Bank Reforms - preparing for the next crisis?

This was published in the DNA newspaper dated 1st Nov 2017

The Public Sector Bank (PSB) recapitalisation plan announced by the government has sparked off renewed debates on the shape and future of Indian banking. The big policy and philosophical question is — what should the Indian banking system look like in the future? Unfortunately, we are saddled with seriously flawed assumptions on what constitutes “reform” in India — some of them borrowed wisdom from the West, yet some more are ideological postures. Let us look at some of the key postulates.

One, the idea of having fewer, (much) larger banks. It’s an old idea, but embedded firmly across the political divide, and was first mooted by P Chidambaram as Finance Minister. Chief Economic Advisor (CEA) Arvind Subramanian reiterated its salience a few days ago. Ironically enough, this is one idea where India is bucking the global trend. Since the global financial crisis in 2008, regulators globally have become extremely wary of banks that are too large. The reason for that is intuitive.

First, larger the bank, larger is its footprint, and hence greater the damage to the wider economy should it fail. Second, Risk Management 101 dictates diversification is a key mitigant of risk, while concentration is a contributor to it. Ergo, smaller, more numerous banks are preferred to larger, fewer ones, from a systemic risk management perspective. Globally Systematically Important Banks, or GSIB — a list of essentially Too-Big-To-Fail (TBTF) institutions — have been identified, and they are required to have more stringent control around capital and risk. In this context, the idea of having larger Indian banks is bizarre, because its stated aim would be to merge small banks into fewer TBTF ones, thereby increasing risks to the system!

Two, assumption of public ownership of PSB to taxpayer-funded “bailout” through recapitalisation. It has been established many times over the years — banking obligations, when banks are under stress, automatically devolve to the taxpayer, irrespective of ownership. Whether Korean banks post the 1997-98 Asian Crisis, US/European banks post the 2008 global financial crisis, or Indian banks many times over (remember Global Trust Bank, Bank of Rajasthan?) — in a crisis, banks need to be bailed out by the government, irrespective of whether they are owned privately or publicly. Banks aren’t ordinary corporate enterprises — failure of a bank has large social impact. Further, increasing complexity of the financial system means there are snowballing effects of a bank failure that are difficult to assess. Therefore, the taxpayer liability isn’t an issue of ownership, but the quality of regulation to ensure risks are appropriately managed.

Three, privatisation as a panacea for all ills. This is an ideological position — based primarily on faith rather than reason. The assumption is the issues afflicting PSB are on account of its state-ownership, which somehow make them structurally vulnerable to taking poor-quality decisions, sometimes compromised with integrity issues. From Leendert Neufville in Holland in the 18th century to a range of Asian banks in the 20th century to American and European banks in 2008 — history is replete with privately-owned banks collapsing on the weight of poor decision-making. Regulatory investigations in the last few years in private sector banks have shown up numerous cases of moral turpitude too. Even in India, large private-sector banks have been found out making poor-quality decisions on transparency, risk-management and governance. In other words, there is too much data disproving the hypothesis of superior governance of a privately-owned banking system.

The question then is, what should policy-makers focus on? The focus should be at the core of the issue, i.e., risk. Banks are fundamentally risky enterprises, allowed a level of leverage in their capital structures and a level of interconnectedness with large parts of the economy that no other commercial enterprise (barring perhaps insurance) is allowed. The example of Lehman Brothers is illustrative. It was a mid-sized bank with no retail deposits — and its collapse engendered a crisis to the global financial architecture. No wonder, banks have a social compact of “backstop” from the taxpayer.

That is where the real issue lies — not in ownership, not in size. Regulators should be concentrating on mitigating that risk on society. Fundamentally, it means converting banks into utilities — essential institutions, but ones that don’t take risks that can put society at risk (similar to, though not the same as, a telephone company). Solutions lie in the domain of smaller (not larger) banks, higher capital requirements, lesser risk-taking, greater state oversight (and not lesser via privatisation) and higher governance. In other words, make banks (and banking) a boring affair. Unfortunately, most of the oft-discussed, clichéd solutions today are taking the other direction — taken to their conclusions, they will increase the risks to the system, and make it even more vulnerable to future taxpayer bailouts.

