Mr Jaitely, Where Will The Money For Public Investment Come From?

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010
On the last page of his magnum opus The General Theory of Employment, Interest and Money, the British economist John Maynard Keynes wrote: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

One of the ideas of Keynes that has never become ‘defunct’ so to say, is that of governments needing to spend more when the economy is in trouble. In The General Theory, Keynes went to the extent of saying: “If the Treasury[i.e. the government] were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again … there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”

How would this help in reviving the economy during bad times? Raj Patel explains this in The Value of Nothing as follows: “Keynes suggested, rhetorically, that if they lacked the imagination for anything more creative, governments could simply bury bottles of money under tons of trash, and that this would help get the economy going. It may sound bizarre, but it would certainly be worth someone’s while to dig up free money. To find these banknotes would require workers. Those workers would need to pay for food and shelter and everything else they needed to survive while they dug. The grocers who fed them and the landlords who rented to the workers would then have cash to spend, which they would use to buy other goods, and so on. This is called the “multiplier effect,” and it’s the added return that a government gets from spending its money in the economy.”

Keynes’ The General Theory was first published in 1936 and since then politicians all over the world have latched on to the idea of the government having to increase public spending when times are tough.

The finance minister Arun Jaitley is not different on this front. As he recently said: “Public investment has been stepped up in the last year and it will continue to remain stepped up… When you fight a global slowdown, public investment has to lead the way.”

In an environment where corporate balance sheets are stressed and public sector banks are in a mess, this might seem like the best way forward. But that is a very simplistic way of looking at things. The question is where will the money to pay for this public investment come from? And how will the government meet this expenditure and at the same time ensure that the fiscal deficit does not go up? Fiscal deficit is the difference between what a government earns and what it spends.

In the budget speech Jaitley made in February 2015, he had said: “I will complete the journey to a fiscal deficit of 3% in 3 years, rather than the two years envisaged previously.  Thus, for the next three years, my targets are: 3.9%, for 2015-16; 3.5% for 2016-17; and, 3.0% for 2017-18.”

From what it looks like, Jaitley is unlikely to meet the fiscal deficit target of 3.5% of the gross domestic product (GDP) in 2016-2017, the next financial year. In fact, the Mid-Year Economic Analysis released by the ministry of finance in December 2015 has hinted at this very clearly.
As the Economic Analysis points out: “If the government sticks to the path for fiscal consolidation, that would further detract from demand…[Fiscal] consolidation of the magnitude contemplated by the government… could weaken a softening economy”. Fiscal consolidation is essentially the reduction of fiscal deficit, along the lines Jaitley had talked about in his budget speech.

What this clearly tells us is that the government is more serious about public investment than meeting the fiscal deficit target. The question is where will the money to finance public investment come from? As I explain here, the total cost of implementing the recommendations of the Seventh Pay Commission and One Rank One Pension will come close to Rs 1,40,000 crore, if the Railways is not bailed out by the government. Over and above this, food and fertilizer subsidies of more than Rs 1,00,000 crore, continue to remain unpaid. This doesn’t leave much scope for public expenditure, unless the government leaves the subsidy bills unpaid.

Further, there are other things that need to be looked at. Take a look at the following table and the debt servicing ratio of the government.




Debt servicing is defined as the amount of money a government spends towards repaying the debt as well as paying interest on the outstanding debt. The debt servicing ratio is obtained by dividing the money spent towards debt servicing by the revenue receipts i.e. the income of the government. What the table clearly tells us is that the debt servicing ratio of the government has worsened over the years.

In 2015-2016, the government is expected to spend close to 60% of what it earns in servicing its debt. And this is clearly not healthy. Any further worsening of the fiscal deficit will only mean a greater amount of government revenues going towards servicing its past debt in the years to come. This will leave a lower amount of money for other more important things, in the years to come. Debt servicing is defined as the amount of money a government spends towards repaying the debt as well as paying interest on the outstanding debt. The debt servicing ratio is obtained by dividing the money spent towards debt servicing by the revenue receipts i.e. the income of the government. What the table clearly tells us is that the debt servicing ratio of the government has worsened over the years.

