Headed For Catastrophe

INDIA is headed for a financial and economic catastrophe, a foreign exchange crisis of the type faced in 1990. Its onset could be as little as 10 months away. Its origins lie in the country's very high and still-rising fiscal deficit. It can be averted by a tough budget that raises revenues and cuts expenditure sharply. But for the finance minister to present such a budget, he first needs to recognise the looming danger. He cannot do so if his senior officials, the ones most directly concerned, refuse to warn him of its approach. An excellent example of the way that he, and through him the prime minister, is being hoodwinked by a do-nothing bureaucracy is furnished by the way in which Javed Chaudhry, the revenue secretary in the finance ministry, dismissed fears that the Centres fiscal deficit would rise to 7 per cent this year against the targeted level of 5.6 percent of gdp, at a ficci conference in New Delhi last week. He claimed that higher-than-expected direct tax revenues would offset the disappointing yield of indirect taxes. Indians could therefore sleep easy, sure that inflation would be contained, and the rupee would hold its value against foreign currencies and be freely available to importers and tourists.

I have no desire to quarrel with Mr Chaudhry's figures. We will know in only six weeks how the government has managed the miracle. What Mr Chaudhry did not mention is that the central government's deficit is not all the deficit. To it must be added the states deficits and the borrowing that both the Centre and the states are doing through their public enterprises to meet their expenditure commitments. Last year, the state deficit was 3.2 percent of gdp. This year it will be much higher because they have to pay some of the Rs 35,000 crore of additional salaries that the Centre's acceptance of the Pay Commission's recommendations has loaded on them. No one knows how much is being borrowed, but it cannot be less than the 1.7 per cent it was in 1994-95. Thus, even if the central deficit remains around 6 to 6.5 per cent, the true budget deficit will be in the neighbourhood of 12 per cent of gdp.

What does this have to with a forex crisis? The answer, in brief, is that the higher the deficit, the higher the interest rates in the country. These can be pushed up by a government having to pay higher interest rates to attract the larger amount of loans it needs to balance its books, or they can be pulled up by the rbi to contain inflation. In India, it is the second that is happening. Higher interest rates make holding Indian rupees more attractive to foreigners. The inflow of foreign exchange props up the exchange rate at a higher level than that merited by its trade balance. That hurts exports and widens the gap in the balance of trade. At a certain point, the same foreign investors decide that the situation is becoming unstable and start pulling their money out. Indians capable of holding their money abroad - NRIs and exporters - follow suit. The reserves start running out. If nothing is done by the government to rebuild confidence in the rupee, a crisis ensues.

Anyone who has studied the Mexican, Thai and now Brazilian foreign exchange crises will see that this is how they landed in trouble. India has travelled about two-thirds of this progression: it drew in several billion dollars of portfolio investment in 1996-97 and the rupee climbed even against a rising dollar. But export growth dropped to four per cent against the 21 per cent of the previous three years. And this was well before the Asian crisis. In 1998, the government used interest rate hikes twice to prop up the rupee - just what Brazil was doing till the other day - and export growth turned negative. All through 1998, portfolio investors have been pulling money out of India and NRI deposits have stagnated. As a result, net foreign investment has risen by just $694 million against $4.5 billion last year. All in all, India faces a sharp fall in foreign currency reserves of around $6 billion this year. If that continues in 1999-2000, exporters will start holding their earnings abroad anticipating a devaluation as they did in 1990-91. In weeks after that the crisis will be upon us.

WHAT would happen then? India would of course go running to the imf as all the other countries have done. And if Brazil, South Korea, Thailand and Indonesia are anything to go by, the imf will demand not only deep political and structural changes (which are in any case long overdue) but in India's case also that the country sign the Non-Proliferation Treaty. Not the ctbt and fmct, but the npt. For that is what the Security Council has demanded already in its resolution No. 1176. What worries me is not what will happen if India signs the npt. All that will really be bruised will be our self-respect. What worries me is what will happen if it does not. For, lets face it, no politician will suffer excessively from the economic consequences of a debt default which is what would follow from the imfs refusal to help. So no politician will court going against Indian jingoism and advocate signing the npt.

Were this to happen, the government would have to put bans on inessential imports, especially of gold; stop foreign travel, and close down the capital market so that foreign investment is unable to leave the country. That is the equivalent of a default, so credit lines abroad would be cut off for importers. Since our most important import is oil, and high-speed diesel, all oil products would go into the black market and eventually become unavailable. This would disrupt domestic distribution of goods and that would lead to shutdowns in production. The overall effect would be mass unemployment, huge inflation and a sharp contraction in gdp. And then, irony of ironies, the government will have to take far harder decisions than the ones that its bureaucrats are preventing it from taking today.