More trouble for Chidu: Fiscal deficit hits 75% of target in first 5 months

The finance minister P Chidambaram has reiterated time and again that the government will adhere to the fiscal deficit target of Rs 5,42,499
 crore or 4.8% of the GDP(gross domestic product) that it has set for itself. On September 5, 2013, he had said that the fiscal deficit target of 4.8% of GDP was a “red line and the red line will not be crossed.” Fiscal deficit is the difference between what a government earns and what it spends.
But the latest data released by the Controller General of Accounts (CGA) on September 30, 2013, shows that fiscal deficit has already reached 74.6%(or Rs 4,04,651 crore of the targeted Rs 5,42,499 crore) of the full year target, as on August 31, 2013. Hence, three fourth of the fiscal deficit target has been reached during the first five months of the financial year (i.e. the period between April 1, 2013 and August 31, 2013).
Now how does the situation look in comparison to the past data? For a period of 16 years since 1998-1999 (for which the data is publicly available on the CGA website), the average fiscal deficit for the first five months of the financial year stands at 54.2% of the annual target.
During the period of the Congress led UPA government has been in power (i.e. Since 2004-2005), the average fiscal deficit for the first five months of the financial year has been 60.4% of the annual target. Last year it was 65.7% of the annual target.
In fact, only in 2008-2009 was the number greater than this year. As on August 31, 2008, the fiscal deficit for the first five months of the financial year had already reached 87.7% of the annual target. This was the year when the Congress led UPA government was getting ready for the Lok Sabha elections which happened in April-May 2009, and hence, had gone overboard on the spending front.
The fiscal deficit in 2008-2009 was estimated to be at Rs 1,33,287 crore or 2.5% of the GDP. It finally came in at Rs 3,36,992 crore or 6% of the GDP. The point being that when the Lok Sabha elections are scheduled to happen next year, the initial estimates of the fiscal deficit can be way off the mark. Lok Sabha elections are due in May 2014 as well. Before that there are several state assembly elections as well. So, it remains to be seen whether the Congress led UPA government sticks to the fiscal deficit target of 4.8% of the GDP or goes overboard with the expenditure as it did last time when the elections were due.
What also does not help the government is a slowdown in tax revenues. As Sonal Varma of Nomura points out in a note dated September 30, 2013, “Fiscal year to date (FYTD), net tax revenue growth was muted at 4.9% year on year (versus the budget target of 19.3% year on year) due to weak indirect tax collections (excise, services, customs), while government expenditure rose 17.3% year on year FYTD, within the budget target of 18.2% year on year.”
When the revenue is growing at around one fourth of the expected rate, meeting the revenue target will be very difficult. Expenditure on the other hand continues to rise more or less at the rate assumed in the annual budget.
Given this, the government will have to make a significantly greater effort to control its expenditure, if it has to get anywhere close to meeting its fiscal deficit target. As Varma puts it “In our view, the government will have to announce another round of spending cuts to offset the fiscal slippage from slowing revenue collections and to meet its financial year 2013-2014 budgeted fiscal deficit target of 4.8% of GDP.”
The government had announced some measures to cut expenditure on September 18, 2013. A mandatory cut of 10% in non plan expenditure of all departments was announced. This did not include expenditure on interest and debt repayment, defence capital, salary, pension and grants to states. Over and above this, restrictions have been put on holding seminars/conferences as well as air travel. These measures will not be enough and more expenditure cuts will have to be put in place. In fact, when the government was in a similar but slightly better scenario last year, it simply froze spending, during the last few months of the year.
As Ruchir Sharma, head of emerging markets and global macro at Morgan Stanley, said
 in a recent interview to the Forbes India magazine “We achieved the [fiscal deficit] target last year, but you have to understand how that was done. The government will have to really freeze spending, and that in turn will compress consumer demand. The issue is whether they have the political appetite to do that…So can the government meet its fiscal deficit target? Of course it can. But the price in this case will be economic growth.”