Through history and literature, bankers have rarely been boring. From the usurious Shylock in Merchant of Venice to the murderous Patrick Bateman in American Psycho to the philandering Humphry Wellwood in The Children’s Book — bankers are usually flamboyant, somewhat unscrupulous characters. The real objective for regulators would be around converting bankers (and banks) into Mr Banks, the benign, boring Bank of England official in the Mary Poppins books. That, and not ideological positions around size and ownership, is what will shape for a safer, better banking architecture for India in the future.

Credit Growth - the real issue is demand, not supply

This was published in the Op-Ed pages of Mint newspaper on 19th Oct, 2017

A constant lament around the state of the economy today is on “low credit growth”. Generally, the twin balance sheet issues are the identified villains. As fresh data on non-performing assets (NPA) keep coming in with numbers worse off at the margin, the noise levels keep getting institutionalized.

The narrative is simple enough—banks are not lending because they don’t have balance sheet capacity to lend (most banks, especially public sector ones, do not have enough capital to write off NPAs and write fresh loans). As a result, credit supply to the larger economy is being crimped, thereby constraining growth. Anaemic growth in non-food bank credit growth (9% in financial year 2016-17, or FY17, in negative territory this fiscal year) is held up as empirical basis of the hypothesis. Weaker-than-expected quarterly gross domestic product (GDP) growth (at 5.7%) provides the ostensibly clinching evidence that weak credit growth is pushing down growth.

Like many popular hypotheses though, this too has a case of missing some really large woods for the trees. First, the popular narrative conflates one source of supply of credit (bank loans) with the overall demand for credit. However, one of the remarkable changes in the Indian financial sector over the last three-four years has been the steady erosion in the importance of banks as financial intermediaries. A host of other credit suppliers—mutual funds, insurance companies, non-banking financial companies (NBFCs)—have taken market share away from traditional banks. These new suppliers of credit are also experimenting heavily with alternative credit instruments (away from loans), like corporate bonds and structured financing instruments. These are often more flexible and cheaper than vanilla bank loans.

Consolidated credit growth (bank loans, corporate bonds, NBFC loans) has been 13% in FY17, while bank loans alone grew only by 9%. The former represents a more representative estimate of real credit growth in the economy, than bank loans alone. The popular press (and even some of the more informed commentary) tends to focus only on bank credit, missing the real big story on disintermediation of credit. The real growth in credit demand is quite in line with nominal GDP growth and the 70% capacity utilization levels in Indian industry.

Second, the base effect of the Ujwal Discom Assurance Yojana (Uday) bonds. Since March 2016, the adoption of the Uday programme by state governments has transferred a large chunk of bank credit from state electricity distribution companies (discoms) to state government-issued Uday bonds. As the latter don’t get counted as “non-food credit”, growth numbers are automatically depressed going forward. Adjusted for Uday bonds issuance of Rs1.7 trillion in FY17, total credit growth in the year would have been about 11.4%, higher than the headline number of 9% and partially higher than the FY16 number of 11%.

Third, even for bank loans, the issue doesn’t seem to be so much about supply (or the willingness of banks to lend) as it is about finding bankable borrowers to lend to. In the recently released Reserve Bank of India (RBI) data on sectoral deployment of bank credit, banks have registered healthy growth in loans to the personal segment, trade, NBFCs. On the other hand, large swathes of manufacturing industries show barely any growth in bank credit.

There are multiple factors at play here. Highly rated (AAA) borrowers are increasingly finding the corporate bond market a cheaper source for fund-raising, compared to traditional banking channels. On the other side of the spectrum, in the riskier (and stressed) segments of borrowers, bank funding has shrunk—partly on regulatory diktat, and partly on account of the diminishing risk appetite of banks. These borrowers have tapped alternative sources of funding—via structured finance instruments—from NBFCs, private equity and alternative investment funds (AIFs).

Fourth, and somewhat non-linearly related, is the dramatic increase in equity raising by Indian industry over the past two years. Total equity raised via public (and rights) issues has risen by 200% over the last three years. At least part of the fresh equity raised has gone towards replacing debt in the capital structure.

We have a fundamental demand issue today in the economy. Total credit flows into the economy mirror the aggregate demand, and as we have seen above, are not a constraint. We looked at commitments raised by AIFs, a key emerging source of “risk-funding” today. As of FY17, only around 40% of the total funds raised by AIFs (in excess of Rs80,000 crore) have been deployed—thereby illustrating a paucity of deployment opportunities even for risk capital.

