Why the Indian economy is in a Catch 22 situation

catch22Vivek Kaul 

Joseph Heller’s Catch 22 remains one of the literary classics of the twentieth century. Set during the course of the Second World War, the book gave a new phrase to the English language. As a paragraph from the book goes:
There was only one catch and that was Catch-22, which specified that a concern for one’s safety in the face of dangers that were real and immediate was the process of a rational mind. Orrwas crazy and could be grounded. All he had to do was ask; and as soon as he did, he would no longer be crazy and would have to fly more missions. Orr would be crazy to fly more missions and sane if he didn’t, but if he were sane he had to fly them. If he flew them he was crazy and didn’t have to; but if he didn’t want to he was sane and had to.
Orr is a bomber pilot who keeps getting shot down. He has been shot down seventeen times, which is more than anyone else in his unit. Given that he is deemed crazy to still be flying. All he has to do to be grounded is to ask. But the catch is that the moment he asks he would no longer be be deemed to be crazy. He would be sane and being sane he would have to fly more missions.
This catch was the Catch 22. Over a period of time such a hopeless no win situation that Orr was in, came to be referred in the English language as a Catch 22.
The Indian economy is currently in a Catch 22 situation. The government of India had a total expenditure of Rs 7,12,671 crore, during the course of 2007-2008 (i.e. the period between April 1, 2007 and March 31, 2008). This grew by nearly 44% over the next two years and during the course of 2009-2010 (i.e. The period between April 1, 2009 and March 31,2010), the total expenditure stood at Rs 10,24,487 crore.
Increasing expenditure is not a problem if its met by increasing income. But that wasn’t the case here. Between 2007-2008 and 2009-2010, the revenue receipts of the government (or the income that the government hopes to earn every year) grew by a minuscule 5.7% to Rs 5,72,811 crore.
Some part of the increase in expenditure was met by selling shares that the government held in public sector companies. But a major part of the increase was met by simply borrowing more. The borrowings and other liabilities of the government shot up from Rs 1,26,912 crore to Rs 4,18,482 crore, a massive jump of nearly 230%, during the period.
The good part of this massive increase in government expenditure was that the Indian economy continued to grow at very high rates, even though economic growth in large parts of the world was slowing down in the aftermath of the financial crisis that had erupted after the investment bank Lehman Brother went bust in September 2008.
The Indian economy grew by 8.6% in 2009-2010 and 9.3% in 2010-2011. And the Indian politicians opened their champagne bottles and told us that India had decoupled from the global economy. As Sajjid Chinoy of JP Morgan
writes in the Business Standard “The charitable (but incorrect) interpretation is that India successfully decoupled from the global economy, returned to its nine per cent growth path post-Lehman.”
The formula seemed to be working and so the government continued with it. For 2012-2013 (the period between April 1, 2012 and March 31, 2013), the government expenditure was expected to come in at Rs 14,30,825 crore. This meant that the government expenditure more than doubled between 2007-2008 and 2012-2013. This when the revenue receipts of the government went up by around 61% to Rs 8,71,828 crore, during the same period.
The borrowings and other liabilities of the government during the same period went up by 310% to Rs 5,20,925 crore. The government borrows money to make up for the difference between what it earns and what it spends. This difference is referred to as the fiscal deficit.
If the economic growth rate of 2009-2010 and 2010-2011 was anything to go by the Indian economy should have continued to grow at the same pace, given that the government was spending more and more money.
But that did not turn out to be the case. Numbers released on February 28,2013, suggested that the Indian economy grew by 4.5% during the three month period ending on December 31,2012. This was the lowest in fifteen quarters.
So what happened that led to the economic growth rate falling by half? Initially increased government expenditure translated into economic growth. As the government spent more money those who got that money benefited. They spent that money by goods and services, and this translated into higher economic growth. But two other things happened as well.
As the government went around spending more it led to a higher inflation. More money chased the same amount of goods and services leading to higher prices. Food inflation rose at a much faster pace than overall inflation.
Higher prices meant that people were spending more to meet their regular expenditure. And this meant lower savings.
In the year 2009-2010 the household savings stood at 25.2% of the GDP. In the year 2011-2012 the household savings had fallen to 22.3% of the GDP. Even within household savings, the amount of money coming into financial savings (i.e. bank deposits, life insurance funds, pension and provident funds, shares and debentures) fell at a faster rate. As the Economic Survey that came out before the budget pointed out “Within households, the share of financial savings vis-à-vis physical savings has been declining in recent years…Financial savings accounted for around 55 per cent of total household savings during the 1990s. Their share declined to 47 per cent in the 2000-10 decade and it was 36 per cent in 2011-12. In fact, household financial savings were lower by nearly Rs 90,000 crore in 2011-12 vis-à-vis 2010-11.”
So we have a situation were the government has been borrowing more and the overall household financial savings have also come down. When the government borrows more it “crowds out” and leaves a lower amount of savings for the banks and other financial institutions to borrow from. This leads to higher interest rates on deposits and hence higher interest rates on loans.
Higher interest rates to some extent have killed economic growth as people have bought fewer homes, cars, consumer durables etc. Corporates have also postponed their expansion plans. So increased government which drove economic growth between 2009-2011, has pulled it down since then as interest rates as well inflation have remained high.
So does this mean that the government expenditure needs to be cut? Yes and no. If interest rates and inflation have to come down, the government expenditure and hence borrowing need to come down. But with the private sector and households going slow on spending money, if the government expenditure is also cut, it will slowdown economic growth even further. So that’s the Catch 22 situation that the Indian economy has been put in.
As Chinoy puts it “A tightening fisc and slowing growth are seen as coincidental. Markets applaud fiscal discipline, but bemoan weak growth. But these are not independent phenomena. Instead, they are inextricably linked. Fiscal austerity impinges upon growth. A reduction in the deficit has a contractionary impact on activity.”
In fact this can already be seen in the Indian context. During the second half of 2012-2013, the government cut down on expenditure as it feared a downgrade by international rating agencies. The targeted expenditure for the year stood at Rs 14,90,925 crore. It was revised to a Rs 14,30,825 crore, which was 4% lower. And this has had an impact of economic growth. “On a cyclically adjusted basis, India’s deficit was reduced by a whopping 1.5 per cent of GDP in 2012-13 – largely by squeezing expenditures. No wonder the slowdown was accentuated further,” writes Chinoy.
Getting out of this Catch 22 situation is difficult. It makes immense sense for the government to cut down on expenditure. Only that can drive down interest rates and inflation and thus revive genuine economic growth. But that of course will take time to happen and meanwhile the economic growth will slowdown further. Given that Lok Sabha elections are due next year, it is not hard to figure out what the government is likely to do.
The government’s targeted expenditure for the year 2013-2014 (i.e. the period between April 1, 2013 and March 31, 2014) is at Rs 16,65,297 crore, which is 16.4% higher than the last financial year. Given this a scenario of high inflation and high interest rates is likely to continue in this financial year as well. And that is no April Fool’s joke.
The article originally appeared on www.firstpost.com on April 1, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek)