Shock Therapy


Belatedly, the UPA-2 kickstarts a new phase in India’s transition from a closed to a market economy

Prem Shankar Jha, Senior Journalist

NOTHING IS more frightening to the people of a country than the suspicion that its government has lost its capacity to govern. The closest parallel is the fear that seizes a family when it loses its breadwinner. This is the reason for the rising hysteria of the past one year, and the increasingly frantic attempts by the chattering classes to pin all the blame on a single scapegoat: Manmohan Singh. It is also the reason for the enormous sigh of relief expressed across the country since the government finally broke its self-imposed shackles and returned to governing in earnest.

Illustration: Anand Naorem

This collective letting out of breath has grown stronger as the government has unveiled more and more of its “reform package”. So far, it has been a good package. But a close look shows that, first, it is incomplete; second, some of the reforms, like FDI in retail, still bear the marks of haste because their consequences have not been fully worked out; and last but most important, they have the potential to sharpen conflict and increase dissatisfaction in society. To get the best out of them, therefore, the government needs to adopt policies that will forestall these conflicts. What is more, it needs to introduce these pre-emptive policies before the reforms begin to bite.

The policy changes announced so far fall into three broad categories: the first aims to reduce the fiscal deficit of the Centre and the states and thereby bring their finances back into balance. At the Centre, the diesel price hike and the reduction in LPG subsidies will cut the subsidy bill by more than Rs 45,000 crore in a full year. This is no small amount, but the Centre has not stopped there. The 12.5 percent VAT on the higher price will bring Rs 5,000 crore to the state governments’ coffers.

An even more courageous decision is to use both the carrot and stick to end the rampant profligacy of state governments in the power sector. The states not only give away electricity virtually free of cost to several sections of consumers, but also refuse to allow private investors to sell power directly to consumers. This has all but blocked private investment. Since the states have all but stopped investing in this sector, India is saddled with chronic power shortages that have kept global manufacturers from making it a part of their production networks. This has utterly frustrated the original purpose of the 1991 reforms. The carrot that the UPA has dangled before the states is the conversion of half of their accumulated debt, of Rs 1.95 lakh crore, into bonds. This will reduce their annual outgo on debt servicing by Rs 7,000 crore and make it possible for them to raise working capital from banks once again. The stick is that to qualify for this capitalisation of half their debt, they must recover the other half through an annually vetted increase in revenues.

What’s missing is an explicit thrust to revive economic, and especially industrial, growth

The second group of reforms — FDI in multi-brand retail and in domestic airlines — is intended to revive the interest of foreign direct investors in India. The third group of reforms, which are still in their incubation, is designed to revive domestic investment, especially in real estate and infrastructure. Among these, the most important are the creation of a Railway Tariff Board to de-politicise the setting of fares and freight rates once and for all, and the creation of a National Investment Board, which will give speedy clearances to infrastructure investment.

What is missing from these reforms is an explicit thrust to revive economic, and especially industrial, growth. The implicit belief that underlies the government’s actions is that investment will revive automatically if it removes the hurdles. This is wishful thinking, for while one may take a horse to water, one cannot force it to drink. The RBI has itself reported that investment fell by more than half in real terms in the past year. Last week, SBI Chairman Pratip Chaudhuri admitted that the bank was sitting on Rs 80,000 crore of surplus lendable funds that it had been forced (or preferred) to park in company deposits or with the RBI. Companies are not investing in new projects because they fear losing money in today’s flat market. As for the commercial banks, many feel that it is far safer to put their money in reverse repo deposits and earn 7 percent than embark upon the stormy sea of investment in a shrinking domestic and uncertain global market.


Rs 45,000 cr
The annual savings on the Centre’s subsidy bill thanks to the diesel price hike and reduction in LPG subsidies

Rs 40,000 cr
The projected savings that the Centre will enjoy by introducing food coupons or stamps to end PDS misuse


The one powerful push that the economy needs, and the only one that a heavily overdrawn government can afford to give it, is a sharp reduction in interest rates. It is worth remembering that the colossal spurt in India’s growth rate that made some of us briefly equate ourselves with China, began in 2002 after the RBI brought interest rates down by half over a period of two years. Today, when the banks are flush with funds they are unable to lend, the only way to kickstart a revival is to lower the repo and reverse repo rates of interest. These are the rates that the RBI charges from banks that borrow from it and pays to them the surplus funds they park with it, respectively. In today’s conditions, a cut in the reverse repo rate will make banks start looking for customers in the market once more. The resulting decline in lending rates will make depositors shift a part of their savings back into the share market. This will push up share prices, lower the cost of raising capital and revive the primary share market once more.

The decline in lending rates will also give a fillip to spending on consumer durables and real estate. Together, these make up a quarter of total consumer spending. Had the interest rate cuts come before the festival season, they would have administered a powerful tonic to industry. But that, alas, was not to be. Because the RBI controls ‘policy’ rates, and it is obsessed with fighting the spectre of inflation to the exclusion of economic growth.

From 2007 till the end of 2011, with only a 17-month respite during the global recession, the RBI raised policy interest rates and the cash reserve ratio (CRR) relentlessly on the grounds that India was suffering from severe inflationary pressures. It did not relent even in December 2011 when industrial growth was grinding to a halt, foreign money was fleeing from the stock market and the rupee was losing 1 percent of its value every two days. Instead, the RBI changed its tune and started saying that it was being forced to keep its rates up because of the government’s large fiscal deficit, and the overhang of spending power that had created in the economy. It would, therefore, cut interest rates only if the government took credible steps to reduce the fiscal deficit.