Unfortunately, most policy actions are concentrating on supply-side fixes (bank consolidation, NPA resolution, etc.). While these are important and necessary, they won’t help kick-start growth. As seen above, there is enough capital available to fund any amount of bankable projects coming on stream. The real issue is elsewhere—it is around lack of demand (both domestic and exports) for Indian industry. This is resulting in capacity utilization picking up painfully slowly, and constraining fresh investments by industry. Paraphrasing Cassius in Julius Caesar, the fault lies within (the industry), not in our stars (of the banking system).

A blueprint for job growth - Urban Employment Guarantee, an idea whose time has come

This article appeared in the DNA opinion page on 29th of September, 2017

The decibel levels have suddenly shot up. The lament of jobless growth is a long-debated one. The last quarterly GDP growth print (at 5.7 per cent) has now seemingly thrown up risks of significant economic slowdown too. To be sure, quarterly GDP numbers are estimates that are prone to massive revisions in the best of times, and we have a still-stabilising method of national income accounting. The issue is even starker for jobs, where almost no standardised, empirically robust data is available on a high frequency basis to make sure determinations.

However, policymaking cannot wait for perfect data. What is certainly verifiable are some indicators that point towards enduring weakness the economy. Capacity utilisation of Indian industry has hovered around the early 70 per cent range for many quarters now (RBI Capacity Utilisation Survey shows a slight decline in Mar 2017 from Mar 2016, at 74.1 per cent). Aggregate credit growth, while much higher than the oft-quoted bank credit growth, is in high single digit levels, and at the margin lower than previous year. Topline sales (and profit) growth numbers of listed firms display the same trend — and are generally undershooting beginning-of-the-year forecasts. On jobs, with the general collapse of private investment (especially Real Estate, the biggest jobs-creating sector), and struggles in the big employment-intensive services (IT and Financial Services) — it is safe to assume that we have a problem.

What should the policymaking response be? While there is never a dearth of ideas in India, is there something that can boost growth and generate additional employment at the same time, and quickly? Often, lessons are closer home than we realise. The National Rural Employment Guarantee Programme (NREGA) provides an interesting template. NREGA by design is an employment generating programme, and by many accounts was a big factor in India quickly bouncing back from the effects of the Global Financial Crisis in 2008.

There is, therefore, merit in considering a National Urban Employment Programme (NUEP) on similar lines. A well-funded NUEP will provide a soak for the urban and semi-urban unemployed, and provide an immediate Keynesian consumption boost to the economy. In principle, the consumption boost should enhance capacity utilisation levels, and hasten a revival of private investment, which is really the big driver of growth and employment. There are three big questions to be addressed though.

First, why a cash transfer programme (which is what employment programmes are), and not enhanced infrastructure expenditure? A couple of reasons. First, NUEP-type programmes are quicker on execution than large infrastructure projects, and hence would tend to have more immediate macro impact. And second, this provides for an immediate employment safety net to the most vulnerable, again something that would come only with a time lag in an infrastructure investment programme. Above all, some of the traditional assumptions around employment-intensity of infrastructure spending have been revisited in the last few years — it takes far fewer people to build a 100 km of highways than used to be the case a decade back.

Second, what would be the sort of jobs created under this programme? NREGA is designed around basic earthworks projects in rural areas, targeting employment for primarily untrained, barely literate farm labour. The workforce available in urban areas is likely to be better educated, and equipped to be trained for more.

They can, therefore, be deployed in auxiliary units for a range of urban services — municipals, schools, traffic control, even elements of basic policing – with a certain amount of training. India suffers from very large capacity gaps in all these areas.

For example, there is one police officer for every 720 Indians. The UN-prescribed standard is one for every 454. While a semi-permanent workforce with rudimentary training cannot be used for cutting-edge frontline policing duties, they could certainly be used for basic administrative and support services to enhance capacity.

Third, and perhaps most important, what should be the size of this programme? Targeting to create how many jobs? As a benchmark, the allocation to NREGA in the current year is Rs 48,000 crore. Let us assume that NUEP has a similar outlay. At an average wage of Rs 1.2 lakh/job (the approximate level at which a single wage-earner can ensure a family of 4 is above the urban poverty level), and assuming a 20 per cent support cost (ie, part of the outlay not accruing to wages, NREGA average is 30-35 per cent), this would create around 32 lakh jobs. India has around 1 crore new entrants into the jobs market every year. 32 lakh vacancies-on-demand will create a material tightness in the labour market to make a dent in wages and opportunities.

