decides money supply is too tight, then you have to loosen it. But they have to look at all the indicators, they have to make the judgement. But the basic point I am making is that these are two independent decisions.
You cannot stop fiscal policy because monetary policy is too tight. There is no inflation problem for the next six months or 12 months.
We have the issue of Rs45,000- odd crore that has to be raised in 2008-09. How will the government finance this year’s fiscal deficit?
The secretary (Ashok Chawla of the finance ministry’s department of economic affairs) said the decision has not yet been taken.
The market is saying it is not possible to unleash Rs45,000 crore...
Because you are assuming the monetary policy will remain unchanged. You are saying there is a monetary policy framework which has resulted in government security prices rising in the last auction and this will continue to happen. I am saying, no, that is a monetary policy indicator and you can change monetary policy to make sure that doesn’t happen. That is for the RBI to decide.
Hypothetically, if RBI relaxes the monetary policy...
Is it too tight or isn’t it? Why should it (RBI) relax just to relax, not to fund the thing (fiscal deficit)? Is it too tight given the shock to the system?
Doesn’t it lead to more money supply to the system?
There are different signals. Somebody might look at credit and say everything is fine. Somebody might look at interest rates and say interest rates are rising so monetary policy is too tight. That judgement has to be made by RBI. If the judgement is (that) monetary policy is fine, then interest rate will keep rising. I cannot give you a more specific answer as I am not authorized to speak on monetary policy.
As chief economic adviser, what do you see now as macro risks?
It is the external thing. There is a massive choking of credit. That is why things remain uncertain and it continues.
In the current year, subsidies are a major issue. The increase has been very steep. Has it reached a point where a national debate is necessary?
On the contrary, my fear is because the big problem has passed—the big problem came from oil and commodity price boom. It has passed for the year. The oil prices are going to rise again when the global economy picks up. That is where there is the biggest uncertainty outside. It is a long-term issue. That is why it is imperative.
The second reason is the credibility of the fiscal stance. People also know when they are looking at the long term that it may arise two years from now. I am also asserting we will be back to the FRBM target. They will be more credible if you do something on oil and fertilizer subsidies. It is not that you have to do it right now. But you have to do it to make that fiscal statement more credible.
It is important now because global capital flows are going to be lower for several years because of deleveraging in the US and other economies.
By the same token, it more important now to do financial sector reforms for the same reason. The global capital flows in a way sidestep the problem of intermediation. Once they are gone, the sidestepping won’t be possible. Savings are there in the economy, (and) you want to make sure they get to people who want to invest. For that you have to have an efficient financial system.
What should be the contours of the oil debate?
Let me tell you a couple of principles. One is the issue of targeting. There we have made progress. Fortunately, after a long time the government has approved the setting up of UID (unique identification number) authority... Once UID is issued, you can set up a smart card based system for fertilizer or for kerosene. It provides you a basis of targeting. It is more efficient to use this mechanism.
The second part, it is possible to decontrol petrol and diesel. If the government wants to subsidize kerosene, we can work out the most efficient way to do that. Prices are now in a situation where it is possible (to decontrol).
What happens when prices rise again?
Well, then prices will have to adjust. You will have to do that to have fiscal credibility. It is up to the government. At that point in time, if it decides to automatically adjust or partially adjust taxes, it can do that.
One element has already been done. You have set up a specific duty which in some sense lowers the rate. As tax purists, one doesn’t like specific duties. But this is one case because this thing is highly volatile, because there is a cartel outside, it can be justified.
It (subsidies) is a credibility issue. It is within the expenditure and tax policies that I have tried to enumerate that this is credible. What the subsidy thing means is that if there is another shock, it adds to the credibility.
Going back to the financial sector reform issue and intermediation, are you saying the Indian financial sector does not have wherewithal...
What I am saying is that over the last five years of high growth, the change in savings rate was higher than the change in investment rate. Savings are there; this is not an externally financed boom as in Eastern Europe and elsewhere.
We have the savings. You will say, why did we need 9% (of GDP) of capital flows? If the savings were there in the economy, how come we had 9%?
What was happening was we had 9% coming in to the corporate sector. You get 7.5% going out (as RBI investment overseas of foreign exchange reserves). All the contribution here is 1.5%, the current account deficit.
The point is, we need something like 1.2-1.5% of GDP as external financing in a macro sense. That is easily available from foreign direct investment and a few minor things. Even if there is a fall in capital flows globally, we only need 1.5% of capital globally. What I am saying is, we can get that. To make it work you have to make sure rest of the savings goes to the best guy.
The domestic saving rate is 38% (of GDP). If you take a capital-output ratio of 4, domestic savings can finance 9% growth. You have savings in the economy as against countries where the current account deficit was 8% of GDP. Their whole boom was financed by money from outside. In a macro sense, our boom was not financed by money from outside.
What is the role of this (capital flows)? Why do we need this at all? The role is it facilitates efficient intermediation. It was not a useless thing.
You are really talking about the quality of intermediation. Do you see a big conflict of interest that the government owns a big part of the banking system?
All those issues are there. The question is, is the public banking system efficient? There is a medium-term issue and a short-term issue. The short-term issue is in a way defused. The public banking system is a source of strength as long as the global financial crisis lasts. Because there are no questions about it failing. In the short term it is actually an advantage.
The most important thing is the market thing: repo market, futures, etc. We have to see where are the bottlenecks and remove them quickly if we have to go back to high growth. This is hot because it has to be done quickly because markets take time to develop.