Another reform in need of sustained follow-up is the elimination of power subsidies

But the huge subsidy cuts the government announced on 12 September left it unmoved. Instead of bringing down interest rates, the RBI quickly changed horses and made rising food prices its excuse for leaving policy rates where they were. As a peace offering to Delhi, it cut the CRR by 0.25 percent and ‘released’ another Rs 17,000 crore into the market. This could have been what prompted the SBI chairman to remark that with more than Rs 80,000 crore of funds for which it could find no takers, his bank did not need any more.

It is possible that the RBI is not being obdurate but cautious. It is slated to make another policy announcement on 30 October and Finance Minister P Chidambaram has already given what could be called a broad hint that the government expects cuts in rates to be announced then. But given its record of obduracy (in 2008 after the global recession began, then RBI governor YV Reddy resisted pressure from the finance ministry to cut rates for three months and only did so when ordered by the prime minister to do so), it is perfectly possible that it will use the 9.7 percent estimated decline in the kharif harvest to “postpone” a rate cut yet again. If it does this, it will leave the government in the worst of all possible situations, with administered price increases beginning to bite and no signs of a rise in sales, investment and employment to ameliorate the deepening distress. This will not only defeat the government’s attempt to revive the economy but put paid to the UPA’s chances of returning to power in 2014.

The moral of this tale is that the government cannot pin its entire strategy for economic recovery on the hope that the RBI will cooperate. For the country’s, and its own sake, it must ensure that the RBI will indeed announce a sharp reduction of interest rates, preferably back to where they were in March 2010. A gentle reminder to the RBI governor that he holds his post at the government’s pleasure might not be out of place.

However, the damage that the RBI has inflicted on investors’ confidence is so deep that even a 3 percent reduction in policy rates will not entirely restore it. To do that, the RBI must also announce that, in the future, it will not link its monetary policy to cost-push inflation. Indeed, it is the RBI’s stubborn refusal to admit that these are entirely different types of inflation, and its insistence that it can control cost-push inflation by crushing domestic demand, which has brought the country and the UPA government to its present mess. In the past five years, cost-push inflation has been triggered by myriad factors over which no government, let alone one lone Central bank in a not very big economy, has had any control. These include droughts in Australia, the diversion of American corn from cattle feed to the production of ethanol, a rash of global speculation in commodity futures in the winter of 2007-08, China’s uncontrolled investment spree that gobbled up raw materials in 2009-10, poor monsoons in 2009 and untimely rains that destroyed half the onion crop in 2010. By linking domestic interest rates (and therefore share prices) to an inflation that it can neither predict nor control, the RBI has made it impossible for financial investors to predict how their investment will do. The realisation that the RBI neither understood this nor was prepared to relent was largely responsible for the exodus of foreign capital that began in August 2011 and the 25 percent depreciation of the rupee that followed.

Another reform that will need sustained follow-up is the elimination of subsidies on the sale of power by the state governments. As several commentators have already pointed out, the proposed bailout contains no provision that can compel the states to meet their obligation to raise tariffs till their current deficits are covered. There is every likelihood that the states will accept the bailout, as they did in 2003, but amass fresh debt in the hundreds of thousands of crores once more. A provision that grants oversight powers to the Central Electricity Regulatory Commission over their plans to eliminate the deficit, with fiscal penalties if they don’t meet their commitments, is therefore urgently needed to make this work.

FINALLY, THE success of the current reforms will itself pose new political challenges to the government. The more it succeeds in cutting the deficit, the more will it bite into people’s disposable incomes. The impact will, inevitably, be greater on the poor than the rich and the middle class. The government seems to think that this is a price that it will have to pay in the short run to increase income, employment and growth in the long run. But that is not the case. Today, the government has a once-in-a-lifetime chance to both reduce subsidies and increase the disposable income of the poor (thereby ensuring that the burden of subsidy cuts falls only on those who can afford to bear it) at the same time. The way to do this is to wind up the antiquated and thoroughly corrupt PDS and replace it with a system by which food stamps or coupons, and where necessary, cash transfers, are mailed directly to the recipients of subsidised foodgrain, sugar and kerosene. In pilot cash transfer schemes for kerosene in Rajasthan and Karnataka, the poor have received their full quota, while the subsidy doled out has fallen by two-thirds (a clear estimate of the amount siphoned off into diesel adulteration and sold in the open market).

By the same token, a Planning Commission study in 2009 had revealed that the average Below Poverty Line family was getting only 14.6 kg of foodgrain at the prescribed price of Rs 5.5-Rs 6.25 a kg. The balance 20 kg was finding its way into the market. Food coupons or stamps would end this misuse altogether and save the Centre up to Rs 40,000 crore by way of subsidies.

To sum up, the reforms announced by the Manmohan Singh regime are not marginal but visceral, for they mark the beginning of a new phase in India’s transition from a closed to a market economy. What is more, they are the kind of reforms that the government cannot afford to leave halfway because it gets political cold feet, if it wants to survive, let alone continue to govern after the next elections. To continue down the new road it has chalked out, it needs all the support we can give it. Future political debate needs to centre on how well and how painlessly they can be implemented, not upon rolling them back. For, whoever comes to power next will face the same problems in an even more acute form.

Prem Shankar Jha is a senior journalist.


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