The last point would be, is it affordable? The amount in question would represent around 0.3-0.4 per cent of GDP. In a scenario where the banking system is flush with post-Demonetisation liquidity, that amount of excess government borrowing can be easily funded. It will have an electrifying message politically, while giving an instant consumption boost to the economy, with all-round multiplier effects. It is an idea whose time has come!

Managing Wealth in times of Constant change

This was published in the DNA newspaper, dated 15th of Sep, 2017

“This time it’s different”, is an oft-ridiculed cliché used in the financial markets, mostly to debunk the idea that a particular phase of the market (usually bullish) has stronger legs than similar phases in the past. Markets are never one sided though, and excesses always tend to be shed through corrections later. This has been the case for centuries of trading history.

What has been truly “different” in the last few years though, especially in the new millennium, is the pace of structural changes presenting themselves to investors. Some are planned (like GST), some related to Moore’s Law effects (like technology), and some are simply Black Swans (like the global financial crisis). Consequently, money management has become tougher. Managing wealth, with its separate, often counter-intuitive and variable sets of objectives, has become tougher still. A few closely-held beliefs need to be junked / modified in order for investors to ensure their money keeps working hard (to use yet another old cliché!).

One, asset allocation is important, but “buy, hold, forget and see it five years later” is an incredibly stupid strategy. Traditional measures of risk, eg volatility, are not by themselves able to capture the impact of severe draw-downs on portfolios due to sudden market or regulatory events. When asset allocations start getting skewed due to sharp upward movements in a particular asset class (say equities), the vulnerability of the portfolio to Black Swan shocks go up exponentially. Investors and their advisors need to be a lot more on top of their portfolios, constantly optimising the same in line with their objectives and risk tolerances.

Two, liquidity management is as important an activity as identifying the next best investment opportunity is. This is especially true of Indian investors, given their heavy exposure to real estate, an asset class most prone to liquidity issues. As it is, even ostensibly liquid instruments have been affected by liquidity issues in the recent past (the JP Morgan Liquid Fund a couple of years back). On top of that, liquidity is often completely ignored in a chase for yields and/or the next exciting investment idea. There is a time and space for illiquid investments, but it is important to define sharply both the time and the space before making such investments.

Three, indexation is a two-way street. Investors judging their portfolios against index performance when broader markets are doing well should do the same when they are doing badly. This is a key difference between managing wealth (for individuals) and managing money (for institutions). At the heart of the difference is the fact that institutions are perpetual going concern entities, while individuals have finite lifespan with (often) non-discretionary objectives. Ergo, relative performance vis-à-vis an index for an individual is an academic, rather than practical construct. In other words, managing personal wealth, more often than not, is an absolute return approach by default. By definition, absolute return approaches do not sit well with benchmarks.

Four, volatility is not an enemy of investors, it can be a very useful friend, if used wisely. The conventional wisdom is for investors to avoid volatile markets, but it is often volatile markets that present the best opportunities. Looking back, in the current millennium, some of the best entry-point opportunities in equity markets presented themselves when markets were at their most volatile – think 2004, or 2008, or even 2013! Rule of thumb is to remain calm and behave with as much dispassionate emotion as possible when volatilities spike up.

Five, and perhaps most importantly, when an individual is looking to “manage wealth”, it is important to concentrate heavily on that, and not on fund managers managing various products in the underlying portfolio. Wealth management is a far more complex, multi-faceted and involved process than only managing a pool of money (which is what fund managers do). It involves elements of tax, estate, succession and other objectives that are non-linear in nature. They require far more attention and diligence than obsessing over an incremental 1% in portfolio returns. Ignoring the former could result in much larger impact. Unfortunately, too many individuals (and their advisors) spend almost their entire attention and time-spans on evaluating product performance, and too little time on what is really critical to successfully managing wealth.

As the Chinese say, the best benediction is “to live in interesting times”. We are fortunate to live in very interesting times. It also means we need to have newer, and sometimes less “interesting” approaches to managing wealth optimally.

