Thursday, January 22, 2009
Future/Forward Markets, Options and Derivatives
Futures Market is a place where future contracts are traded. Future contract is an agreement between two parties (buyers and sellers) to buy/sell an asset at a certain future time at a certain price. Consider the following example. A paddy cultivator, whose crop will mature with in four months, is eager to get a remunerative price but has no means to ensure it. Suppose the current paddy price is Rs.8/kg but Rs.10/kg is the remunerative price. Now consider a rice mill owner who finds that if only paddy is available for a maximum of Rs.10/kg he could continue milling in a profitable manner. But he also has no means which will ensure a predictable and reasonable price for paddy.
It is in this context futures market will help both. Both have no mechanism to monitor and ensure a price which is profitable for both. A price rise would help the cultivator while it would hurt the miller and vice versa. Thus both face uncertainty regarding future prices. Moreover, if they take decisions in such an uncertain environment, the associated risk with such decisions would be very high. So both have an incentive to enter in a contract—which is called as “futures contract”—which would ensure reasonable price for both.
Suppose both enters in a futures contract where the cultivator is ready to supply paddy for Rs.10/kg by the time of harvest and the miller is ready to purchase it at the same price at that time. The price mutually agreed upon is called as the futures’ price of paddy.
In this way they can ink contacts for any period, say for instance, after six month, after one year and so on. Note that, it is the absence of information about the future prices and the consequent uncertainty and the lack of mechanism which would ensure a stable and remunerative/reasonable price that compelled both parties to enter in a contract like this. Put other wise, futures market is a mechanism devised by the market to deal with uncertainty in prices and also to allocate and reduce risks.
Hedgers and Speculators
Hedgers are participants of futures market who want to protect or hedge against the adverse movements in price. In our example the cultivator and the miller are the hedgers. They hedge against the adverse movements in price by entering into future contracts.
Speculators are people whose main role is to widen the market for futures. They ensure that people who want to purchase futures find sellers of futures. They believe that they have enough skills to acquire all the relevant information for conducting the trade on futures. They are ready to take the risks also.
How future prices increase current prices?
Those who hold inventories of goods reduce the supply to the market when they see that future prices are moving up in order to take benefit in future from the higher prices. Thus supply in the current period falls and consequently current prices also increase.
Disadvantages of Futures
If prices are higher than what is agreed in the future contract, sellers would feel that they did not get benefit from the favourable movement in price. The buyers would feel same when the actual price is below the agreed price in the contract. In short, futures trading prevent the parties to take benefit from the favourable price movements even though the contract gives them excellent cover from uncertainty.
Delivery
It is surprising to know that majority of futures contracts do not lead to delivery or cash settlement. Most of the parties ‘close out’ their contracts before the contract date by executing opposite contracts to that of the original ones.
Options
I help to take advantage from favourable price movements and also give a protective cover from adverse movements of price. Moreover, options have been traded for a shorter period than that of futures. The option signifies the fact that it involves an option; i.e. the option holder has the—option to execute or not what is involved in it. Put otherwise, options give the holder a right to do some thing. Whether to use that right or not, is the discretion of the holder.
There are two types of options. They are call option and put option. Call option gives the holder the right to buy an asset at a certain time for a certain price. Similarly, put option gives the holder the right to sell an asset at a certain time for a certain price. To buy an option a mutually agreed price must be paid.
Illustration
Suppose the current price of oil is Rs.60/kg. A baker wants to purchase oil in bulk quantity after six months and he finds that if the price moves above Rs.65/kg, it would be unprofitable to him. So he purchases call option for Rs.65/kg at an option price of Rs.3 per option. Now, after six months, the price became Rs.70/kg, he exercises the option and purchases for Rs.65/kg. But his effective price would be 65 + option price 3 = Rs.68/kg. With out option he had to spend Rs.5 more and thus reduced the possible loss by Rs.2.
Similarly, if the price is Rs.61/kg after six months, there is no need to exercise the option and he buys directly from the market. But his actual profit is not Rs.4/kg but 4-3=1 rupees only.
Thus if the price is lower than Rs.62/kg the option holder takes benefit from the favourable movement in price and if the price is above Rs.68/kg, he benefits through the execution of the contract.
Outflow Minimising Price Range
Up to a price of Rs.68/kg he is reducing the outflow of money from him. If price is Rs.67/kg, he exercises the option and thus saves Rs.2/kg. But he already spent Rs.3/kg for buying the option. Thus the net saving or outflow of money is only one rupee.
Also, consider the opposite case where the price is Rs.63/kg. Then he purchases directly from the market with out exercising the option. But the benefit is not Rs.2/kg as he already spent Rs.3/kg as option price. Thus the outflow is reduced and is only one rupee.
In between the range of Rs.62/kg-- Rs.68/kg, the option holder minimises the outflow of money from him through the purchase of options.
Forward Contracts
Similar to that of Futures Contracts. But it is custom made one between parties and is not traded in an exchange. It does not have a standardised form like futures and are private agreements or contract between the parties. Unlike futures contracts, most of the forward contracts do lead to delivery in terms of assets or cash settlement.
Derivatives
Derivatives are financial instruments whose value depends upon the values of the underlying basic variables or assets. Options, futures all are examples of derivatives.
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Monday, November 3, 2008
Hot Money Crisis Painted as Liquidity Crisis
As a consequence of the transfiguration and transmission of US financial crisis into a full blown economic crisis across the globe, the Indian foreign exchange market also nosedived into new abyss. The exchange rate plummeted from Rs 39 per US dollar on the beginning of January 2008 to Rs 49 by early October 2008. The Sensex also dovetailed from 20,000 to 10,000 during same period which accentuated the role of volatile movements in the capital market upon exchange rates. Dissecting further, FII or the hot money component in the Indian capital market was quite high during this period and FIIs took away $11.1 billion during the first nine-and-a-half months of calendar year 2008, of which $8.3 billion occurred over the first six-and-a-half months of financial year 2008-09 (April 1 to October 16). It is this highly volatile hot money component that rendered Indian capital market so capricious which eventually pulled down the exchange rate to the new abyss of Rs.49-50 per US dollar.
When FIIs all around the globe pumped money into the capital market The Indian government rolled out red carpet welcome to these forces of market fundamentalism. They all showered praises for the Globalisation and liberalisation policies of the government and then and there pointed out that it was because of the strong Macro economic fundamentals of the nation. But when exchange rate appreciated as the supply of foreign exchange increased due to this FII inflow, the government and market fundamentalists did not let things to the so called omnipotent market mechanism (forces of market demand and supply). Instead, they intervened in the market, a position that these market fundamentalists loathe when interventions are made for improving the life of people, and purchased all the foreign exchange brought by the FIIs through various measures. The consequence was that when RBI purchased the foreign exchange it resulted in pumping liquidity into the system. All private players and the pro-market government were so delighted in that economic situation.
US Financial Crisis, Capital Market and its consequences
But things changed dramatically consequent of US financial crisis. FIIs took away all their money and as a sequel, Sensex and exchange rate dovetailed to find all new low lying areas. Exactly the opposite of the events followed and liquidity was squeezed out. The economy witnessed the clamour from all quarters and from roof tops that the system is facing a new threat of ‘liquidity crisis’ which should be avoided at any cost. RBI came with its instruments of monetary policy and made several attempts to pump liquidity (money supply) into the system by reducing CRR etc.
Now the question is whether this fall in liquidity due to the outward movement of hot money—is a liquidity crisis or just a ‘hot money crisis’ alone? Why did the RBI again intervened in the market to pump money into the system when the so called so efficient market mechanism is in overdrive? The very same pro-market fundamentalists pontificated that there should not be any sort of intervention the market as market, when let free, by itself will find out the most ideal solution and outcome! These incidents clearly unmasked the real agenda of market fundamentalists. They do want to follow the rules of free market and not ready to accept its outcomes. They but pontificate the virtues of market only to avoid all sorts of government intervention in the economy (Santhosh, 2008) . When the private players and their self-interest face a crisis they conveniently shed the market philosophy and implement all sorts of intervention only to save corporate self-interest for ever high profits.
Precisely because of this reason it is widely publicised that the economy is facing a liquidity crisis and the economy must be saved from its ominous consequences. The creation of an enabling environment for intervention for helping the private self-interest was the objective for this deliberate campaign. Why did not the market fundamentalists who crave for free market operation let the outflow of foreign exchange due to the fickle hot money component of capital market and the consequent fall in money supply (or liquidity) be corrected by the market itself. Recall, the very same people pontificated the benefits of free market operation repeatedly from all roof tops.
Factors that Influence Money Supply
Simple economic theory says that monetary authorities implement monetary policy by setting the interest rates and letting the money stock be determined by how much is demanded at that interest rate. But to complete the picture we need to understand the influences on demand for money. The three important factors that influence short term variations in nominal quantity of money demanded are nominal rate of interest, real GDP and the price level. The relation with the first is negative and the other two are positive. Real GDP and price level mainly depend upon production of goods and services in the economy. Movements in nominal rate of interest have bearing upon the movements in price level which is basically related to the production of goods and services in the economy. In short all the major factors that influence the nominal quantity of money demanded are basically related to the production of goods and services in the economy. As a matter of fact, the supply and demand for money have an important bearing upon the level of production in the economy.
“Hot Money Crisis” or “Hot Money Induced Liquidity Crisis”
But the above said events viz. the massive outflow of foreign exchange due to the fickle hot money component of the capital market and the consequent fall in money supply has nothing to do with the production in the economy. Hence, this fall in money supply is simply not a fall in liquidity or a liquidity crisis of the economy. Put other wise, this fall in liquidity is not a demand side phenomenon, ie., not due to a sudden rise in demand for money consequent to increased production of goods and services in the economy. As such, it is fall in money supply or liquidity due to the capricious element of hot money rather than any dramatic fall in the level of economic activity. Whatever be the phenomenon, it must convey the underlying features and characteristics of the phenomenon with its name. Hence the crisis under consideration must also convey its true colours that it must be referred as “hot money crisis” or at least “hot money induced liquidity crisis”.
But the market fundamentalists loathe this reference as it will eventually dig its on grave as general public will realise the manipulations done by the arms of government for fortifying the private self-interest of big corporates. Further more, it sends the clear message that these private players not all like the outcomes of market mechanisms even though they swear loudly every time about the multifarious advantages of free markets! They like market as long as it showers private benefits but at the moment when the market shows its true colours all these private players would take volte-face and beg for intervention by the arms of government as covertly as possible. Hence they popularise the general term of liquidity crisis for this “hot money crisis”.
Visit at: www.santhoshtv.in
As a consequence of the transfiguration and transmission of US financial crisis into a full blown economic crisis across the globe, the Indian foreign exchange market also nosedived into new abyss. The exchange rate plummeted from Rs 39 per US dollar on the beginning of January 2008 to Rs 49 by early October 2008. The Sensex also dovetailed from 20,000 to 10,000 during same period which accentuated the role of volatile movements in the capital market upon exchange rates. Dissecting further, FII or the hot money component in the Indian capital market was quite high during this period and FIIs took away $11.1 billion during the first nine-and-a-half months of calendar year 2008, of which $8.3 billion occurred over the first six-and-a-half months of financial year 2008-09 (April 1 to October 16). It is this highly volatile hot money component that rendered Indian capital market so capricious which eventually pulled down the exchange rate to the new abyss of Rs.49-50 per US dollar.
When FIIs all around the globe pumped money into the capital market The Indian government rolled out red carpet welcome to these forces of market fundamentalism. They all showered praises for the Globalisation and liberalisation policies of the government and then and there pointed out that it was because of the strong Macro economic fundamentals of the nation. But when exchange rate appreciated as the supply of foreign exchange increased due to this FII inflow, the government and market fundamentalists did not let things to the so called omnipotent market mechanism (forces of market demand and supply). Instead, they intervened in the market, a position that these market fundamentalists loathe when interventions are made for improving the life of people, and purchased all the foreign exchange brought by the FIIs through various measures. The consequence was that when RBI purchased the foreign exchange it resulted in pumping liquidity into the system. All private players and the pro-market government were so delighted in that economic situation.
US Financial Crisis, Capital Market and its consequences
But things changed dramatically consequent of US financial crisis. FIIs took away all their money and as a sequel, Sensex and exchange rate dovetailed to find all new low lying areas. Exactly the opposite of the events followed and liquidity was squeezed out. The economy witnessed the clamour from all quarters and from roof tops that the system is facing a new threat of ‘liquidity crisis’ which should be avoided at any cost. RBI came with its instruments of monetary policy and made several attempts to pump liquidity (money supply) into the system by reducing CRR etc.
Now the question is whether this fall in liquidity due to the outward movement of hot money—is a liquidity crisis or just a ‘hot money crisis’ alone? Why did the RBI again intervened in the market to pump money into the system when the so called so efficient market mechanism is in overdrive? The very same pro-market fundamentalists pontificated that there should not be any sort of intervention the market as market, when let free, by itself will find out the most ideal solution and outcome! These incidents clearly unmasked the real agenda of market fundamentalists. They do want to follow the rules of free market and not ready to accept its outcomes. They but pontificate the virtues of market only to avoid all sorts of government intervention in the economy (Santhosh, 2008) . When the private players and their self-interest face a crisis they conveniently shed the market philosophy and implement all sorts of intervention only to save corporate self-interest for ever high profits.
Precisely because of this reason it is widely publicised that the economy is facing a liquidity crisis and the economy must be saved from its ominous consequences. The creation of an enabling environment for intervention for helping the private self-interest was the objective for this deliberate campaign. Why did not the market fundamentalists who crave for free market operation let the outflow of foreign exchange due to the fickle hot money component of capital market and the consequent fall in money supply (or liquidity) be corrected by the market itself. Recall, the very same people pontificated the benefits of free market operation repeatedly from all roof tops.
Factors that Influence Money Supply
Simple economic theory says that monetary authorities implement monetary policy by setting the interest rates and letting the money stock be determined by how much is demanded at that interest rate. But to complete the picture we need to understand the influences on demand for money. The three important factors that influence short term variations in nominal quantity of money demanded are nominal rate of interest, real GDP and the price level. The relation with the first is negative and the other two are positive. Real GDP and price level mainly depend upon production of goods and services in the economy. Movements in nominal rate of interest have bearing upon the movements in price level which is basically related to the production of goods and services in the economy. In short all the major factors that influence the nominal quantity of money demanded are basically related to the production of goods and services in the economy. As a matter of fact, the supply and demand for money have an important bearing upon the level of production in the economy.
“Hot Money Crisis” or “Hot Money Induced Liquidity Crisis”
But the above said events viz. the massive outflow of foreign exchange due to the fickle hot money component of the capital market and the consequent fall in money supply has nothing to do with the production in the economy. Hence, this fall in money supply is simply not a fall in liquidity or a liquidity crisis of the economy. Put other wise, this fall in liquidity is not a demand side phenomenon, ie., not due to a sudden rise in demand for money consequent to increased production of goods and services in the economy. As such, it is fall in money supply or liquidity due to the capricious element of hot money rather than any dramatic fall in the level of economic activity. Whatever be the phenomenon, it must convey the underlying features and characteristics of the phenomenon with its name. Hence the crisis under consideration must also convey its true colours that it must be referred as “hot money crisis” or at least “hot money induced liquidity crisis”.
But the market fundamentalists loathe this reference as it will eventually dig its on grave as general public will realise the manipulations done by the arms of government for fortifying the private self-interest of big corporates. Further more, it sends the clear message that these private players not all like the outcomes of market mechanisms even though they swear loudly every time about the multifarious advantages of free markets! They like market as long as it showers private benefits but at the moment when the market shows its true colours all these private players would take volte-face and beg for intervention by the arms of government as covertly as possible. Hence they popularise the general term of liquidity crisis for this “hot money crisis”.
Visit at: www.santhoshtv.in
Saturday, October 18, 2008
‘Innovations for Crisis’ and Financial Meltdown: Implications for Growth and Economic Policy
[Paper was later presented in “Confluence 2008”, Seminar Series conducted by Sree Narayana College, Alathur, Palakkadu affiliated to Calicut University, on 18th of November, 2008.]
1.1 Introduction
The much famed “Wall Street” simply became ‘Fall Street’ on an otherwise sunny day sending panic signals across the globe. The integration of markets of different countries, especially financial and capital, as a consequence of the so called resounding success 0f globalisation made its impact felt so swift across borders! This time it did not let the ‘mature economies’ go scot free who often proudly pontificate the virtues of ‘transparency’ and the benefits of religiously adhering to the capital adequacy norms of Bassle Settlements to the hapless chaps who struggle in the southern part of the equator . At last, globalisation showed its true colours and once again unfettered capitalism proclaimed from the roof top that it is so brittle and so irrational.
1.2 Excess liquidity growth and the eventual fall down
It is better to understand the chain of events that may happen when the central bank injects liquidity (or increases money supply) into the system. Increased liquidity means increased purchasing power and what usually follows is that, it moves to those areas where it can take more returns. Borrowing becomes the rule as rate of interest falls and the funds thus taken, will be parked at lucrative avenues. Naturally, financial assets like shares, securities etc and real estate becomes the preferred avenues for investment. Their prices then start to climb and a boom like situation sets in the economy. The upward movement of the economy gradually raise the concerns of inflation as prices are moving up. As inflation rises, the real rate of interest beings to fall (real rate of interest = nominal rate – inflation). To counter act, central bank intervenes in the market and take measures to raise the rate of interest to put the inflation under the leash. When interest rates rise, the prices of assets like shares and real estate becomes over valued and a switch back will happen from shares, real estate, etc to bank deposits and related form of assets. As such, prices of shares or real estate begin to fall and eventually the economy crash-lands and crisis unfolds the pall of gloom.
1.2.1 Three instances of Excess Liquidity in 20th Century
The three notable instances with excess liquidity growth in USA happened in 1928, 1987 and 1999. The last one was the result of dotcom and tech bubble during which the liquidity growth was at an annualized rate of 76% in the last quarter of 1999. At that time the Fed was preparing to deal with the ‘Y2K situation’ and wanted to make sure there was enough liquidity in the system. As a consequence, stock prices took a steep upward movement and the Nasdaq Composite stock index rose 107% in less than 6 months only to decline by -50% later.
1.2.2 Aftermath of dotcom bubble and 9/11, 2001
The investment in US fell remarkably in the wake of shattered business confidence after the dotcom bubble and lingering uncertainty consequent of the terror attack of 9/11, 2001. The US Fed adopted the easy money policy to restore confidence and to prop up rate of investment. Rate of interest started to fall and stayed below 2% level through out 2002-2005. Since September 11, 2001, a new mantra of ‘borrow and spend’ was coined where “consumerism has been cast as new patriotism”. The cheap money policy of the US Fed at last helped the economy to take a U-turn and a new growth trajectory was made visible by 2002. 1.2.3 Sub-Prime lending It was proclaimed as loudly as possible that the new growth trajectory, after the dotcom bubble, was the telling outcome of the resilience of the capitalist system which is so efficient, innovative and powerful to lay out new paths when the human ingenuity is let free to take course. As pointed out above, the continuous injection of liquidity into the system helped the rate of interest to fall considerably and to stay below 2% up to the end of 2005. Borrowing became easy and an effortless thing and the funds were recklessly spent on conspicuous consumption and investment in stocks and real estate assets. Spending on new residential houses became the preferred item. As demand for housing increased real estate prices also took an upward movement.
This booming price of housing and real estate assets gave a golden opportunity to the ‘innovative scamsters’ and speculators of the so-called ingenious financial markets. For private lenders, credit worthiness is one among the important criteria for giving loans. Credit worthiness is quantified through computing credit scores. Credit scores help to know about the payment history of the borrower. The score quantifies the credit history in terms of his ability and willingness to repay the loan taken by the borrower. This is done often by assigning a numerical value. A credit score greater than 660 makes him a prime borrower. Borrower with a score less than this is called as a sub-prime borrower and will not normally get loans because it is risky to lend. Their credit worthiness is considered as poor. But they also get loans if the additional risk is covered through higher rate of interest. Lending in this manner is called as sub-prime lending. Sub-prime lending involves sub-prime mortgages, sub-prime credit cards etc.
The main risk in the normal bank lending process is called as the ‘credit risk’ or the risk of default. Since the sub-prime lenders have high risk regarding default, they are offered loans with higher rate of interest than that of given to prime customers. Since the Fed rate is well below 2% level, even a higher rate of interest appears lower to such sub-prime customers.
1.3 The role of ‘Innovative’ derivatives
To reap the full benefit out of the boom situation, the financial institutions want to increase business as far as possible through whatever means possible. The original lenders who directly lend to the house owners for making the real estate purchases have a resource limitation in extending the business after a point. In this context, the financial derivative[1] ‘Mortgage Backed Securities’ (MBS) comes into the scene.
MBS is an asset backed security (ABS). Assets can be anything that has cash flows like mortgage loans, home equity loans[2], credit card payments, auto loans, etc. When the underlying assets are home mortgages it becomes MBS.
MBS is a repackaged loan. After the purchase of housing loans from banks and other non-banks which originally gave the loans , the financial institutions repackage them by pooling several loans into one. In other words, the housing mortgages are bundled together to form a single asset. By taking the original housing mortgage as the core asset they issue the financial security called as MBS. The MBS gets value only because it is backed by a real asset. Thus the value of the MBS depends upon the value of the basic/core variable or asset.
Then MBSs will be sold in the secondary capital market. This issue of new security (MBS) out of the original mortgage loan is called as the ‘Securitisation’ of residential mortgages[3]. The proceeds they earn from the sale of MBS will then be used to purchase new set of original mortgage loans from the primary lenders. In that process primary lenders are provided with liquidity enabling them to give fresh housing loans.
1.3.1 The Business Operation
As pointed out above, the original providers of housing loans are banks and non-bank mortgage institutions. Their capacity to make loans is limited by the availability of their resources. But the US government wanted to raise that limitation and liquidity in mortgage financing. Thus Fannie Mae[4] and Freddie Mac come into the picture. Up to 1968 only Fannie Mae was there and it purchased and held these housing loans with it from the originators of the loan. Fannie Mae raised resources from market by issuing debt in the form of securities. The interest rate on the securities issued by Fannie Mae was lower than the rate of interest charged for housing loans. Thus the spread between the rates is the income of Fannie Mae. Once Fannie Mae purchases loans from originators, they will get fresh resources which could be in turn used for giving new housing loans. Only that loans which are following the guidelines of Fannie Mae alone were purchased. Such loans are called as conforming loans. By and large this was the system up to 1970. Since these loans are conforming to the guidelines of Fannie Mae they were safe for the purchase and so posed no threat.
After 1970 with the creation of Freddie Mac, the new instrument MBS (Mortgage Backed Securities) were issued first in 1971. Fannie Mae also followed suit by 1981. Earlier they were only purchasing the loans by issuing debt. Now they were responding to the ‘innovations’ of financial market by issuing MBS.
MBS securities were purchased by the ‘Investment Banks’ in the Wall Street or else where. A guarantee will be given that the principal and the interest payments are given to the investment banks irrespective of any default by the original borrower. The institutions which issue MBS also benefits by collecting guarantee fee, service charge etc from the investment banks. It will also receive an interest rate spread. For example, if the rate of interest of the original loan is 6.5%, MBS institutions can take up to 2.5% as their various charges and only the remaining 4% rate of interest paid by the original borrower will be handed over to the investment banks. Thus it was a win-win situation for all players according to market enthusiasts. Even a 4% interest payment was a bonanza for the investment banks who were sitting on huge cash balances received from super rich persons. As long as these original mortgage loans were given to prime borrowers there is no apparent threat. Further more, MBSs were issued by government sponsored enterprises like Fannie Mae and Freddie Mac and there is only minimal risk. This was the situation up to 1995 or so.
But the landscape changed dramatically during the 1990s. It all started innocuously as private financial institutions sensed an opportunity in extending loans to self-employed individuals. The nature of their employment and the variable behaviour of their income and the consequent problems in furnishing documentary proof thereof initially motivated them to relax the requirements for becoming eligible for loan. Self certification of income, employment nature etc were became the only requirements. The additional risk in granting such loans is compensated by charging higher rate of interest. Later, loans are issued with still reduced documentation or with no documentation! The additional risk in such lending is covered by adopting the ‘risk-based pricing’ policy, that is, by charging higher rate of interest. (Such loan offering is prevalent in India also especially in the two wheeler loan market by following suit but surfaced only 2003 or so.) Gradually this way of dispensing loans were aggressively attempted by private entities to borrowers who have low credit scores. The additional risk is compensated by charging higher rate of interest.
But with high interest rates there will be only few takers for the loans. The borrower is attracted by offering low initial interest rates which will gradually but progressively increase after a small period. Such loans are called as adjustable-rate mortgages (ARM) where the rates for the initial 2 years were fixed and after that rates become flexible and is calculated by indexing them with LIBOR (London inter bank offered rate) plus a margin. During the initial period teasing interest rates (ranging from 0—2% interest) are offered. Both the borrower and the lender forget about the difficulty in repayment of such high interest loans by persons having poor credit worthiness. They simply gamble on the increasing real estate prices and put their hopes on it. The lender promises that a refinance option will be given at favourable terms and rates as and when there happens sufficient increase in residential prices. Everything appears fine as long as the real estate prices are booming.
1.4 The Complicated Phase of Sub-Prime Lending
Lending to self-employed with relaxed documentation requirements is understandable given the nature of their employment and income behaviour. But as time elapsed funds are loaned even as both the lender and the borrower knew each other that false statements are furnished in the self attestations. No body cared it and increasingly indulged in activity called as sub-prime lending. Even government sponsored agencies like Freddie Mac started to issue MBS with sub-prime mortgages as early as 1995.
The sub-prime lending and the MBSs of agency issuers like Fannie Mae and Freddie Mac were backed by their guarantee against any default. But this is not the case with non-agency MBSs (issued by private banks, investment banks, insurance companies, pension funds etc). No guarantee is there for the sub-prime element under such MBSs. The added credit and default risk were not covered. Even in the case of agency MBSs, the added risk created problems.
As a consequence, financial derivative called as CDO (Collateral Debt Obligations) surfaced in the sphere. Another credit derivative CDS (Credit Default Swap) also came into the scene as a cover of insurance in the event of any default.
1.4.1 Collateral Debt Obligations (CDO)
CDO is a special purpose vehicle. Assets form the core of a CDO. Assets of a CDO can be anything ranging from mortgage backed securities, corporate loans, bonds etc. The structure and assets of a CDO can vary on the basis of the structure and assets it holds. But the essential mechanism of all CDOs is same. CDOs offer access to various financial instruments issued by different entities through a single instrument. Hence the purchaser of CDO can have a diversified portfolio of assets and is believed to have helped him to diversify the risk.
Since CDO has a divergent portfolio, the risk associated with it also has a hybrid nature. Apart from that, the cash flow for the underlying assets is also not uniform and may have different repayment periods etc. When assets of a CDO are segregated on the basis of nature and degree of risk, and returns different layers or tranches are created. Some assets like MBS with prime borrowers have low risk while MBS with sub-prime borrowers have high risk. When they are segregated, the CDO is said to have two tranches[5]. Generally CDOs have three tranches called as Senior (lowest risk an AAA rated), mezzanine (medium risk) and equity (high risk and unrated). Investment banks purchase tranches according to their appetite for risk and this segregation of assets on the basis of risk is supposed to have helped to price securities in a more efficient manner.
CDO became essential as sub-prime lending was aggressively attempted in massive volumes which made it more and more risky as more and more poorly credit rated individuals were given loans . CDO deals with such increased level of risk. Already sub-prime MBSs are very risky. As new and new individuals with still poor credit scores are made eligible for loans it became very risky to buy such MBSs. The introduction of CDO thus enhanced and ensured continuous market for MBSs. The different layers or tranches are so created that it will be credit rated impressively by ‘independent credit rating’ firms. But it is now revealed that these very ‘independent’ credit rating firms colluded with the issuers that it advised how to design a CDO layer and to earn triple ‘A’ rating!
Apart from that, initially CDO were sold with ‘Credit Enhancements’. Its purpose is to reduce the risk associated with CDO. It reduces the risk by adding other assets (or collaterals like property, inventories, oil reserves, etc), third party loan guarantees, credit insurances etc with the CDO. All this give an assurance to the purchaser of CDO that it will be compensated if the original borrower defaults in any event. But as time elapsed, the level of credit enhancements were reduced and even not resorted at all.
CDS (Credit Default Swap) is another instrument which gives insurance to a bad or doubtful debts or CDOs. The investment bank which bought sub-prime CDOs was concerned about the associated risks. They purchase CDS from insurance firms or other financial institutions. In the event of a credit default the seller will make the payment and in that way CDS provided insurance cover for sub-prime doubtful CDOs. Insurance firms which sell CDSs, in turn, charge a protection fee similar to insurance premium. Thus the institutions thought that the risks involved with CDOs are effectively insured and neutralised! The ‘super efficient’ financial institutions took complete solace (with CDOs and CDSs) in the process of sub-prime fuelled economic boom[6]. Apart from normal CDOs , CDO squared and CDO cubed also surfaced. The CDO squared is created in the same manner in which CDOs are created but the underlying assets is CDO itself and the asset base of the CDO cubed is nothing but CDO squared!
In manner explained above, the ‘innovative’ financial institutions created lot of derivatives again upon the CDOs and sold them to all sorts of financial institution across global capital markets including investment banks, hedge funds, pension funds, banks, non banking financial institutions, insurance companies etc who were replete with resources collected from super rich individuals, pension and insurance contributions of ordinary citizens. The pricing of such additional financial derivatives were computed by using sophisticated computer models regarding the behaviour of the original borrower and the various possibilities like prepayment, curtailing, foreclosure, part payment etc with ever revising assumptions regarding the behaviour! Any way, the level of sophistication in the computer modelling notwithstanding, once a crisis happens at one spot, it spills over and all institutions, which indulged in this crazy and greedy rush for registering profits, across the globe, would fall like nine pins.
1.5 The Onset of the Crisis and the Downfall
When the interest rates started to move northwards by 2006-07, it became very difficult to repay the sub-prime loans. Moreover the adjustable-rate mortgages (ARM) entered into the phase of flexible rate regime when interest rates increased. The borrowers felt it difficult to make the repayment in these situations. The result was increased default rates and foreclosure rates. By that time housing prices also started to fall consequent of the fall in the demand for housing with the rise in rate of interest. When financial institutions attempted to sell the defaulted mortgages to recoup their money, they found that their value has been fallen well below the amount of debt on it! Crisis loomed everywhere and the rest of the story of collapse became history.
1.6 The lessons from the whole episode
Private lenders normally do not extend credit to customers having poor creditworthiness. Credit worthiness includes the repayment capacity, payment history, defaults committed for previous loans etc by the loanee. But these private financial institutions want to show a bloated balance sheet with bulging profits continuously and this greed prompted them to somehow give loans to even customers having poor credentials. A boom like situation in real estate sector gave them a golden opportunity. Even if a default happens, the value of the underlying asset (the house upon which loan is given) is high enough to pay the principal and interest as far as the real estate prices are soaring. They could sell the mortgage through ‘foreclosure’ and recoup what ever amount involved it in the form of principal, interest payments, other related charges etc. So these hell-bent lenders of all sorts, made all these lending bonanza and wrote all sorts of financial derivates upon them, with the clear understanding about the risks involved. They were very sure that they could sell all the mortgages in a soaring real estate market for hefty profits in any event of default.
The other financial institutions who are not directly involved in the sub-prime fuelled boom process like European and Asian banks and financial institutions (including the UK arm of ICICI bank and State Bank of India etc) purchased different kinds of derivatives created from the original housing loan given in US with a view to registering quick and easy profits.
All this clearly underscores the simple fact that in an era glorified phase of globalisation and unfettered capitalism all players wanted to show ‘growth’ figures in the monthly/quarterly/annual reports. Growth was so glorified, irrespective of the area in which it happens, and an artificial aura has been deliberately painted around it. The more substantive ‘growth process’ was relegated to the back place in the run-up towards the present crisis.
It is argued that the securitisation process and with the use of the so-called innovative derivatives, the risk associated with debts were successfully diffused. Robert Kuttner, who was once Business Week columnist, however, pointed out that securitisation of mortgages resulted in the concentration of risk rather than diffusing it, as every one is placing hopes on the soaring prices of residential plots. And exactly this was what happened.
1.6.1 Growth Concerns and Independent Policy making
It is now officially announced that Germany and Japan have entered into a phase of recession. The growth predictions of RBI have also taken a tail spin. In a glorified era of globalisation where the integration of global financial markets plays a vital role no country can keep away from a crisis that happens in few markets. Indian financial institutions had only a low exposure to sub-prime crisis as majority are public sector enterprises. But the largest private financial institution, ICICI bank, has indeed exposure to this crisis but it is the domestic regulatory environment prevented such institutions to indulge neck deep in to shady financial transactions like this. It is worth noting the fact that it is not because of any prudence or transparency in the dealings of the management of private institutions that averted a full fledged crisis in India but the strong regulatory environment and the irresistible resistance from the public that really saved the economy form the hell-bent reformers of Indian establishment.
But the opening up of capital market and the consequent inflow of funds from Foreign Institutional Investors (FII) that simply bloated the foreign exchange reserves of RBI is creating great problems to the economy. FIIs are taken back their investments by selling the shares and this was the reason for the heavy outflow of dollar in the past few weeks. The consequent fall in liquidity, as rupee is handed over to RBI for dollar by FIIs, is creating problems to the economy. It is to deal with this liquidity crunch RBI announced a slew of measures including reduction in CRR, repo rates, increased rate of interest for NRI deposits etc. SEBI has given permission to issue Participatory Notes (P-notes or PN) by FII to check the outflow of foreign exchange.
Rupee depreciated from around 39 to 49 between the period of January to October 2008 vis-à-vis US dollar. The SENSEX also took a dovetail from around 20,000 to around 10,000 during the same period. RBI intervened in the market heavily otherwise the exchange rate would have plummeted something near to Rs 60 per dollar! But even the Rs 10 depreciation could not help to boot exports in a situation of global recession. Export sector is already crippled with the crisis. The following table gives the sectoral growth rates of Indian economy. The share of agriculture is near to 20% while the service sector accounts more than 50% and the industrial sector accounts more than 25% of the GDP. Rate of growth of GDP at factor cost at 1999-2000 prices (per cent)
Rate of growth of GDP at factor cost at 1999-2000 prices (per cent)
[Paper was later presented in “Confluence 2008”, Seminar Series conducted by Sree Narayana College, Alathur, Palakkadu affiliated to Calicut University, on 18th of November, 2008.]
1.1 Introduction
The much famed “Wall Street” simply became ‘Fall Street’ on an otherwise sunny day sending panic signals across the globe. The integration of markets of different countries, especially financial and capital, as a consequence of the so called resounding success 0f globalisation made its impact felt so swift across borders! This time it did not let the ‘mature economies’ go scot free who often proudly pontificate the virtues of ‘transparency’ and the benefits of religiously adhering to the capital adequacy norms of Bassle Settlements to the hapless chaps who struggle in the southern part of the equator . At last, globalisation showed its true colours and once again unfettered capitalism proclaimed from the roof top that it is so brittle and so irrational.
1.2 Excess liquidity growth and the eventual fall down
It is better to understand the chain of events that may happen when the central bank injects liquidity (or increases money supply) into the system. Increased liquidity means increased purchasing power and what usually follows is that, it moves to those areas where it can take more returns. Borrowing becomes the rule as rate of interest falls and the funds thus taken, will be parked at lucrative avenues. Naturally, financial assets like shares, securities etc and real estate becomes the preferred avenues for investment. Their prices then start to climb and a boom like situation sets in the economy. The upward movement of the economy gradually raise the concerns of inflation as prices are moving up. As inflation rises, the real rate of interest beings to fall (real rate of interest = nominal rate – inflation). To counter act, central bank intervenes in the market and take measures to raise the rate of interest to put the inflation under the leash. When interest rates rise, the prices of assets like shares and real estate becomes over valued and a switch back will happen from shares, real estate, etc to bank deposits and related form of assets. As such, prices of shares or real estate begin to fall and eventually the economy crash-lands and crisis unfolds the pall of gloom.
1.2.1 Three instances of Excess Liquidity in 20th Century
The three notable instances with excess liquidity growth in USA happened in 1928, 1987 and 1999. The last one was the result of dotcom and tech bubble during which the liquidity growth was at an annualized rate of 76% in the last quarter of 1999. At that time the Fed was preparing to deal with the ‘Y2K situation’ and wanted to make sure there was enough liquidity in the system. As a consequence, stock prices took a steep upward movement and the Nasdaq Composite stock index rose 107% in less than 6 months only to decline by -50% later.
1.2.2 Aftermath of dotcom bubble and 9/11, 2001
The investment in US fell remarkably in the wake of shattered business confidence after the dotcom bubble and lingering uncertainty consequent of the terror attack of 9/11, 2001. The US Fed adopted the easy money policy to restore confidence and to prop up rate of investment. Rate of interest started to fall and stayed below 2% level through out 2002-2005. Since September 11, 2001, a new mantra of ‘borrow and spend’ was coined where “consumerism has been cast as new patriotism”. The cheap money policy of the US Fed at last helped the economy to take a U-turn and a new growth trajectory was made visible by 2002. 1.2.3 Sub-Prime lending It was proclaimed as loudly as possible that the new growth trajectory, after the dotcom bubble, was the telling outcome of the resilience of the capitalist system which is so efficient, innovative and powerful to lay out new paths when the human ingenuity is let free to take course. As pointed out above, the continuous injection of liquidity into the system helped the rate of interest to fall considerably and to stay below 2% up to the end of 2005. Borrowing became easy and an effortless thing and the funds were recklessly spent on conspicuous consumption and investment in stocks and real estate assets. Spending on new residential houses became the preferred item. As demand for housing increased real estate prices also took an upward movement.
This booming price of housing and real estate assets gave a golden opportunity to the ‘innovative scamsters’ and speculators of the so-called ingenious financial markets. For private lenders, credit worthiness is one among the important criteria for giving loans. Credit worthiness is quantified through computing credit scores. Credit scores help to know about the payment history of the borrower. The score quantifies the credit history in terms of his ability and willingness to repay the loan taken by the borrower. This is done often by assigning a numerical value. A credit score greater than 660 makes him a prime borrower. Borrower with a score less than this is called as a sub-prime borrower and will not normally get loans because it is risky to lend. Their credit worthiness is considered as poor. But they also get loans if the additional risk is covered through higher rate of interest. Lending in this manner is called as sub-prime lending. Sub-prime lending involves sub-prime mortgages, sub-prime credit cards etc.
The main risk in the normal bank lending process is called as the ‘credit risk’ or the risk of default. Since the sub-prime lenders have high risk regarding default, they are offered loans with higher rate of interest than that of given to prime customers. Since the Fed rate is well below 2% level, even a higher rate of interest appears lower to such sub-prime customers.
1.3 The role of ‘Innovative’ derivatives
To reap the full benefit out of the boom situation, the financial institutions want to increase business as far as possible through whatever means possible. The original lenders who directly lend to the house owners for making the real estate purchases have a resource limitation in extending the business after a point. In this context, the financial derivative[1] ‘Mortgage Backed Securities’ (MBS) comes into the scene.
MBS is an asset backed security (ABS). Assets can be anything that has cash flows like mortgage loans, home equity loans[2], credit card payments, auto loans, etc. When the underlying assets are home mortgages it becomes MBS.
MBS is a repackaged loan. After the purchase of housing loans from banks and other non-banks which originally gave the loans , the financial institutions repackage them by pooling several loans into one. In other words, the housing mortgages are bundled together to form a single asset. By taking the original housing mortgage as the core asset they issue the financial security called as MBS. The MBS gets value only because it is backed by a real asset. Thus the value of the MBS depends upon the value of the basic/core variable or asset.
Then MBSs will be sold in the secondary capital market. This issue of new security (MBS) out of the original mortgage loan is called as the ‘Securitisation’ of residential mortgages[3]. The proceeds they earn from the sale of MBS will then be used to purchase new set of original mortgage loans from the primary lenders. In that process primary lenders are provided with liquidity enabling them to give fresh housing loans.
1.3.1 The Business Operation
As pointed out above, the original providers of housing loans are banks and non-bank mortgage institutions. Their capacity to make loans is limited by the availability of their resources. But the US government wanted to raise that limitation and liquidity in mortgage financing. Thus Fannie Mae[4] and Freddie Mac come into the picture. Up to 1968 only Fannie Mae was there and it purchased and held these housing loans with it from the originators of the loan. Fannie Mae raised resources from market by issuing debt in the form of securities. The interest rate on the securities issued by Fannie Mae was lower than the rate of interest charged for housing loans. Thus the spread between the rates is the income of Fannie Mae. Once Fannie Mae purchases loans from originators, they will get fresh resources which could be in turn used for giving new housing loans. Only that loans which are following the guidelines of Fannie Mae alone were purchased. Such loans are called as conforming loans. By and large this was the system up to 1970. Since these loans are conforming to the guidelines of Fannie Mae they were safe for the purchase and so posed no threat.
After 1970 with the creation of Freddie Mac, the new instrument MBS (Mortgage Backed Securities) were issued first in 1971. Fannie Mae also followed suit by 1981. Earlier they were only purchasing the loans by issuing debt. Now they were responding to the ‘innovations’ of financial market by issuing MBS.
MBS securities were purchased by the ‘Investment Banks’ in the Wall Street or else where. A guarantee will be given that the principal and the interest payments are given to the investment banks irrespective of any default by the original borrower. The institutions which issue MBS also benefits by collecting guarantee fee, service charge etc from the investment banks. It will also receive an interest rate spread. For example, if the rate of interest of the original loan is 6.5%, MBS institutions can take up to 2.5% as their various charges and only the remaining 4% rate of interest paid by the original borrower will be handed over to the investment banks. Thus it was a win-win situation for all players according to market enthusiasts. Even a 4% interest payment was a bonanza for the investment banks who were sitting on huge cash balances received from super rich persons. As long as these original mortgage loans were given to prime borrowers there is no apparent threat. Further more, MBSs were issued by government sponsored enterprises like Fannie Mae and Freddie Mac and there is only minimal risk. This was the situation up to 1995 or so.
But the landscape changed dramatically during the 1990s. It all started innocuously as private financial institutions sensed an opportunity in extending loans to self-employed individuals. The nature of their employment and the variable behaviour of their income and the consequent problems in furnishing documentary proof thereof initially motivated them to relax the requirements for becoming eligible for loan. Self certification of income, employment nature etc were became the only requirements. The additional risk in granting such loans is compensated by charging higher rate of interest. Later, loans are issued with still reduced documentation or with no documentation! The additional risk in such lending is covered by adopting the ‘risk-based pricing’ policy, that is, by charging higher rate of interest. (Such loan offering is prevalent in India also especially in the two wheeler loan market by following suit but surfaced only 2003 or so.) Gradually this way of dispensing loans were aggressively attempted by private entities to borrowers who have low credit scores. The additional risk is compensated by charging higher rate of interest.
But with high interest rates there will be only few takers for the loans. The borrower is attracted by offering low initial interest rates which will gradually but progressively increase after a small period. Such loans are called as adjustable-rate mortgages (ARM) where the rates for the initial 2 years were fixed and after that rates become flexible and is calculated by indexing them with LIBOR (London inter bank offered rate) plus a margin. During the initial period teasing interest rates (ranging from 0—2% interest) are offered. Both the borrower and the lender forget about the difficulty in repayment of such high interest loans by persons having poor credit worthiness. They simply gamble on the increasing real estate prices and put their hopes on it. The lender promises that a refinance option will be given at favourable terms and rates as and when there happens sufficient increase in residential prices. Everything appears fine as long as the real estate prices are booming.
1.4 The Complicated Phase of Sub-Prime Lending
Lending to self-employed with relaxed documentation requirements is understandable given the nature of their employment and income behaviour. But as time elapsed funds are loaned even as both the lender and the borrower knew each other that false statements are furnished in the self attestations. No body cared it and increasingly indulged in activity called as sub-prime lending. Even government sponsored agencies like Freddie Mac started to issue MBS with sub-prime mortgages as early as 1995.
The sub-prime lending and the MBSs of agency issuers like Fannie Mae and Freddie Mac were backed by their guarantee against any default. But this is not the case with non-agency MBSs (issued by private banks, investment banks, insurance companies, pension funds etc). No guarantee is there for the sub-prime element under such MBSs. The added credit and default risk were not covered. Even in the case of agency MBSs, the added risk created problems.
As a consequence, financial derivative called as CDO (Collateral Debt Obligations) surfaced in the sphere. Another credit derivative CDS (Credit Default Swap) also came into the scene as a cover of insurance in the event of any default.
1.4.1 Collateral Debt Obligations (CDO)
CDO is a special purpose vehicle. Assets form the core of a CDO. Assets of a CDO can be anything ranging from mortgage backed securities, corporate loans, bonds etc. The structure and assets of a CDO can vary on the basis of the structure and assets it holds. But the essential mechanism of all CDOs is same. CDOs offer access to various financial instruments issued by different entities through a single instrument. Hence the purchaser of CDO can have a diversified portfolio of assets and is believed to have helped him to diversify the risk.
Since CDO has a divergent portfolio, the risk associated with it also has a hybrid nature. Apart from that, the cash flow for the underlying assets is also not uniform and may have different repayment periods etc. When assets of a CDO are segregated on the basis of nature and degree of risk, and returns different layers or tranches are created. Some assets like MBS with prime borrowers have low risk while MBS with sub-prime borrowers have high risk. When they are segregated, the CDO is said to have two tranches[5]. Generally CDOs have three tranches called as Senior (lowest risk an AAA rated), mezzanine (medium risk) and equity (high risk and unrated). Investment banks purchase tranches according to their appetite for risk and this segregation of assets on the basis of risk is supposed to have helped to price securities in a more efficient manner.
CDO became essential as sub-prime lending was aggressively attempted in massive volumes which made it more and more risky as more and more poorly credit rated individuals were given loans . CDO deals with such increased level of risk. Already sub-prime MBSs are very risky. As new and new individuals with still poor credit scores are made eligible for loans it became very risky to buy such MBSs. The introduction of CDO thus enhanced and ensured continuous market for MBSs. The different layers or tranches are so created that it will be credit rated impressively by ‘independent credit rating’ firms. But it is now revealed that these very ‘independent’ credit rating firms colluded with the issuers that it advised how to design a CDO layer and to earn triple ‘A’ rating!
Apart from that, initially CDO were sold with ‘Credit Enhancements’. Its purpose is to reduce the risk associated with CDO. It reduces the risk by adding other assets (or collaterals like property, inventories, oil reserves, etc), third party loan guarantees, credit insurances etc with the CDO. All this give an assurance to the purchaser of CDO that it will be compensated if the original borrower defaults in any event. But as time elapsed, the level of credit enhancements were reduced and even not resorted at all.
CDS (Credit Default Swap) is another instrument which gives insurance to a bad or doubtful debts or CDOs. The investment bank which bought sub-prime CDOs was concerned about the associated risks. They purchase CDS from insurance firms or other financial institutions. In the event of a credit default the seller will make the payment and in that way CDS provided insurance cover for sub-prime doubtful CDOs. Insurance firms which sell CDSs, in turn, charge a protection fee similar to insurance premium. Thus the institutions thought that the risks involved with CDOs are effectively insured and neutralised! The ‘super efficient’ financial institutions took complete solace (with CDOs and CDSs) in the process of sub-prime fuelled economic boom[6]. Apart from normal CDOs , CDO squared and CDO cubed also surfaced. The CDO squared is created in the same manner in which CDOs are created but the underlying assets is CDO itself and the asset base of the CDO cubed is nothing but CDO squared!
In manner explained above, the ‘innovative’ financial institutions created lot of derivatives again upon the CDOs and sold them to all sorts of financial institution across global capital markets including investment banks, hedge funds, pension funds, banks, non banking financial institutions, insurance companies etc who were replete with resources collected from super rich individuals, pension and insurance contributions of ordinary citizens. The pricing of such additional financial derivatives were computed by using sophisticated computer models regarding the behaviour of the original borrower and the various possibilities like prepayment, curtailing, foreclosure, part payment etc with ever revising assumptions regarding the behaviour! Any way, the level of sophistication in the computer modelling notwithstanding, once a crisis happens at one spot, it spills over and all institutions, which indulged in this crazy and greedy rush for registering profits, across the globe, would fall like nine pins.
1.5 The Onset of the Crisis and the Downfall
When the interest rates started to move northwards by 2006-07, it became very difficult to repay the sub-prime loans. Moreover the adjustable-rate mortgages (ARM) entered into the phase of flexible rate regime when interest rates increased. The borrowers felt it difficult to make the repayment in these situations. The result was increased default rates and foreclosure rates. By that time housing prices also started to fall consequent of the fall in the demand for housing with the rise in rate of interest. When financial institutions attempted to sell the defaulted mortgages to recoup their money, they found that their value has been fallen well below the amount of debt on it! Crisis loomed everywhere and the rest of the story of collapse became history.
1.6 The lessons from the whole episode
Private lenders normally do not extend credit to customers having poor creditworthiness. Credit worthiness includes the repayment capacity, payment history, defaults committed for previous loans etc by the loanee. But these private financial institutions want to show a bloated balance sheet with bulging profits continuously and this greed prompted them to somehow give loans to even customers having poor credentials. A boom like situation in real estate sector gave them a golden opportunity. Even if a default happens, the value of the underlying asset (the house upon which loan is given) is high enough to pay the principal and interest as far as the real estate prices are soaring. They could sell the mortgage through ‘foreclosure’ and recoup what ever amount involved it in the form of principal, interest payments, other related charges etc. So these hell-bent lenders of all sorts, made all these lending bonanza and wrote all sorts of financial derivates upon them, with the clear understanding about the risks involved. They were very sure that they could sell all the mortgages in a soaring real estate market for hefty profits in any event of default.
The other financial institutions who are not directly involved in the sub-prime fuelled boom process like European and Asian banks and financial institutions (including the UK arm of ICICI bank and State Bank of India etc) purchased different kinds of derivatives created from the original housing loan given in US with a view to registering quick and easy profits.
All this clearly underscores the simple fact that in an era glorified phase of globalisation and unfettered capitalism all players wanted to show ‘growth’ figures in the monthly/quarterly/annual reports. Growth was so glorified, irrespective of the area in which it happens, and an artificial aura has been deliberately painted around it. The more substantive ‘growth process’ was relegated to the back place in the run-up towards the present crisis.
It is argued that the securitisation process and with the use of the so-called innovative derivatives, the risk associated with debts were successfully diffused. Robert Kuttner, who was once Business Week columnist, however, pointed out that securitisation of mortgages resulted in the concentration of risk rather than diffusing it, as every one is placing hopes on the soaring prices of residential plots. And exactly this was what happened.
1.6.1 Growth Concerns and Independent Policy making
It is now officially announced that Germany and Japan have entered into a phase of recession. The growth predictions of RBI have also taken a tail spin. In a glorified era of globalisation where the integration of global financial markets plays a vital role no country can keep away from a crisis that happens in few markets. Indian financial institutions had only a low exposure to sub-prime crisis as majority are public sector enterprises. But the largest private financial institution, ICICI bank, has indeed exposure to this crisis but it is the domestic regulatory environment prevented such institutions to indulge neck deep in to shady financial transactions like this. It is worth noting the fact that it is not because of any prudence or transparency in the dealings of the management of private institutions that averted a full fledged crisis in India but the strong regulatory environment and the irresistible resistance from the public that really saved the economy form the hell-bent reformers of Indian establishment.
But the opening up of capital market and the consequent inflow of funds from Foreign Institutional Investors (FII) that simply bloated the foreign exchange reserves of RBI is creating great problems to the economy. FIIs are taken back their investments by selling the shares and this was the reason for the heavy outflow of dollar in the past few weeks. The consequent fall in liquidity, as rupee is handed over to RBI for dollar by FIIs, is creating problems to the economy. It is to deal with this liquidity crunch RBI announced a slew of measures including reduction in CRR, repo rates, increased rate of interest for NRI deposits etc. SEBI has given permission to issue Participatory Notes (P-notes or PN) by FII to check the outflow of foreign exchange.
Rupee depreciated from around 39 to 49 between the period of January to October 2008 vis-à-vis US dollar. The SENSEX also took a dovetail from around 20,000 to around 10,000 during the same period. RBI intervened in the market heavily otherwise the exchange rate would have plummeted something near to Rs 60 per dollar! But even the Rs 10 depreciation could not help to boot exports in a situation of global recession. Export sector is already crippled with the crisis. The following table gives the sectoral growth rates of Indian economy. The share of agriculture is near to 20% while the service sector accounts more than 50% and the industrial sector accounts more than 25% of the GDP. Rate of growth of GDP at factor cost at 1999-2000 prices (per cent)
Rate of growth of GDP at factor cost at 1999-2000 prices (per cent)
Note: Plan period is simple average.Source: Economic Survey, 2008
The growth rate of service sector will be more affected consequent of this crisis. Since the sector’s share in GDP is higher its impact will also be greater on the overall growth of the economy. The Indian case becomes a lucid example as to explain how speculation in an open capital market led by FIIs creates havoc in the entire economy.
Independent policy making that takes into account the domestic realities and development objectives were the causalities during the heyday of neo-liberal economic policies shamelessly implemented by the market messiahs from 1991 onwards. One specific incident is pointed out to underscore the argument. The enactment of ‘The Fiscal Responsibility and Budget Management (FRBM) Act 2003’ that came into effect on July 5 2004 was taken by following the footsteps of neo-liberal paradigm and the policy initiates taken by nations like US. The eventual objective of the FRBM Act is highly susceptible given the words of the all-influential Milton Friedman, the champion economist of free market economy who clearly articulated that “A balanced budget amendment . . . is a means to an end. The end is holding down the growth of (or better sharply reducing) government spending” (Wall Street Journal, 4 January 1995, p. 12).
It is the Eleventh Finance Commission that set the ball to roll. It recommended the contents of the monitorable fiscal reform programme and the role envisaged for the next finance commission in reviewing the monitoring and implementation of the grants given under Article 275 of the Constitution. Prof. Amaresh Bagchi, member of the Eleventh Finance Commission, has given a note of dissent that the commission is not competent to make grants given under Article 275 of the Constitution conditional on implementation of a monitorable programme. But his views were brushed aside by taking shelter in the normative concept of sound finance in the Article 280 (3d) of the Constitution . It is through this backdoor the centre government forced the state governments to enact FRBM acts with a clear view to cut down public expenditure.
In addition, it must be noted that the decision to allow a small part of pension to be deposited in capital market is a grand strategy to make valid arguments beforehand when again in future the government need to save the capital market from similar crises.
Now the same perpetrators of this neo-liberal policy is advocating for a fiscal stimulus to the economy! The Economic Times, enthusiastic supporter of market reforms wrote an editorial titled ‘Fiscal stimulus needed’ on 17th of November, 2008! ‘The Teleraph’ published from Kolkatta, which has no left leanings, wrote on 14th of November, 2008 that Manmohan Singh was burdened with the contradiction of rejecting the left arguments for government interventions but to advice the same to global leaders to move out from this crisis!
What is relevant in the present context is how the government is preparing to design the fiscal stimulus for the economy. India has its own peculiarities and development objectives that need to be taken into account. More important is the fact that ‘fiscal stimulus’ is not a policy tool that has potency only in a phase of economic cycle. This aspect should be taken in to account before designing the details of the rescue plan.
1.7 Recapitulation
The present crisis demolished all the arguments that were repeatedly proclaimed from the roof-tops that ‘the government that governs least is the government that governs best’. All such arguments are laid to rest with this crisis. Media is abound with reports that the finance minister is busy advising public sector banks to lower interest rates contrary to the market philosophy stance that ‘market will correct by itself’. If are markets are let to correct itself there will be not only recession but would happen an all-round crisis as well. This is the most important lesson to be learnt from this crisis.
The crisis revealed that the so called ‘innovations of the financial market’ are nothing but machinations to amass profit at cost of public. It must be discerned that this greed for profit cannot be curtailed down by simply constituting regulatory mechanisms and other controls. It must be realised that capitalist system will devise ingenious methods to bypass whatever regulations imposed upon them in their quest to amass profits. The capitalist system could not function with out ever increasing profits lest it would not become capitalist system. The rescue plan must contain elements that reflect this inherent nature of forces of capitalism that drives the capitalist economy.
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Endnotes
[1] Derivatives are financial instruments whose value depends upon the values of the underlying basic variables or assets. Options, futures are the popular examples of derivatives.
[2] Home equity loan is a loan given to an existing home loan borrower by considering the market value of the property for purposes like home improvement etc.
[3] Securitisation is a process whereby a financial asset is transferred into a security by pooling and repackaging the financial assets having cash flows in the form of interest and principal payments.
[4] It is instructive to have a brief idea regarding the institutions that roam in the terrain of residential mortgage markets. Both GSEs (Government Sponsored Enterprises) and private players are operating in the field.
One of the re-construction efforts initiated by Franklin Roosevelt through the ‘New Deal’ after the Great Depression of 1929 was in the field of housing. The ‘Deal’ wanted to stimulate house construction and tried ways to provide adequate credit for it. It wanted to establish an active and efficient secondary mortgage market. Thus it formed the “Federal National Mortgage Association (FNMA). It is commonly referred by the market participants as ‘Fannie Mae’. It was originally created as a federal agency under the ‘National Housing Act’ of 1938. But in 1968, it was split by an amendment to the ‘National Housing Act’ and converted ‘Fannie Mae’ into a GSE (Government Sponsored Enterprise) but to be run as a private corporation with a view to removing its activity from the federal budget to deal with the federal budget deficits . As a result ‘Fannie Mae’ could not be a guarantor of government-issued mortgages, which it was prior to that. That responsibility was then given to a newly created entity popularly called as ‘Ginnie Mae’ or the “Government National Mortgage Association” (GNMA).
Later with the passage of The Emergency Home Finance Act of 1970 another mortgagee entity called as ‘Freddie Mac’ (Federal Home Loan Mortgage Corporation) was also created. Its objective was to create a national level secondary market for residential mortgages and to increase the level of competition in the mortgage market.
[5] Suppose the bundled portfolio has a yield of 12% but different assets have varying risk. The first tranche having prime MBS are offered with an 8% return and the second tranche having sub-prime MBS is offered with a 16% return because of the higher risk it bears. Note that the weighted average of yield is equal to the yield of the initial portfolio.
[6] It is the CDS that was the main reason for the collapse of the insurance giant AIG. CDS were of the tune of 45 trillion US dollars (1 trillion = 1000 billion) on mid of 2007 which is almost double the market capitalisation of US stock market which had a value of only 22-25 trillion US dollars!
Sunday, March 23, 2008
A Comment on Barak Obama’s Philadelphia Election Speech
It is true to say that Barak Hussein Obama’s Philadelphia (as it is delivered at Philadelphia's National Constitution Centre) speech may be considered as a sequestered one among the speeches that reflect the social and economic reality of the present day world in general and US in particular. To some it is one among the greatest speeches ever delivered. It may be considered as a sequestered one because it clearly shows that the “predicament of politicians”—especially during the run-up to power when confronting the barrage of criticisms—is ‘exactly same’, which side of the equator you are notwithstanding.
In short, Obama is confronting multifaceted criticisms and even abuses from the campaign side of Hilary Clinton ever since he proved that he is a real challenger to the once-thought-the-solitary contender for the democratic candidature for the Presidential election. Mrs Clinton became so nervous that she used all the dirty tactics against him and tried to manipulate the general sentiment among public by simply but cannily spreading rumours that Obama is a Muslim. It is true that his Kenyan father is a Muslim but his mother is a white US Christian and he is also a Christian. To prove that Obama supporters even produced evidence that it was none other than Pastor Jeremiah Wright who inculcated Obama into the faith of Christianity etc. Mrs. Clinton failed miserably, then but not for all. She opened then the next obvious flood gate to Obama. Suddenly the Sunday sermons of Pastor Jeremiah Wright were made readily available with the media including youtube.
The noteworthy fact about all these sermons is that they all were delivered in the past period. But they were made available as if they are delivered very recently! The common thread of all these sermons (the main three charges against Pastor Wright) is the references to racial discrimination of America, severe criticisms against US foreign policy, the view of terrorist attack on US as a natural backlash of its own policies etc. The purport is obvious. Plainly speaking, they have nothing to do either with the Presidential elections or with Obama. But conclusions are swiftly drawn and they are invariably linked with the credentials of Obama to lead USA. Just because of the reason that Obama’s marriage was solemnised by Wright or his daughters were baptised by him or he was brought into the faith by Wright or Wright was in the support committee of Obama, one cannot blame Obama for whatever speeches made by Wright. It all again proved that human beings respond in the same manner, that is, they let ‘passion to rule over reason’. Other wise this new controversy would not have happened.
Now, given this situation, what Obama must do, as just like any other politician who face a do or die battle? On April 22nd Obama is facing the vote at Pennsylvania state primary. Naturally he chose the Philadelphia's National Constitution Center of Pennsylvania state to make a reply to this virulent and nasty vilification campaign against him. In such a situation what would be the natural response of any politician? The simple and straight response would be to take a distance from the alleged three charges against Wright. Obama also did the same thing, nothing else!! Thus came the Obama speech at Philadelphia.
Many commentators thought that Obama in his speech pushed aside the issues of racial discrimination and rose above the sectarian views and made a clarion call for the discussion of issues which touch the USA as a whole. But BBC news story clearly showed that this is only a fiction and they aptly titled one story covering the Philadelphia speech as “Obama says US cannot ignore race” on 19th Wednesday of March 2008. But it is true that Obama wanted to discuss that issues which touch USA as whole also.
Thus the predicament of politicians is same regardless of the nation where the election battle is fought. Since he is a half-black, to win the election he need to win the white votes in a decisive manner. But now he has been painted as a person who still nurtures the issue of racial discrimination. So he wanted to convey the message that he has sympathy to the issues and problems of Whites also. Hence he made a call to conduct a joint effort by blacks and whites to overcome the problems of US in general rather than problems of black or white alone. What else Obama could do in such a situation?
His political predicament is understandable, but the grounds cited by Obama for a joint effort for the larger interests of America were so flimsy that it is very visible that he trips frequently thought out that speech if one makes a closer scrutiny. Thus it gives the impression that the Philadelphia speech was a clever smokescreen meticulously crafted by Obama to ward off the vilification campaign supposedly piloted by Mrs Clinton.
Let us first see what the commentators have to say:
David R. Henderson, research fellow with the Hoover Institution and associate professor in Economics argued that there are three faults with the Obama speech. First, Obama argued that Wright’s speech was full of hatred. But Henderson argued that Wright’s speech has only anger and have no hatred. Obama instead argued that Wright’s sermons were full of hatred and hence need to be brushed aside and condemned. But if anger when expressed with explanation cannot contain hatred, says Henderson. If that is the case, Obama’s speech looses one of its grounds.
Secondly Obama distorted the speech of Wright just to make mileage and strike a chord with the conservative whites who denounces Palestinian cause and blindly supports Israel. Wright only said that "We (US) supported Zionism shamelessly while ignoring the Palestinians and branding anybody who spoke out against it as being anti-Semitic." But Henderson pointed out that, in his speech, Obama referred to Wright's view as: "...a view that sees the conflicts in the Middle East as rooted primarily in the actions of stalwart allies like Israel, instead of emanating from the perverse and hateful ideologies of radical Islam." Henderson said that, that may be what Wright believes – Obama would know better than I – but that's certainly not what Wright said in the passage which Obama cited.
Third, Obama asks us to get past the race issue and look at the other issues in the campaign. But Henderson said that, in doing so, he stired up resentment against people (ie. The business managers) who are just as innocent as the struggling black man and the struggling white man displaced by affirmative action. Obama states: "Just as black anger often proved counterproductive, so have these white resentments distracted attention from the real culprits of the middle class squeeze – a corporate culture rife with inside dealing, questionable accounting practices, and short-term greed. Henderson pointed out that this is only a standard Democratic riff about how nasty corporations have caused a middle class squeeze and there have been Enrons (the notorious US company for shady accounting practises), but is Obama seriously saying that these have been so widespread as to make the middle class worse off?
Charles Krauthammer the columnist of Washington Post with the title, “The Speech: A Brilliant Fraud” (Friday, March 21, 2008; Page A17) argued that Obama's purpose in the speech was to put Wright's outrages in context. Charles said that by context, Obama meant history. And by history, he meant the history of white racism. He underlined that even though Obama in the speech said that "We do not need to recite here the history of racial injustice in this country," but proceeded to do precisely that. Charles asked what lied at the end of— Obama’s recital of the long train of white racial assaults from slavery to employment discrimination and said that it was nothing else other than Jeremiah Wright itself!!
Charles at last asked a question to Obama that if Wright is a man of the past (as Obama played down Wright by saying that he is a man past), then why would you expose your children to his vitriolic divisiveness and why did you gave $22,500 just two years ago to a church run by a man of the past who infected the younger generation with precisely the racial attitudes and animus you say you have come unto us to transcend?
The essence of these comments is that Obama’s speech is only a smokescreen to avoid the white backlash in the upcoming primary votes. Read with this the polls findings that even though 90 % of the blacks support Obama his support base among whites is still low.
I want to write more as to the ‘smokescreen’ argument but I feel that I wrote too much. If any body writes back I will get a chance.
To conclude, indeed, Obama clearly accentuated the adverse impact of white atrocities upon the blacks and clearly underscored that this issue cannot be wished away. But at the same time, he wanted to show that he understand the problems and hardships of whites also, otherwise how he could remain as a Presidential aspirant! And ironically, Obama’s “hope” that he could give better results for the whole USA clearly stems from the teachings of Wright especially from the sermon of “Audacity to Hope”!!!
Visit at: www.santhoshtv.in
It is true to say that Barak Hussein Obama’s Philadelphia (as it is delivered at Philadelphia's National Constitution Centre) speech may be considered as a sequestered one among the speeches that reflect the social and economic reality of the present day world in general and US in particular. To some it is one among the greatest speeches ever delivered. It may be considered as a sequestered one because it clearly shows that the “predicament of politicians”—especially during the run-up to power when confronting the barrage of criticisms—is ‘exactly same’, which side of the equator you are notwithstanding.
In short, Obama is confronting multifaceted criticisms and even abuses from the campaign side of Hilary Clinton ever since he proved that he is a real challenger to the once-thought-the-solitary contender for the democratic candidature for the Presidential election. Mrs Clinton became so nervous that she used all the dirty tactics against him and tried to manipulate the general sentiment among public by simply but cannily spreading rumours that Obama is a Muslim. It is true that his Kenyan father is a Muslim but his mother is a white US Christian and he is also a Christian. To prove that Obama supporters even produced evidence that it was none other than Pastor Jeremiah Wright who inculcated Obama into the faith of Christianity etc. Mrs. Clinton failed miserably, then but not for all. She opened then the next obvious flood gate to Obama. Suddenly the Sunday sermons of Pastor Jeremiah Wright were made readily available with the media including youtube.
The noteworthy fact about all these sermons is that they all were delivered in the past period. But they were made available as if they are delivered very recently! The common thread of all these sermons (the main three charges against Pastor Wright) is the references to racial discrimination of America, severe criticisms against US foreign policy, the view of terrorist attack on US as a natural backlash of its own policies etc. The purport is obvious. Plainly speaking, they have nothing to do either with the Presidential elections or with Obama. But conclusions are swiftly drawn and they are invariably linked with the credentials of Obama to lead USA. Just because of the reason that Obama’s marriage was solemnised by Wright or his daughters were baptised by him or he was brought into the faith by Wright or Wright was in the support committee of Obama, one cannot blame Obama for whatever speeches made by Wright. It all again proved that human beings respond in the same manner, that is, they let ‘passion to rule over reason’. Other wise this new controversy would not have happened.
Now, given this situation, what Obama must do, as just like any other politician who face a do or die battle? On April 22nd Obama is facing the vote at Pennsylvania state primary. Naturally he chose the Philadelphia's National Constitution Center of Pennsylvania state to make a reply to this virulent and nasty vilification campaign against him. In such a situation what would be the natural response of any politician? The simple and straight response would be to take a distance from the alleged three charges against Wright. Obama also did the same thing, nothing else!! Thus came the Obama speech at Philadelphia.
Many commentators thought that Obama in his speech pushed aside the issues of racial discrimination and rose above the sectarian views and made a clarion call for the discussion of issues which touch the USA as a whole. But BBC news story clearly showed that this is only a fiction and they aptly titled one story covering the Philadelphia speech as “Obama says US cannot ignore race” on 19th Wednesday of March 2008. But it is true that Obama wanted to discuss that issues which touch USA as whole also.
Thus the predicament of politicians is same regardless of the nation where the election battle is fought. Since he is a half-black, to win the election he need to win the white votes in a decisive manner. But now he has been painted as a person who still nurtures the issue of racial discrimination. So he wanted to convey the message that he has sympathy to the issues and problems of Whites also. Hence he made a call to conduct a joint effort by blacks and whites to overcome the problems of US in general rather than problems of black or white alone. What else Obama could do in such a situation?
His political predicament is understandable, but the grounds cited by Obama for a joint effort for the larger interests of America were so flimsy that it is very visible that he trips frequently thought out that speech if one makes a closer scrutiny. Thus it gives the impression that the Philadelphia speech was a clever smokescreen meticulously crafted by Obama to ward off the vilification campaign supposedly piloted by Mrs Clinton.
Let us first see what the commentators have to say:
David R. Henderson, research fellow with the Hoover Institution and associate professor in Economics argued that there are three faults with the Obama speech. First, Obama argued that Wright’s speech was full of hatred. But Henderson argued that Wright’s speech has only anger and have no hatred. Obama instead argued that Wright’s sermons were full of hatred and hence need to be brushed aside and condemned. But if anger when expressed with explanation cannot contain hatred, says Henderson. If that is the case, Obama’s speech looses one of its grounds.
Secondly Obama distorted the speech of Wright just to make mileage and strike a chord with the conservative whites who denounces Palestinian cause and blindly supports Israel. Wright only said that "We (US) supported Zionism shamelessly while ignoring the Palestinians and branding anybody who spoke out against it as being anti-Semitic." But Henderson pointed out that, in his speech, Obama referred to Wright's view as: "...a view that sees the conflicts in the Middle East as rooted primarily in the actions of stalwart allies like Israel, instead of emanating from the perverse and hateful ideologies of radical Islam." Henderson said that, that may be what Wright believes – Obama would know better than I – but that's certainly not what Wright said in the passage which Obama cited.
Third, Obama asks us to get past the race issue and look at the other issues in the campaign. But Henderson said that, in doing so, he stired up resentment against people (ie. The business managers) who are just as innocent as the struggling black man and the struggling white man displaced by affirmative action. Obama states: "Just as black anger often proved counterproductive, so have these white resentments distracted attention from the real culprits of the middle class squeeze – a corporate culture rife with inside dealing, questionable accounting practices, and short-term greed. Henderson pointed out that this is only a standard Democratic riff about how nasty corporations have caused a middle class squeeze and there have been Enrons (the notorious US company for shady accounting practises), but is Obama seriously saying that these have been so widespread as to make the middle class worse off?
Charles Krauthammer the columnist of Washington Post with the title, “The Speech: A Brilliant Fraud” (Friday, March 21, 2008; Page A17) argued that Obama's purpose in the speech was to put Wright's outrages in context. Charles said that by context, Obama meant history. And by history, he meant the history of white racism. He underlined that even though Obama in the speech said that "We do not need to recite here the history of racial injustice in this country," but proceeded to do precisely that. Charles asked what lied at the end of— Obama’s recital of the long train of white racial assaults from slavery to employment discrimination and said that it was nothing else other than Jeremiah Wright itself!!
Charles at last asked a question to Obama that if Wright is a man of the past (as Obama played down Wright by saying that he is a man past), then why would you expose your children to his vitriolic divisiveness and why did you gave $22,500 just two years ago to a church run by a man of the past who infected the younger generation with precisely the racial attitudes and animus you say you have come unto us to transcend?
The essence of these comments is that Obama’s speech is only a smokescreen to avoid the white backlash in the upcoming primary votes. Read with this the polls findings that even though 90 % of the blacks support Obama his support base among whites is still low.
I want to write more as to the ‘smokescreen’ argument but I feel that I wrote too much. If any body writes back I will get a chance.
To conclude, indeed, Obama clearly accentuated the adverse impact of white atrocities upon the blacks and clearly underscored that this issue cannot be wished away. But at the same time, he wanted to show that he understand the problems and hardships of whites also, otherwise how he could remain as a Presidential aspirant! And ironically, Obama’s “hope” that he could give better results for the whole USA clearly stems from the teachings of Wright especially from the sermon of “Audacity to Hope”!!!
Visit at: www.santhoshtv.in
Friday, February 1, 2008
The Exclusive Agenda beneath the Mantra of ‘Inclusive’ Economic Development: Some Reflections
[Welcome Speech and Introduction to the theme of the National Seminar “Emerging Issues in the Business Environment and their Implications upon Development”
Two day UGC—Sponsored National Seminar jointly conducted by Post Graduate Departments of Commerce and Economics, Government College, Malappuram.
March 14 (Wednesday) and 15 (Thursday) of 2007.]
Venerable president of the meeting Dr. KK Mohamed, Principal, Govt. College, Malappuram, Mr. MC Bose, Chairman, South Malabar Gramin Bank, valued vice-president of PTA Mr. Abdul Rassaq master, beloved secretary of alumni association Adv. Kunjumuhammed Paravath, VP and HOD of Commerce Mr. PK Velayudhan, HOD of Economics Mr. YC Ibrahim, my senior colleagues from various faculties Mr P Moideen kutty representing science faculty, Mr. Sabari K Ayyappan representing Humanities faculty, Mr PP Narayanan representing Social science faculty, college union chairman, distinguished delegates, other participants, my colleagues and dear students,
This seminar is being conducted in a dismal situation where a number of people were butchered at the alter of the so-called great development initiative in the name of SEZs. Perhaps, we are in the making of a record of sorts; a record for slaughtering helpless and hapless people in the name of economic development. Are we shattering the cherished dream of economic development so passionately envisioned by the founders of this great republic?
In another plane, politicians, policy makers and even academicians are chanting the all-new mantra of ‘inclusive growth and development’. The approach paper of the 11th five year plan titled its fourth chapter as, ‘Strategic Initiatives for Inclusive Development’. But strictly speaking, the concept of ‘inclusive economic development’ is fraught with theoretical ambiguity. It gives the impression that it germinates from lack of theoretical lucidity, even though the concept of inclusive growth is plausible otherwise. Why should we talk about ‘inclusive economic development’ when the concept of economic development itself is inherently inclusive? Moreover, the concept has different connotations that it alludes that ‘exclusive development—in the sense that developmental activities excludes different sections of the society—is also possible. If economic development is not inclusive it cannot be considered as economic development any more rather it should be something else which is far away from the concept as understood in the literature.
It all seems that we need to discuss, re-discover and reinforce the meaning of economic development, as, so expatiated by stalwarts of economic science right from Antonio Serra of Naples, the first economic theorist according to Prof. Joseph Schumpeter to the Indian pride Amarthya Kumar Sen.
Sen redefines development as entitlements that build capabilities that help human beings to enjoy freedom for which they have reason to believe. In other words, development is to be redefined in terms of universalisation and the effective exercise of all human rights: political, civil and civic; economic, social and cultural; as well as collective rights to development and environment. If economic development is defined and understood in this manner why should we waste words in the form of ‘inclusive economic development’? Or is it a decoy to divert attention from the core and fundamental issues of economic development itself? The seminar realises that it is high time to introspect and ponder in this respect.
The ambiguity in the understanding of development and the futility in the zest and zeal for rhetorical terms, become pertinent in the present economic scenario. On the one side, we see the mad rush for Special Exploitation Zones. On the other side we witness sky-rocketing growth rates for the privileged class and the nose diving share of GDP for the majority, who wane and wilt in the agricultural sector. It all seems that we do not understand properly the very basic tenets of economic science.
It is an all simple question and nothing complex is there as in the case of space research here. How we can proclaim progress when we displace people from their own land and make them refugees in their own region, how we can broadcast from the roof top that we are marching towards full employment when small and marginal employment generation activities are in the threat of being decimated. It is an all simple question, but solution to these nagging problems can be visualised only if our vision is incisive enough and free from the influence of free market philosophy.
We always pontificate the efficiency and wisdom of market forces arising out of competition but our entrepreneurs and enterprises are so scared about real competition in their on respective fields. No body wants the virtues of market mechanism that arise from competition rather all wants only monopoly elements to be tightly reinforced in their own fields all in the name of virtues of market mechanism!!
Take a simple example from the media industry and I am not naming any one. Market leaders in different segments spend uncountable space and time for educating the virtues of market reforms. But they seldom allow competitive elements to be flourished in their own segments. They virtually preach the virtues of market mechanism but adopt and follow only monopoly practices!! Remember, virtues of market friendly reforms do not flow from monopoly market practices. It will flow only from a situation where assets and capabilities are accessible to all and any attempt to dominate the market space will always increase the monopoly power. This deep gap between rhetoric and practise is so glaring and the seminar wants to take note of that as it will badly defeat whatever progress we have achieved so far.
It is in this backdrop we organise this national seminar. We have got some eminent academicians who did good research work in the respective areas. The keynote speaker Dr. KJ Joseph, fellow of CDS, is a well known economist whose present interest hovers around the growth and development of Asian economies. Further, we have professor in marketing from IIM Kozhikode Dr. Anadakuttan Unnithan and Dr. Joseph Thomas to criss-cross the hot issue of corporate entry to the retailing scenario. For the second session that deals with the issue of SEZs, we have TG Jacob who did his doctoral research at JNU on the problem of agricultural land utilisation of Waynadu. For the last session of mergers, acquisition and competitiveness we have Dr. Beena PL who did her doctoral research in the same topic under CP Chandrasekhar of JNU. We have many other speakers as well who conduct research in the respective areas. All these scholars confirmed their presence in the seminar, though some slight changes would be there with respect to their arrival.
Coming to the inaugural session we have invited the chairman of South Malabar Grameen Bank. Unfortunately he could not turn up here for this session. Mr. Ramesh Kumar, Senior GM of the bank will inaugurate the seminar. I extend you hearty welcome to this academic congregation.
Principal Dr. KK Mohamed is always the source of strength behind all our activities. When the UGC sanctioned the grant for a joint conduct of the seminar by the depts. of commerce and economics, this much enthusiasm for conducting the seminar was not there, sicnce it initially seemed that it was highly difficult to identify a theme equally acceptable for both the depts. Activities were totally lethargic in the early stages. But his constant motivation and enquiry about the progress of the seminar preparations, that really increased the pace of our activities. With out that intervention we could not have pursued the organisation of the seminar to this stage. On behalf of all the delegates and participants and on behalf of the seminar secretariat I extend you sir whole hearted welcome to this seminar.
PTA is an important pillar upon which the activities of institutions like this take their foundation both in terms of money and support. And Abdul rassaq master is an affable person to whom we can share and discuss our concerns. I extend you sir cheerful welcome to this occasion.
Alumni association is one among the very active organisations that function in the college and they always ahead in planning and implementing innovative projects for the college. Secretary of the organisation Adv. Kunjumuhamed Paravath is with us and I extend you sincere welcome to this august occasion.
My senior colleagues including Vice principal and HOD of Commerce Mr P K Velayudhan, Mr. YC Ibrahim HOD of Economics dept, Mr P Moideen kutty representing science faculty, Mr. Sabari K Ayyappan representing Humanities faculty, Mr PP Narayanan representing Social science faculty, college union chairman all are with us for the successful conduct of the seminar. On behalf of the seminar secretariat I extend you all, hearty welcome to this academic discourse.
Last but not least, (Before concluding, as the coordinator of the seminar I want to welcome all) the delegates and the participants of the seminar who came up here to make this event a grand gala success. We have teachers, research scholars and PG students from different parts of the state registered for the seminar. With out you the seminar has no meaning at all. I extend you all red carpet welcome to this academic discourse.
It is often said in a jocular manner that seminar is a place where the confusion of the speaker gets multiplied by the number of participants! I hope we would get a different experience from here.
Now let me conclude my speech here.
Thanks, thanks to all.
Visit at: www.santhoshtv.in
[Welcome Speech and Introduction to the theme of the National Seminar “Emerging Issues in the Business Environment and their Implications upon Development”
Two day UGC—Sponsored National Seminar jointly conducted by Post Graduate Departments of Commerce and Economics, Government College, Malappuram.
March 14 (Wednesday) and 15 (Thursday) of 2007.]
Venerable president of the meeting Dr. KK Mohamed, Principal, Govt. College, Malappuram, Mr. MC Bose, Chairman, South Malabar Gramin Bank, valued vice-president of PTA Mr. Abdul Rassaq master, beloved secretary of alumni association Adv. Kunjumuhammed Paravath, VP and HOD of Commerce Mr. PK Velayudhan, HOD of Economics Mr. YC Ibrahim, my senior colleagues from various faculties Mr P Moideen kutty representing science faculty, Mr. Sabari K Ayyappan representing Humanities faculty, Mr PP Narayanan representing Social science faculty, college union chairman, distinguished delegates, other participants, my colleagues and dear students,
This seminar is being conducted in a dismal situation where a number of people were butchered at the alter of the so-called great development initiative in the name of SEZs. Perhaps, we are in the making of a record of sorts; a record for slaughtering helpless and hapless people in the name of economic development. Are we shattering the cherished dream of economic development so passionately envisioned by the founders of this great republic?