Varma had written along similar lines in a note titled 
Government Announces Austerity Measures and dated September 18, 2013. As she wrote “The spending cuts will adversely impact growth. High government spending was one of the main drivers of real GDP growth of 4.4% year on year in Q2 2013. With spending likely to be slashed and financial conditions much tighter starting July, we expect private demand to slow down further.” And this will impact economic growth.
The other option before the government is to raise diesel prices. 
The under-recovery on diesel being sold by oil marketing companies(OMCs) for the fortnight starting October 1, 2013 is at Rs 10.51 litre. In the previous fortnight the under-recovery on diesel stood at Rs 14.50 litre. This fall has been primarily on account of the rupee rallying against the dollar, leading to the price of oil falling in rupee terms. Despite the fall, at Rs 10.51 per litre, the under-recovery on diesel continues to be substantially high.
The government compensates the oil marketing companies for a part of this under-recovery and this means higher expenditure for the government. The oil producing companies like ONGC and Oil India Ltd, compensate the oil marketing companies for the remaining part of the under-recovery.
If the government has to meet its fiscal deficit target it needs to bring down the under-recovery on diesel. And this can only be done by raising diesel prices significantly. Currently, the oil marketing companies increase the price of diesel by 50 paisa every month, which is clearly not enough, given that the under-recovery is greater than Rs 10 per litre.
As Sharma put it “The government will have to raise diesel prices. Currently, they are Rs 9-10 behind on under-recoveries. They need to raise diesel prices by such a massive amount to stick to the fiscal deficit target.”
Other than diesel, there are significant under-recoveries on cooking gas as well as kerosene. The under-recovery on cooking gas for the week starting October 1, 2013, stands at Rs 532.86 per cylinder whereas the under-recovery on kerosene is at Rs 38.32 per litre.
The government is essentially in a situation where it has to decide between either meeting the fiscal deficit target or sacrificing economic growth. If it looks like that the government will be unable to meet its fiscal deficit target then India is likely to be downgraded by rating agencies.
A sovereign downgrade will see India’s rating being reduced to ‘junk’ status. This would lead to many foreign investors like pension funds having to sell out of the Indian stock market as well as the bond market, given that they are not allowed to invest in countries which have a “junk” status.
When they sell out, they will will be paid in rupees. In order to repatriate this money, they will have to sell rupees and buy dollars. This will increase the demand for dollars and put further pressure on the rupee, in the process undoing all the damage control carried out by the RBI to prevent the rupee from falling.
A weaker rupee will mean that our oil import bill will shoot up further. We will also have to pay more for the import of coal, fertilizer etc. This will put further pressure on the fiscal deficit as the government expenditure will increase given that it currently offers subsidies on oil as well as fertilizer.
To conclude, in order to meet its fiscal deficit target the government will have to raise diesel prices and at the same time cut its expenditure dramatically, which will have an impact on economic growth. As things currently stand, it looks like the government will have to sacrifice economic growth on the altar of the fiscal deficit.
If the government does not meet its fiscal deficit target then the repercussions of that will also have a huge impact on economic growth. Hence, the choice is between the devil and the deep sea. As Franklin Roosevelt, the President of America between 1933 and 1945, put it “Any government, like any family, can, for a year, spend a little more than it earns. But you know and I know that a continuation of that habit means the poorhouse.” The Congress led UPA government has been running high fiscal deficits for way too long and the negative consequences of that have started to catch up.
The article originally appeared on on October 2, 2013