Crackdown on Corruption - a Crackdown on Economic Growth?

Corruption is an emotive issue, and anti-corruption is a potent political platform, like it has been for the Modi government. A slew of policy interventions – Demonetisation, RERA, GST – have been predicated on eliminating corruption. An interesting question to consider, morally abhorrent as it is, if corruption’s actually a facilitator of economic growth?

Usually, corruption is assumed to hinder growth through increase in transaction costs, inefficiency and arbitrary decision-making.

Consider a though experiment, around the Real Estate Regulation and Development Act (RERA). The new law aims at curbing unethical practices, reduces discretionary decision-making, and generally aims to clean-up the Real Estate sector. At the same time, implementation of this law has seen a massive decline in the rate of new launches by developers, softening of property sales and fear of a general slowdown in the sector. Given that Real Estate is highly employment-intensive, this portends bad news for growth and jobs. While its early days yet (for the new law), could we surmise that a certain amount of corruption greased the sector, and has caused a slowdown now that the grease has been taken out?

Corruption as a grease (or sand) to wheels of development has long been studied by academics. And the counter-intuitive narrative, ie, corruption could have positive effects on growth, has long (and erudite) legs.

Samuel Huntington famously wrote in 1968,“only thing worse than a society with a rigid, over-centralised, dishonest bureaucracy is one with a rigid, over-centralised, honest bureaucracy”. The hypothesis sits well with day-to-day experience (especially) of the poorer sections, with local municipal authorities. A broken water tap is often repaired quicker with a bribe than via strict adherence to laid down processes.

Is it a poor country phenomenon? Or, as some people have suggested, there is an Asian Paradox (it happens in Asia)? Let us look at some headline numbers. The table below posits a sample of countries at various levels of incorruptibility (as measured by Transparency International rankings) against their economic performance.

Source: IMF, Transparency InternationalCPI: Corruption Perceptions Index, Transparency International

As we can see, while richer countries tend to have high CPI scores, there are notable exceptions like Italy, Saudi Arabia and South Korea (per-capita incomes above USD 10,000 – “rich country” benchmark) with comparatively low CPI. At the same time, while a lot of Asian countries tend to rank lower, Singapore and Japan buck the trend. It is also remarkable that India and China, both with fairly low CPI scores (and ranks), have been the fastest growing major economies in the world for over 2 decades. So, is “good corruption” a reality?

There was further empirical boost to the hypothesis of “good corruption” in a more recent (2008) cross-country study by Professors Jac Heckelman and Benjamin Powell, titled Corruption and Institutional Environment for Growth. They found that definition of corruption as “good” or “bad” for growth depended heavily on the institutional environment. In countries with low economic freedom, high levels of regulation and inefficient bureaucracy, corruption has a positive effect on growth. Lower corruption aids growth when institutions are strong. Sounds intuitively familiar? The water tap is repaired faster with bribes if the municipality is an inefficient entity?

Research on Asian (especially East Asian) countries, with generally imperfect institutions, tends to have some vindication of the hypothesis. Prof CJ Huang of Feng Chia University, Taiwan, in perhaps the most comprehensive quantitative study on the topic (his coverage was on 10 East Asian countries, including China), found an overwhelming positive impact of corruption on economic growth.

In the Indian context, Prof Aseema Sinha of the Woodrow Wilson Center found widespread evidence of bribes facilitating investment and growth, in her book, Regional Roots of Developmental Politics in India (2005). She quotes a manager of a large company in West Bengal, “I wish there was more corruption in West Bengal. Then things might move and I would know that I could do something to speed things up. Currently, nothing moves; government officers are usually honest and morally superior, but they refuse to help you.” In contrast, the same study also found that bureaucrats in Gujarat worked very hard to facilitate new investments, but demanded 5-8% as bribes. Essentially, this is the concept of speed money that hastens economic processes.

In a nutshell therefore, can growth slowdown be blamed (partly) on anti-corruption policies? Like with everything else in policy-making, a black-and-white answer is impossible. It is widely recognized that corruption eats away at the vitals of a society, reduces efficiency, and thus is structurally sub-optimal in the long term. Politicians have to balance short term exigencies with a long term vision, and make appropriate choices.

What is clear though, is that the narrative of corruption as an unambiguous negative isn’t quite correct always. There is an alternative narrative to consider.

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.