Also, most analysts and experts tend to just look at the fiscal deficit of the central government, without taking into account the fiscal deficits of the state governments as well. As economist M Govinda Rao wrote in a recent column in The Financial Express: “This year, the Union government’s deficit is set at 3.9%, and with the states together having a deficit of about 2.2%, the aggregate fiscal deficit of the government works out to 6.1%. It is reported that 21 distribution companies are likely to join the UDAY scheme and the deficit on that account could be about 1%.”

If we were to add all this the real fiscal deficit of the government would come at 7.1% of the GDP. The household financial savings in 2014-2015 stood at 7.5% of GDP. What this tells us very clearly is that the government captures most of the household financial savings. Any further increase in fiscal deficit leading to increased borrowing by the government will only push up interest rates. Also, Rao estimates that public sector enterprises claim around 2% of the GDP. Hence, as he asks “where can financial institutions find the money to lend for private investment?”

Over and above all these numbers the credibility of Arun Jaitley is at stake as well. In his maiden budget speech in July 2014 he had said: “We need to introduce fiscal prudence that will lead to fiscal consolidation and discipline. Fiscal prudence to me is of paramount importance because of considerations of inter-generational equity. We cannot leave behind a legacy of debt for our future generations. We cannot go on spending today which would be financed by taxation at a future date.”

In his February 2015 speech Jaitley went against what he had said earlier and loosened the fiscal strings a little. If he does that again this year, how much credibility would what he says, continue to have? Also, is Jaitley still worried about inter-generational equity? Or was what he said in July 2014 innocent murmurs of a new finance minister, which should not have been taken seriously?

Further, there has been very little effort on part of the government to take tough decisions on the expenditure front. It continues to fund loss making entities like MTNL, Air India etc. The finance ministry had set up the Expenditure Management Commission in 2014. The reports of the Commission have not been made public up until today. This clearly tells us how serious the government is about cutting wasteful expenditure.

Also, there has been very little new thinking on part of the government in order to increase its income. Even low hanging fruit like the stake the government holds in companies like ITC, L&T and Axis Bank, through the Specified Undertaking of Unit Trust of India (SUUTI)., hasn’t been cashed in on. All the government seems to be doing to increase its revenue is to increase the excise duty on petrol and diesel.

It is also worth asking why does the fastest going large economy in the world need a fiscal stimulus from the government?

To conclude, since I started this column with Keynes it is only fair that I end it with him as well. One of the misconceptions that people have is that Keynes was an advocate of the government running high fiscal deficits all the time. It needs to be clarified that his stated position was far from that.

Keynes believed that, on an average, the government budget should be balanced. This meant that during years of prosperity, governments should run budget surpluses. But when the economic environment is weak, governments should spend more than what they earn, and even run high fiscal deficits.

But over the decades, politicians have only taken one part of Keynes’ argument and run with it. The idea of running deficits during bad times has become permanently etched in their minds. However, they have forgotten that Keynes had also wanted them to run surpluses during good times as well.

Jaitley is a politician, he is no different from others of his ilk.

(The column originally appeared on SwarajyaMag on January 7, 2016)

Can Modi govt afford to run a higher fiscal deficit?