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

The Great Indian FDI conundrum

ghemawat 2

Our politicians think our problems come from being connected with the world, but the reality is we are too little connected to the world, says Pankaj Ghemawat.

Vivek Kaul

The United Progressive Alliance government is fond of telling us that India’s weakening macroeconomic indicators – a falling rupee, a declining stock market, rising bond yields – are the result of being tied to a weak global economy and factors external to India. But if you were to ask Pankaj Ghemawat, Anselmo Rubiralta Professor of Global Strategy at IESE Business School in Barcelona, Spain, India is not exactly as globally connected as we think it is.
Ghemawat has constructed a broad index of international integration, the DHL Global Connectedness Index, which was first released in November 2011. The 2012 version of this index was released last year and it shows India closer to the bottom. “This index extends beyond trade to incorporate capital, information and people flows as well, and covers 140 countries that account for 95% of the world’s population and 99% of its GDP,” says Ghemawat.
India ranks 119 out of 140 countries on the depth of its global connectedness. “When it comes to trade intensity, India still ranks in the bottom 25% in the sample. As far as capital connectedness is concerned, it is closer to the median,” says Ghemawat.
Capital connectedness is calculated from measures of foreign direct investment (FDI) and foreign portfolio equity investment into the stock market of the concerned country. India’s decent performance on capital connectedness is primarily on account of the huge money that has come into the Indian stock market from abroad in the last decade and big outward FDI flows in the form of overseas acquisitions by Indian corporates.
If one looks at just inward FDI, the performance is dismal. As Ghemawat puts it, “In terms of inward FDI stock (i.e. foreign companies having built or bought businesses in India) expressed as a percentage of GDP, India comes in the bottom 10%.”
FDI flows into India have also fallen in three out of the last four years. For 2012-13, FDI fell by 21% to $36.9 billion, government data show. The United Nations Conference on Trade and Development (UNCTAD), in a recent release, said that FDI inflows to India declined by 29% to $26 billion in 2012.
The government has, faced with an unsustainable current account deficit (CAD), has been trying to encourage FDI into the country to firm up the rupee against the dollar. Last year in September, the government opened up FDI in multi-brand retailing with the rider that each state can decide whether it wants companies like Wal-Mart to set up shop within its borders.
But since then not a single dollar has come into the sector. “One reason for foreign money not coming in is that investors are not sure whether the policy will continue as and when a new government comes in. Also, letting states set their own rules on such an international economic policy matter is basically unheard of elsewhere,” said Ghemawat. Towards the middle of July 2013, the government relaxed FDI norms in 12 sectors, including telecom, insurance, asset reconstruction, petroleum refining, stock exchanges and so on. 
Ghemawat feels that there is a lot that India can learn from China on this front. China started opening up its retail sector to FDI in 1992, initially with various restrictions, but ultimately allowing 100% FDI in 2004. This benefited them with foreign players bringing in new management practices along with supporting technology and investment capital. And we shouldn’t forget the complementarity for foreign retailers between sourcing from China (contributing to China’s export boom) and selling there.
Ghemawat argues that much of the fear about FDI in retail is exaggerated, because even with full liberalisation, foreign retailers would hardly come to dominate the Indian market. “Retail is a very local business, where an intimate understanding of customers, real estate markets, and so on, is essential to success.” He cites a recent estimate that 40 foreign players account for only about 20% of organised retail in China, to suggest that foreign and domestic retail could thrive side-by-side in India.
“Foreign retailers don’t always win out against domestic rivals,” he adds. “Electronics retailers Best Buy from the US and Media Markt from Germany both shut down their stores in China in the last few years. They just couldn’t compete with local rivals Gome and Suning, which had greater domestic scale and business models more attuned to the Chinese market. Home Depot also exited China in 2012. But Chinese consumers gained anyway – competition against foreign retailers spurred locals to improve customer service, one of their weak points.”
Coming back to data from the Indian market, Ghemawat notes an interesting factoid from the 2013 Economist Corporate Network Asia. The nominal GDP of India grew by 12.6% in 2012. In comparison, the sales of MNCs (mainly Western) in India grew by only 6.3%, only half as fast as the GDP. “While this could be viewed as positive regarding Indian firms, a difference of such a big magnitude is probably reflective of a lack of openness,” said Ghemawat.
There are multiple reasons for India’s poor showing on these indicators India regularly figures in the bottom tier of countries in terms of the extent to which its policies promote trade. In the World Economic Forum’s 2012 Global Enabling Trade Index, India figures in the bottom tier. On the market access parameters, in particular, it figures third from last in a list of 132 countries. Ghemawat also cites the OECD’s FDI restrictiveness index which he has inverted into the FDI Friendliness Index. “India again figures in the bottom 10% of 50 countries in terms of the extent to which it encourages FDI.” No amount of ministerial cajoling of potential foreign investors is likely to outweigh the impact of such protectionist policies.
These indicators, of course, translate into low productivity and lack of infrastructure required to carry out a profitable business. “The Global Competitiveness Report tells us all we need to know about India’s poor infrastructure and low productivity,” says Ghemawat. “India currently ranks 59th on the list (out of 144 countries). It has fallen 10 places since peaking at the 49th spot in 2009. Once ahead of Brazil and South Korea it is now 10 places behind them. China is 30 places ahead of India,” he adds.
