Fiscal crisis again

Financial Express, 26 February 2009

The downgrade by S&P reflects the growing realisation in financial markets that the Indian sovereign is in troublesome territory. In the India of old, rating agencies did not matter. But today, the Indian private sector has $166 billion of foreign borrowing outstanding, and each 100 bps of higher cost of borrowing generates a direct hit of Rs.8,300 crore per year. The fiscal crisis of the early 1990s is now back, and the first task of the new government must be to address it.

What ratings mean

When India's credit rating goes up or down, we go through one more round of a "Do ratings matter" discussion. The best way to think about this is that the rating is a messenger. Even if S&P did not exist, the financial markets are anxiously watching India, and the credit risk perception of India and Indian firms has been changing anyway. S&P is merely one among many observers who are saying that Indian public finance has markedly taken a turn for the worse in 2007 and 2008.

Why ratings now matter

For a while, the argument was made that India had figured out how to finance the fiscal deficit by expropriating the people who keep deposits with banks, and hence risk perceptions about debt stability do not matter. But things have changed considerably. In March 2004, the foreign debt of the Indian private sector was $67 billion. By September 2008, this had risen to $166 billion. As a consequence, the views of credit analysts abroad, about Indian credit risk, now matter. When the cost of capital for the private sector goes up by 100 bps, this yields a direct hit of a higher interest cost to the tune of Rs.8,300 crore a year. The risk perception in the minds of the private sector matters in a way that was not the case just five years ago.

Why single out India?

Some feel it is unfair for S&P to downgrade India but not downgrade countries like the UK, which have dramatically enlarged fiscal deficits in these dire times. The reason lies in superior institutional infrastructure. In the UK, debt management is done by a professional Debt Management Office. The central bank is independent, transparent and accountable, and will not get influenced by debt financing considerations. Banking regulation is done by a dedicated financial regulator, and will not get influenced by debt financing considerations. This three-way separation ensures that massive public debt issuance does not distort either monetary policy or banking regulation. Further, the UK started off in 2007 with a fairly healthy fiscal situation. They have enlarged the fiscal deficit dramatically in response to an unprecedented business cycle downturn. This is unlike India, where massive fiscal deficits and a growing debt/GDP ratio prevailed in the good times of 2007 and 2008.

Finally, the UK has unmatched institutional credibility that comes from a multi-century track record of repaying on debt. As an example, war with Napoleon led to a rise in the UK debt/GDP ratio from 150% to 250% of GDP. This financing depth helped them win the war. Debt was remorselessly paid off in following decades, yielding a debt/GDP ratio of 40% of GDP in 1914. Similarly, massive debt was used to finance two world wars, and then the debt/GDP ratio crashed in peacetime.

In contrast, the private sector has watched India of the UPA years fecklessly run deficits and add to debt in unprecedented good times. Just a few months after the greatest business cycle expansion in Indian history, we are back to fiscal conditions reminiscent of 1991. Hence, there is a lack of trust, in the eyes of the private sector, in the extent to which sound public finance is written into the DNA of the Indian State.

Tackling the situation

The next government must embark on the slow, long, arduous path of building up trust and credibility in the eyes of the private sector, much like the UK did ever since the 17th century. This requires work on two fronts:

Down payment on fiscal consolidation
An immediate down payment on fiscal consolidation is required, involving three elements:
  1. It must candidly step forward with truthful data about the true deficit and debt/GDP ratio, and offer immediate and dramatic improvement on both;
  2. This can be achieved by setting up a cash transfer program -- where Rs.100 per person per month is paid to each BPL family - replacing all existing subsidy programs;
  3. Asset sales must be initiated, to yield immediate relief of a lower debt/GDP ratio, and thus lower interest payments also.
Institutional reform
The second front concerns the institutional infrastructure surrounding public finance. The new government must:
  1. Enact a new FRBM;
  2. Setup a Debt Management Office so as to remove the burden of debt management from monetary policy and banking regulation, and
  3. Enact a new RBI Act which puts RBI on a sound foundation of transparency, accountability and independence thus immunising monetary policy from the exchequer.

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