The Razor's Edge
It has always been hard to understand the Indian economy. Today, it is harder than ever. There are aspects of the picture today which are extremely bleak and seem to be the prelude to a crisis. There are aspects which offer more optimism than ever before. Faced with these extremes, it is hard to emerge with a judgement about how we are faring and where we might go. In this razor's edge situation, understanding the issues and addressing some of the essential problems is more important than ever.
Prelude to a crisis? Ever since the breakdown of "the Congress system" in the 1970s, fiscal laxity has been an important tool for obtaining and keeping political power. This gave us two crises (1981, 1991) which are relatively easy to understand. The ingredients were: a large deficit, monetisation of the deficit, a relatively fixed exchange rate. These added up to currency crisis in a way which economists think is now well understood.
The situation today is similar in some ways and different in others. We are back to extremely dangerous levels of the deficit. Several different arguments suggest that the State is now in a debt trap.
In addition, we have much greater openness on the capital account than ever before. Foreign investors, Indian firms, and Indian individuals are all now equipped with greater freedom in moving capital outside India if they feel so inclined. If a next crisis does come about, it will be swift and sudden when compared with the previous two crises.
There are important differences as well. We have very little direct monetisation of the deficit; instead we have worked out a giant machinery through which banks and the pension system buy up government bonds. We have greater flexibility on the currency than was prevalent before the previous two crises.
The background of fiscal crisis is crowding out the production of public goods, which is supposed to be the only role of the State. In an ideal world, the State would produce public goods using tax revenues. Instead, the tax revenues of our State are primarily spent on interest payments, and gifts to various political constituencies. The starvation of resources is giving us a breakdown of governance and a failure to produce public goods even at the low levels seen two decades ago. This disease is the most advanced in Uttar Pradesh and Bihar.
Does this add up to a crisis? We have weathered one shock (the spike in oil prices) remarkably well. Will we be able to survive a global stock market crash? Will we be able to survive a year or two of unstable governments (e.g. the conditions in the late 1980s)?
The engine of growth. In this gloomy backdrop, in the decade of the 1990s, we have successfully opened up completely new avenues of growth.
India missed out on the growth opportunities of the 1960s and 1970s owing to an inward orientation in the manufacturing sector. Even today, the old manufacturing firms in India continue to be hobbled by these decades of protection: they look fearfully and unconfidently upon the outside world. India's intelligensia was ignorant of how the world worked, and unable to harness the best ideas into running the country.
In contrast, there is a new economy that is opening up based on services exports. India is faring well in the global trade in services, which is growing rapidly today given the improvements in telecommunications. The firms in India in services exports, and the stance of public policy, present a refreshing contrast to that seen in the 1960s and 1970s. In these areas, we have enthusiastically embraced state of the art technologies; we have no hangups in favour of "swadeshi"; our firms enthusiastically participate in global markets in every way possible.
The software sector has captured the public imagination. However, software is a high skill area, and India's educational system is failing woefully in producing adequate skills. Hence, India's opportunities in services exports are much more pronounced in relatively low--tech areas: call centers, medical transcription, back offices, etc.
How large does the services exports sector have to get for it to make a dent upon macroeconomic outcomes? India's labour force is roughly 350 million strong. If 10 million workers obtain a value added of $10,000 per year owing to services exports, this gives us additional GDP of $100 billion, or a quarter of India's GDP today. Such numbers are within reach in a short time. Our ability to reach these numbers critically depends upon the supply of public goods: education, health, telecommunications, law and order, and electricity distribution.
The services exports sector contains all the ingredients that were missing in India in the 1960s: outward orientation, world-class technology, labour intensity, etc. It is possible for India to obtain export--led growth through this sector in exactly the same fashion that the East Asian countries did with manufacturing in the 1960s. For the first time in India's history, we are within striking reach of one decade of growth at 8% per year, which will remove mass poverty.
The way forward. There is a certain complacence in India with the fiscal deficit. We've just been through the best decade in India's history under conditions of a high fiscal deficit, so it is felt that the deficit cannot be such a big problem. Such complacence is fundamentally misplaced. The arithmetic of the debt trap is simple and brutal. The debt trap has already stripped away the ability of the government to improve the supply of public goods, and it will soon leave the government unable to pay salaries.
In the early years after independence, we operated under "the Congress System", which was able to resolve conflicts while producing public goods and adhering to fiscal prudence. This system broke down in the 1970s, and the Second System (which we face today) is the main driver of the fiscal deficit and failure in producing public goods. We have had a sequence of three finance ministers - Manmohan Singh, P. Chidambaram and Yashwant Sinha - who have all had a great focus on the fiscal deficit, but they were not able to overcome the fiscal laxity that is innate in the Second System.
In 1993, we phased out the monetisation of the deficit. This historic event meant that the Second System had to come to an end. We are now about to come to a confrontation.
In the next one or two years, the BJP and the Congress and everyone else in politics will have to craft a new system. This system will be the third milestone in India's political history. This system will need to obtain stable governance and production of public goods, while resolving the conflicting goals of competing constituencies and separatist impulses. It will need to function at equilibrium without the toxic combination of high subsidies and low direct taxes; yet it will need to cope with the crippling burden of public debt that it will inherit.
The creation of this system is the most important problem in India today. If we fail to come out of this confrontation with a sound new system, we will face capital flight, a collapse in the supply of public goods, and choke off the remarkable growth opportunities that are so alluringly within reach.
Back up to Ajay Shah's BS column