When it comes to the supply of transport, energy and ICT (information, communications technology) infrastructure, India is 84th on the list. This lack of infrastructure is the single biggest hindrance to doing business in India, feels Ghemawat. And this has kept foreign investors away from the country. Also given India’s weak health and basic education infrastructure (where it is 101st on the list), India remains low on productivity, which is an important factor for any foreign investor looking to make an investment. And as if all this was not enough it is worth remembering that it is not easy to start any business in India. Every year the World Bank puts out a ranking which measures the Ease of Doing Business across countries. In the 2013 ranking, India came in at rank 132 on the list – the same as in 2012. When it comes to starting a new business In
dia is 173rd on the list. Hence, foreign investors have an option of starting their business in a much easier way in many other countries. Given this, why should they be hurrying to India?
The spate of recent scams also has not helped the way India is viewed abroad. There is significant evidence to show that corruption hampers trade. Says Ghemawat: “According to one study, an increase in corruption levels from that of Singapore to that of Mexico has the same negative effect on inward foreign investment as raising the tax rate by over 50 percentage points.” India stood at 94th position in Transparency International’s 2012 Corruption Perception Index. “Given this, tackling corruption has to be a priority,” adds Ghemawat.
The moral of the story is that although India is much more open than it used to be 20 years ago, there is a lot that still needs to be done. And this is important because there is a clear connect between the global connectedness of a country and measures of prosperity. As Ghemawat puts it, “There is a strong positive correlation across countries between the depth of a country’s global connectedness and measures of its prosperity, such as its GDP per capita and its ranking on the UN’s Human Development Index. To be sure, correlation is not the same as causation, but statistical analysis indicates that after controlling for initial income levels, countries with deeper global connectedness have tended to grow faster than less-connected countries.”
The point is further buttressed by one look at the list of countries that are on the top of 2012 DHL Global Connectedness Index created by Ghemawat. These countries are the Netherlands, Singapore, Luxembourg, Ireland, Switzerland, the United Kingdom, Belgium, Sweden, Denmark, and Germany. In the recent past some of these countries have been caught up in the aftermath of the financial crisis, but it’s important not to let recent growth rates overshadow measures of current prosperity, on which all of these countries far surpass India.
Ghemawat gives the example of the Indian information technology sector. “Ask this simple question to yourself: Would Indian IT companies have been as globally competitive if we had protected them from international competition?” The answer of course is no. But that is the case with the business services sector. There is a huge protective moat around it. This, despite the fact that the sector has a huge potential to create jobs.”
And he backs his argument with numbers. “Although some services (like haircuts) will always be delivered locally, liberalizing trade in services alone could boost global GDP by at least 1.5%.” In India’s case, opening up business services is even more important given that we don’t trade much with our neighbours due to various reasons. “For example, Indian trade with Pakistan, according to one study, is only 2 to 4% of what it might be under friendlier circumstances. The rest of India’s neighbours are relatively small and poor, presenting limited opportunities compared with, for example, the benefits China realised by tying into Japanese and Korean production networks. It is neither exaggerated nor xenophobic to say that one of India’s key structural problems is that it is located in a difficult neighbourhood,” says Ghemawat.
Countries tend to trade the most with their neighbours.  Ghemawat explains, “all else being equal, if you cut the distance between a pair of countries in half, their trade volume will go up almost 200%.  Add a common border, and trade rises another 60%.  That’s why more trade happens within world regions than across them, and the US’s top export destinations are Canada and Mexico.”
In India’s case, at least over the short-to-medium term, trading primarily with neighbours won’t be workable (though Ghemawat does urge India to take the lead on regional integration in South Asia). Hence, he feels that some business services can be outsourced over greater distances than many categories of merchandise are traded, since physical shipment of products is not required. 
One exception he notes is how, recently, China became India’s biggest trading partner, overtaking the United States. But Ghemawat feels that caution is in order. “India runs a huge trade deficit with China and exports mainly primary products there: Cotton, copper and iron ore account for nearly one-half of the total. Given the limited progress the US has made in rebalancing its trade with China, it’s hard to see what India might accomplish within any reasonable timeframe,” he says. Trade deficit is the difference between imports and exports.
Ghemawat also feels that India has a lot to gain by encouraging trade within states. “I have been trying unsuccessfully for years to get hold of data on trade between Indian states,” he says. “India has a lot to gain by encouraging and increasing trade between states. As the former Chairman of Suzuki once put it to me, what India needs is not external trade liberalisation but internal trade liberalisation. And I heard Ratan Tata say something similar about the need for more integration and fewer barriers within India. For a large country, the potential gains from internal trade are typically much larger than those from international trade,” Ghemawat concludes. 

The interview originally appeared in the Forbes India magazine in the edition dated Sep 20, 2013