Defence expenditure: Fantasy replaces deft planning

This article was published in the DNA, dated 27th of Jul, 2017

In the recent Unified Commanders’ Conference, the Indian military has reportedly asked for an allocation of Rs 26.84 lakh crore for the next 5 years. To put the figure in context, this represents a number that is almost triple of the previous five years’ allocation. The annual simple average of the demand made this time (Rs 26.84 lakh crore over 5 years) would be double the defence budget allocated for the current fiscal (Rs 2.74 lakh crore). The numbers, analysed whichever way, are staggering.

Let us look at the headline numbers. At current levels, defence expenditure constitutes 2.1 per cent of the GDP. Assuming a 10 per cent nominal growth in GDP (6-7 per cent real GDP growth plus 3-4 per cent deflator, or inflation), the demand for 26.84 lakh crore represents 3.3 per cent of total GDP generated over the next five years. Realistically though, expenditure cannot go up overnight from 2.1 per cent of the GDP this year to 3.3 per cent next year. They will go up gradually, with a “hockey stick” (exponential) increase towards the latter half. However, that also means, given the same numbers (expenditure demand and GDP, over five years), the ratio will likely touch 5-6 per cent in 2022. Very few countries that could manage to sustain such levels of 3 per cent of GDP over 4-5 years in the late 80s ended up with a bankrupt treasury in the 90s.

Next, how do these numbers stack up on a global comparative basis? It’s an old chestnut in military policymaking, ie, India doesn’t spend enough on defence. Is that correct? There are two benchmarks typically used.

First, defence expenditure as a percentage of GDP, popularly used, but largely limited in its real policymaking import, as it is not truly reflective of fiscal affordability. As per the World Bank, the numbers stack up as follows: China (1.94 per cent), East Asia-Pacific (1.73 per cent), European Union (1.48 per cent), Republic of Korea (2.64 per cent), Pakistan (3.55 per cent), Russia (4.86 per cent), Turkey (2.13 per cent), Israel (2.38 per cent) and US (3.30 per cent)

India’s very much in the global ballpark. We are higher than China (and Asia-Pacific average), lower than Pakistan, and in the same range as Turkey and South Korea (both having complex military challenges). Major countries that spend significantly more — US, Russia, Israel — are characterised by very large domestic Military Industrial Complexes (MIC). Military expenditure accounts for large investments and employment in these economies. The situation is quite the opposite in India.

Second, share of defence expenditure in total government expenditure — less popular, but a lot more insightful for policymaking, as it reflects fiscal constraints.

It is here that the real constraints become starkly visible. India already spends a very high proportion of government revenues on defence. In fact, defence is the single biggest item in the Union Budget, outside of debt servicing.

The only major country higher is Pakistan. In a country with significant deficits in social and economic capital, the fiscal space for a bigger share of the pie for defence simply does not exist.

Lastly, India’s high import-intensity of defence expenditure makes it an inefficient medium to channelise Keynesian boosts to the economy. With 70 per cent of all defence capital expenditure spent on imports (India’s been the top weapons importer in the world now), and low multiplier on military imports, the ability of policymakers to allocate part of government “pump priming” expenditure to defence is absent.

In a nutshell, plans with numbers like Rs 26.84 lakh crore are pipe dreams rather than effective plans. On top of that, we have a severe issue in terms of quality of military spends.

In the last 5-6 years, 45-50 per cent of the defence budget has been spent on personnel costs (salaries and pensions). This component is expected to grow exponentially, thanks to more “boots on ground” — Indian Army has expanded by 25 per cent in the last 15 years. And, now the new big daddy of Budget Expenditure is OROP. Increase in personnel costs in the years to come would far outstrip nominal GDP growth.

This is not new, or even surprising. A generalist MoD bureaucracy and a (largely) hands-off political class have let the military get away with fantastic wish lists in the name of planning. Unless structural changes are brought about in organisation and management, we will continue to have hopes as plans in India’s military.

 

Obsession with Fiscal Deficit is Hurting Growth, and hurting democracy too

This was published in the DNA Op-Ed page on the 5th of July

Farm loan waivers have reignited concerns of fiscal deficit (FD), which is essentially the difference between the government’s revenues and its expenditure. While the focus on FD reaches its zenith just before the Union Budget, it is a core element of our economic narrative. Is 3.5 per cent too high, or 3.2 per cent? From rating agencies to economists to pundits, FD has assumed divine dimensions, with a 0.2-per cent slippage deemed blasphemous.

The question is, how important is FD to growth and welfare? Textbooks are divided. Neoclassical theories frown upon FD like plague, Keynesian theories privilege FD as a preferred policy tool, and Ricardian theories preach complete indifference to the concept itself!

The neoclassical view, the source of most punditry on the subject, base FD’s divinity on four basic canons.

One, debt (incurred to fund FD) growing faster than income (GDP) is unsustainable. Two, excessive debt leaves us vulnerable to foreign investors pulling out, triggering an economic crisis. Three, high FD causes an increase in interest rates, increasing the cost of capital for the private sector. And four, the moral argument of burdening our children to finance our consumption today.

Not trusting “irresponsible politicians” to protect the holy covenants, a Fiscal Responsibility and Budget Management (FRBM) law was enacted in 2003 to enforce discipline through prescribed targets. Unfortunately, this has meant elected representatives are constrained on a key policy tool to react to economic distress — because of technocratic limits.