narendra_modiIn his maiden budget speech finance minister Arun Jaitley had talked about the government working towards lower fiscal deficits in the years to come. “ My Road map for fiscal consolidation is a fiscal deficit of 3.6 per cent for 2015-16 and 3 per cent for 2016-17,” Jaitley had said in July 2014, when he presented the first annual budget of the Narendra Modi government. Fiscal deficit is the difference between what a government earns and what it spends.
A lot has changed since then. The mainstream view that now seems to be emerging is that the government needs to spend more in the days to come, given that the private sector is not spending as much as it should.
One of the first to advocate this view was Arvind Subramanian, the Chief Economic Adviser to the ministry of finance. In the Mid Year Economic Analysis Subramanian wrote: “Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world. The ripples from the corporate sector have extended to the banking sector where restructured assets are estimated at about 11-12 percent of total assets. Displaying risk aversion, the banking sector is increasingly unable and unwilling to lend to the real sector.”
This has led to a situation where banks aren’t interested in lending and corporates aren’t interesting in investing. In order to get around this problem Subramanian suggested that: “it seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward, not to replace private investment but to revive and complement it.”
On the face of it, this make perfect sense. It is being suggested that finance minister Jaitley should give up on the fiscal deficit target of 3.6% of the GDP for 2015-2016 and look to work with a higher fiscal deficit number. The logic offered is straightforward. The public liabilities of the central government(which includes the public debt and other liabilities like external debt reported at current exchange rates and liabilities of the national small savings fund) have been falling over the years.
The public liability in 2008-2009 stood at 48.9% of the GDP. Since then the number has fallen to 45.7% of the GDP in 2014-2015 (estimated). The biggest fall has come under other liabilities which include national small savings fund and the state provident funds. These liabilities have fallen from 9.7% of the GDP to 5.8% of the GDP. The public debt has risen marginally from 39.1% of the GDP in 2008-2009 of the GDP to 39.9% of the GDP in 2014-2015.
On the face of it, the public debt and liability numbers of the central government are in a comfortable range. All in all the simple point is that the government can spend more, run a higher fiscal deficit and look to finance that through higher borrowing.
But these numbers do not take into account the public liabilities and debt of the state governments. How do there numbers look? Article 293(1) of the Indian Constitution empowers the state governments to borrow domestically. The public liabilities of the state governments stood at 26.1% of the GDP in 2008-2009. This has since fallen to 21.4% in 2013-2014. The public debt of the state governments has also fallen from 19.1% of the GDP to 16.1% of the GDP.
The number that one needs to look at is the general government liabilities and not just the central government liabilities. As the latest
Government Debt Status Paper points out: “General government [liabilities] represents the indebtedness of the Government sector (Central and State Governments). This is arrived at by consolidating the debt of the Central Government and the State governments, netting out intergovernmental transactions viz., (i) investment in Treasury Bills by States which represent lending by states to the Centre; and (ii) Centre’s loans to States.”
As can be seen from the accompanying table the general government liabilities were at 70.6% of the GDP in 2008-2009 and have fallen to 65.3% of the GDP in 2013-2014. This fall has primarily come about due to a fall in liabilities of the state governments.

So does this mean that the government can borrow and spend more and in the process run a higher fiscal deficit? The answer is not so straightforward. The latest government debt status paper provides several reasons in favour of India’s debt being sustainable. As it points out: “Government debt portfolio is characterized by favourable sustainability indicators and right profile. Share of short-term debt is within safe limits, although it has risen in recent years. Most of the debt is at fixed interest rates which minimizes volatility on the budget.”
Over and above this most of government debt is domestic in nature and hence, there is no currency risk. “Conventional indicators of debt sustainability, level and cost of debt, indicate that debt profile of government is within sustainable limits, and consistently improving,” the status paper points out.
But does this mean that the government can borrow and spend more without attracting the ire of the international rating agencies which have been following India’s fiscal deficit levels rather closely over the last few years? The thing is that India’s public liabilities and debt cannot be looked at in isolation.
We live in a highly globalized world where economic numbers are constantly being compared. As economist Sajjad Chinoy wrote
in a recent column in the Business Standard: “India’s consolidated fiscal deficit is currently close to 6.5 per cent of GDP, while countries with the same sovereign rating as us have a median and mean deficit of 2.5 per cent of GDP – 400 bps lower! The inflation tax has been chipping away at India’s debt/GDP ratio, but at 65 per cent – it is substantially higher than the 40 per cent debt/GDP ratio of the median country amongst our sovereign ratings peers.”
This is a very important point which most mainstream views on the subject seem to be ignoring. Jaitley in his maiden budget speech had promised a path of fiscal consolidation. If he chooses to abandon it midway this is not likely to go down well with foreign investors as well rating agencies.
Further, it is worth remembering that the Federal Reserve of the United States plans to start raising interest rates sometime this year. This means that a lot of easy money that has come into India and other emerging markets might leave the country.
The last time this happened in May 2013 was when Ben Bernanke, the then Chairman of the Federal Reserve merely hinted at interest rates going up in the future. Back then, a lot of easy money left India (particularly the debt market) and the rupee fell to 69 to a dollar in the process. I am sure the finance minister does not want anything of that sort to happen all over again.
Given this, he should be very careful about how he goes about financing any big public investment programme. In tomorrow’s column I will discuss how Jaitley can look to finance a public investment programme.

The column originally appeared on as a part of The Daily Reckoning on Jan 28, 2015