Tight fiscal policy no cure for India (page 2 of 2)

Between 1989 and 2003 the average annual rate of GDP growth was 2.9 percent and 2.3 percent in Argentina and Brazil, respectively.

Over the same period, the ratio of public sector debt to GDP increased from 28 percent to 140 percent in Argentina and 26 percent to 91 percent in Brazil. In addition to reducing economic growth and pushing the debt burden much higher, tight fiscal policy produced unprecedented political and social instability and the largest ever sovereign default in Argentina.

The probability is high that Brazil will also be forced into default as continued economic weakness leads to further political and social instability, undermining investor confidence.

In comparison to Argentina and Brazil, fiscal policy has been easier in India over the past 15 years. Apart from a short period in the early 1990's following the country's balance of payments crisis, India has not been subject to IMF-directed fiscal adjustment policies.

India's endemically large fiscal deficit, which averaged 8.4 percent of GDP between 1990 and 2003, supported GDP growth, which averaged 5.6 percent annually over the same period. Despite the large fiscal deficit, the ratio of public sector debt to GDP has risen modestly from 60 percent in 1989 to 75 percent in 2003.

Strong economic growth, underpinned by easy fiscal policy, prevented Latin-style runaway buildup of public sector debt in India. Economic growth in India could have been even faster over the past 15 years if public sector investment had not been sharply reduced after the country's balance of payments crisis in 1991.

In that year, Finance Minister Manmohan Singh implemented fiscal reforms that included the reduction of public sector investment as well as rationalization of public sector employment - reductions and rationalizations that were deepened by the Vajpayee government.

The case for increased public sector investment in India is compelling. Between 1989 and 2003, capital outlays by the public sector have plummeted from 6 percent of GDP to 2.5 percent of GDP. Coinciding with this decline in investment has been the reduction of government subsidies, particularly food subsidies.

The consolidation of public sector investment and subsidy payments has had an enormous negative impact on rural India. This has encouraged rural-urban migration, overwhelming the capacity of urban public utilities.

In addition, the steady reduction of import tariffs has further contributed to deteriorating social conditions by subjecting both the agricultural and manufacturing sectors to imports that are often heavily subsidized in their home countries.

Doubling the rate of public sector investment, targeting agricultural infrastructure in particular, would sharply increase long-term economic growth in India. Investment in agricultural infrastructure, as well as increased food subsidies, would benefit a very large portion of the population, promoting political and social stability.

Such an increase of investment and subsidies could be financed by a hike in import tariffs. Admittedly, this perspective is quite unconventional, but conventional methods of increasing economic growth, namely fiscal deficit reduction, have proven unworkable.

To avoid Latin-style political, social and economic instability, the Singh government should take advantage of the very limited leverage multilateral lenders and foreign investors have over India and act unconventionally.