Beyond the point of (democratic) principles, obsession with FD is untenable on multiple grounds. To start with, the divinity canons are tenuous in the Indian context. The Government of India (GoI) doesn’t borrow overseas (from foreign investors) to fund FD. It is funded entirely out of domestic savings. With capital account controls, GoI bonds represent the highest-quality investment for the domestic investor. Ergo, GoI can run high levels of FD without triggering a currency crisis. This is the exact opposite of oft-quoted examples — Russia, Argentina, Greece — where high FD triggered economic crises. In all these cases, governments depended heavily on foreign investors to fund FD.

When the basic issue is a lack of demand, the antidote has to stimulate demand. Private sector investment decisions are not predicated on a 1-per cent higher (or lower) interest rate, but capacity utilisation and expected future demand. Obsession with an incremental 0.5-per cent FD jeopardises growth and ability to service debt in the long term.

A hard FD target acts as what Harvard professor Lawrence Summers calls a harmful ‘repression of budget deficit’. To meet the target, the government imposes arbitrary spending cuts on maintenance and critical investments in social and physical infrastructure. The result is a lowering of national productivity, leading to lower long-term growth. We have seen this with distressing regularity in India, where FMs have cut investments to meet FD targets.

Currently, the biggest challenge confronting the economy today concerns jobs. Boosting job creation by 3-4 per cent (and nominal GDP by a bit more) will do a lot more to balance the FD in the future (after all, FD’s real relevance is as a percentage of GDP) than targeting a sacrosanct number today.

Above all, causality between low FD and growth is extremely tenuous in terms of data in India. High growth has typically been a result of higher demand creation. Without supporting data, to base policy on ideology is simply bad policy-making.

The bigger philosophical question though is the usurping of sovereign democratic powers by an unelected technocratic elite. The FRBM Act was a primer. Recently, the NK Singh Committee appointed to recommend improvements to FRBM has suggested setting up of an autonomous Fiscal Council (staffed by technocrats) to administer and monitor FD targets set out in the law. This would represent a further erosion of political authority to tackle a political economy question.

Forex Reserves to the rescue

This was published in the DNA Opinion Page on 19th of June

The Public Sector Bank (PSB) recapitalisation debate continues unabated. Clearly, “simple” options — amalgamation, Bad Bank, Indradhanush — are “dead on arrival”. It is also quite clear that the government has limited appetite to infuse fresh capital, given fiscal constraints. Depressed valuations make raising capital from public markets a challenge, especially for weaker PSBs. So, is there a game left in town?

There could be, via direct Central Bank (CB) intervention. In recent times, both in the US and in Europe, CBs have bailed out banks, primarily through purchases of stressed assets (mortgage-backed securities in US, Greek bonds in Europe). The modus operandi is simple. Say, a bank needs to write off $100 of stressed assets, and it does not have the capital to do so. The CB prints $100 of fresh money uses it to buy out the stressed assets, enabling the bank to remain solvent. This, of course, means an increase in CB balance sheet and consequently money supply in the economy, which could fuel inflation. But in the low inflation scenarios in US/Europe for many years, it has been a politically acceptable risk to take.

Can RBI do this in India? Technically yes, practically difficult. India, unlike US/Europe, typically suffers from high inflation. While inflation has been tapering off recently, it is often vulnerable to systemic shocks like oil prices and bad monsoons. As recently as the last monetary policy, RBI flagged off upside risks on inflation. Ergo, RBI printing more money to buy back NPAs (non-performing assets) from banks has significant inflation risks, making it politically untenable (as well as running counter to RBI’s Inflation Targeting mandate).

There could, however, be another way, and that is to use RBI’s foreign exchange reserves to directly recapitalise banks. How does this work? Today, RBI holds $380 billion of Fx reserves as assets in its balance sheet. These are typically deployed in a variety of financial market instruments — predominantly hi-grade Treasuries (like US), Bonds and Gold. RBI could use a part of these reserves to buy capital instruments issued by PSBs. This would achieve a couple of objectives:

• It doesn’t expand RBI’s balance sheet/money supply — it simply swaps one type of securities (say, US Treasuries) for another (Indian Bank Capital, or IBC). There is no increase in money supply and downstream pressure on inflation.
• It keeps the funding off the government’s budget. Consequently, it does not deteriorate fiscal ratios. Let’s look at the broad math:

Total Banking NPA — estimated at $180 billion

Haircut required to make the loans viable (say) — 50 per cent

Capital required for write-offs — $90 billion

Now, RBI uses (say) $45 billion of its reserves to buy IBC, providing 50 per cent of the required capital. Such a large capital injection will lift underlying sentiments and stock prices, enabling PSBs to tap the capital markets for the balance $45 billion. Coupled with other reforms (Bankruptcy Code, RBI cover for bankers to settle NPAs etc), PSBs could start on a cleaner slate. In a few years, stock prices could rise sufficiently for RBI to sell off the IBC at a profit, similar to what happened with the TARP programme (to bail out banks in 2008) in the US.

There is no free lunch, and this approach isn’t without risks. The biggest is the fact that Fx reserves are not sovereign wealth. RBI has liabilities (primarily remittance claims from foreign investors/importers) against these reserves. These reserves are usually deployed in liquid, high-quality securities to enable RBI to have liquidity in times of stress. As IBCs would be illiquid, Private Equity-type investments, it would mean RBI has proportionately fewer reserves to call upon in an emergency.

That being said, $45 billion constitutes a fairly small part (12 per cent) of India’s reserves, and can be relatively quickly replenished given the strong capital flows that we are seeing today. A repaired banking system will add to the “India story” and further enhance those flows.

This isn’t an idea that’s new, but one whose time certainly has come (to at least being evaluated). India’s PSBs need capital, and to use a Sherlockian adage, once all wickers have been burnt, the one left standing is the most plausible one. Using Fx reserves is a plausible wicker left to recapitalise India’s PSBs.