In another plane, politicians, policy makers and even academicians are chanting the all-new mantra of ‘inclusive growth and development’. The approach paper of the 11th five year plan titled its fourth chapter as, ‘Strategic Initiatives for Inclusive Development’. But strictly speaking, the concept of ‘inclusive economic development’ is fraught with theoretical ambiguity. It gives the impression that it germinates from lack of theoretical lucidity, even though the concept of inclusive growth is plausible otherwise. Why should we talk about ‘inclusive economic development’ when the concept of economic development itself is inherently inclusive? Moreover, the concept has different connotations that it alludes that ‘exclusive development—in the sense that developmental activities excludes different sections of the society—is also possible. If economic development is not inclusive it cannot be considered as economic development any more rather it should be something else which is far away from the concept as understood in the literature.
It all seems that we need to discuss, re-discover and reinforce the meaning of economic development, as, so expatiated by stalwarts of economic science right from Antonio Serra of Naples, the first economic theorist according to Prof. Joseph Schumpeter to the Indian pride Amarthya Kumar Sen.
Sen redefines development as entitlements that build capabilities that help human beings to enjoy freedom for which they have reason to believe. In other words, development is to be redefined in terms of universalisation and the effective exercise of all human rights: political, civil and civic; economic, social and cultural; as well as collective rights to development and environment. If economic development is defined and understood in this manner why should we waste words in the form of ‘inclusive economic development’? Or is it a decoy to divert attention from the core and fundamental issues of economic development itself? The seminar realises that it is high time to introspect and ponder in this respect.
The ambiguity in the understanding of development and the futility in the zest and zeal for rhetorical terms, become pertinent in the present economic scenario. On the one side, we see the mad rush for Special Exploitation Zones. On the other side we witness sky-rocketing growth rates for the privileged class and the nose diving share of GDP for the majority, who wane and wilt in the agricultural sector. It all seems that we do not understand properly the very basic tenets of economic science.
It is an all simple question and nothing complex is there as in the case of space research here. How we can proclaim progress when we displace people from their own land and make them refugees in their own region, how we can broadcast from the roof top that we are marching towards full employment when small and marginal employment generation activities are in the threat of being decimated. It is an all simple question, but solution to these nagging problems can be visualised only if our vision is incisive enough and free from the influence of free market philosophy.
We always pontificate the efficiency and wisdom of market forces arising out of competition but our entrepreneurs and enterprises are so scared about real competition in their on respective fields. No body wants the virtues of market mechanism that arise from competition rather all wants only monopoly elements to be tightly reinforced in their own fields all in the name of virtues of market mechanism!!
Take a simple example from the media industry and I am not naming any one. Market leaders in different segments spend uncountable space and time for educating the virtues of market reforms. But they seldom allow competitive elements to be flourished in their own segments. They virtually preach the virtues of market mechanism but adopt and follow only monopoly practices!! Remember, virtues of market friendly reforms do not flow from monopoly market practices. It will flow only from a situation where assets and capabilities are accessible to all and any attempt to dominate the market space will always increase the monopoly power. This deep gap between rhetoric and practise is so glaring and the seminar wants to take note of that as it will badly defeat whatever progress we have achieved so far.
It is in this backdrop we organise this national seminar. We have got some eminent academicians who did good research work in the respective areas. The keynote speaker Dr. KJ Joseph, fellow of CDS, is a well known economist whose present interest hovers around the growth and development of Asian economies. Further, we have professor in marketing from IIM Kozhikode Dr. Anadakuttan Unnithan and Dr. Joseph Thomas to criss-cross the hot issue of corporate entry to the retailing scenario. For the second session that deals with the issue of SEZs, we have TG Jacob who did his doctoral research at JNU on the problem of agricultural land utilisation of Waynadu. For the last session of mergers, acquisition and competitiveness we have Dr. Beena PL who did her doctoral research in the same topic under CP Chandrasekhar of JNU. We have many other speakers as well who conduct research in the respective areas. All these scholars confirmed their presence in the seminar, though some slight changes would be there with respect to their arrival.
Coming to the inaugural session we have invited the chairman of South Malabar Grameen Bank. Unfortunately he could not turn up here for this session. Mr. Ramesh Kumar, Senior GM of the bank will inaugurate the seminar. I extend you hearty welcome to this academic congregation.
Principal Dr. KK Mohamed is always the source of strength behind all our activities. When the UGC sanctioned the grant for a joint conduct of the seminar by the depts. of commerce and economics, this much enthusiasm for conducting the seminar was not there, sicnce it initially seemed that it was highly difficult to identify a theme equally acceptable for both the depts. Activities were totally lethargic in the early stages. But his constant motivation and enquiry about the progress of the seminar preparations, that really increased the pace of our activities. With out that intervention we could not have pursued the organisation of the seminar to this stage. On behalf of all the delegates and participants and on behalf of the seminar secretariat I extend you sir whole hearted welcome to this seminar.
PTA is an important pillar upon which the activities of institutions like this take their foundation both in terms of money and support. And Abdul rassaq master is an affable person to whom we can share and discuss our concerns. I extend you sir cheerful welcome to this occasion.
Alumni association is one among the very active organisations that function in the college and they always ahead in planning and implementing innovative projects for the college. Secretary of the organisation Adv. Kunjumuhamed Paravath is with us and I extend you sincere welcome to this august occasion.
My senior colleagues including Vice principal and HOD of Commerce Mr P K Velayudhan, Mr. YC Ibrahim HOD of Economics dept, Mr P Moideen kutty representing science faculty, Mr. Sabari K Ayyappan representing Humanities faculty, Mr PP Narayanan representing Social science faculty, college union chairman all are with us for the successful conduct of the seminar. On behalf of the seminar secretariat I extend you all, hearty welcome to this academic discourse.
Last but not least, (Before concluding, as the coordinator of the seminar I want to welcome all) the delegates and the participants of the seminar who came up here to make this event a grand gala success. We have teachers, research scholars and PG students from different parts of the state registered for the seminar. With out you the seminar has no meaning at all. I extend you all red carpet welcome to this academic discourse.
It is often said in a jocular manner that seminar is a place where the confusion of the speaker gets multiplied by the number of participants! I hope we would get a different experience from here.
Now let me conclude my speech here.
Thanks, thanks to all.
Visit at: www.santhoshtv.in
From Geographical Gridlock to Economic Impasse—The Chronicle of Kuttanadu:
A Region Deranged.
[Keynote paper presented in the Workshop on “Kuttanadu Studies” organised by St. Berchmans’ College, Changanacherry, Kerala, India, in participation with IVO, Tilburg University, The Netherlands ,on January 23-24, 2002]
The study analyses the developmental problems of Kuttanadu region of Kerala state, India. The region has geographical similarities with The Netherlands as both lie below sealevel. Kuttanadu region is often considered as the rice bowl of Kerala. But the region is facing a crisis in paddy cultivation. Several projects were implemented to support the agriculture in Kuttanadu, but all failed to deliver the promised results. It is in this backdrop the study surveys major development projects implemented in this region and the analyses the crisis in Kuttanadu afresh.
The study undeniably displays that there is no pari passu relationship between decrease in paddy cultivation in Kuttanadu and Kerala. The index of area under production to the state as a whole decreased from 100 to 45.9 during the period of 1956-57 to 1999-2000. The index of area under Mundakan and Punja also inscribed a downfall, nevertheless painted a better picture than that of the former. The index stood at 57.4 and 76.6 in 1999-2000 respectively.
But, the index of Virippu crop fared badly and took a tailspin to 31.2 in 1999-2000.Thus it is obvious that crisis in paddy to the state as a whole is chiefly due to the decrease witnessed in the case of Virippu crop. Moreover, Virippu accounted for more than 50% of the area during 1956-57 by declined to near 30% by around 2000. The Punja crop has nothing to do with it as its share almost doubled during the same period.
Furthermore, it found that the factors responsible for the nosedive in area under paddy in Kuttanadu is region specific rather than state specific and wherefore should be dealt accordingly.
It is now pretty obvious that the decrease in area for Punja crop is valid only to Alappuzha district. The area and index to non-Alappuzha districts almost plateaued during the reference period while in case of production they marched towards new heights. The inference is that the reasons for dip in area under paddy in Kuttanadu are quite different to that of the decrease to the state as a whole. Had it been not so, the area under Punja crop in non-Alappuzha district would have been not remained almost unchanged.
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Contents of the Paper
1 Contours of Kuttanadu
1.1 Mythological Roots and Historical Facts
1.2 Different Conjectures and the Term Kuttanadu
1.3 Antiquity and Prominence of Kuttanadu
1.4 Geographical Boundaries and Definition of Kuttanad
1.5 Location
1.6 Formation of Kuttanadu Thaluk
1.7 Climate
1.8 Geology of Kuttanadu
1.9 Soils of Kuttanadu
1.10 Geographical Features of Kuttanadu
1.10.1 The Pamba River System
1.10.2 The Vembanadu Lake
2 Pigeonhole of Land in Kuttanadu
2.1 Taxology of Wetlands of Kuttanadu
2.1.1 Kayal Padsekharams
2.1.2 Padasekharam in Bund Areas
2.1.3 The Kari Lands
2.1.4 Karapadoms
2.1.5 Kolappala Lands
3 A Wee History of Paddy Cultivation: A Detour
3.1 The Cultivation Practices
4 Genesis of Land Reclamation: A Tangent
4.1 Types of Land Reclamation
4.1.1 Natural Reclamation
4.1.2 Passive Reclamations
4.1.3 Deliberate Reclamations
4.2 Prospect of Kayal Reclamation
4.3 Respite in Reclamation
4.4 Kuttanadu Incandescent: The Era of Progressive Reclamations
4.5 The Process of Kayal Reclamation
4.6 Gilt-Edged Vision and Grit –Edged Mission: Anecdotes of Kuttanadan Chaebols
4.7 Economic Features of Kayal Reclamation and Cultivation
4.8 Meier’s “Double Dualism” and Theoretical Underpinnings of Kayal Cultivation
4.9 The R-Block Reclamation or “The Holland Scheme"
5 Freaks Of Nature and the Extent of Damage
5.1 Floods
5.2 Salinity
5.3 Acidity
5.4 Pests and Diseases
5.5 Problem of Weeds
5.6 The Problem of Transportation
6 Attempts to Unlock the Grid Lock of Nature
6.1 The Backdrop
6.2 Kuttanadu Development Scheme (KDS)
6.3 First Stage of KDS
6.3.1 Thottappally Spill Way
6.3.2 Thanneermukkom Salt Water Barrage
6.3.3 A-C Road
6.4 Expected Benefits from the Schemes
6.5 A Broadside on the Benefits
7 From Permanent Bunds to Semi-Submersible Permanent Bunds
7.1 Nature of Temporary Bunds and the Idea of Permanent Bunds 7.2 The Idea of Semi-Submersible Bunds and the KLDC Project
7.2.1 The Necessity of Semi-Submersible Permanent Bunds
7.2.2 Objectives of the Project
7.2.3 The Cropping Season
7.2.4 The Assumption of Kuttanadu Development Project
7.2.5 The Project in a Nutshell
8 Kuttanadu Paddy Cultivation Development Project
9 Second Thoughts on Schemes Implemented In Kuttanadu
9.1 Density of Kuttanadu
9.2 Interface of High Density, Dearth of Cultivable Land and Nature’ Fury
9.3 Food Scarcity and Paddy Development Projects
9.4 Stabilising Agriculture of Kuttanadu: A Mission Unaccomplished
A Region Deranged.
[Keynote paper presented in the Workshop on “Kuttanadu Studies” organised by St. Berchmans’ College, Changanacherry, Kerala, India, in participation with IVO, Tilburg University, The Netherlands ,on January 23-24, 2002]
The study analyses the developmental problems of Kuttanadu region of Kerala state, India. The region has geographical similarities with The Netherlands as both lie below sealevel. Kuttanadu region is often considered as the rice bowl of Kerala. But the region is facing a crisis in paddy cultivation. Several projects were implemented to support the agriculture in Kuttanadu, but all failed to deliver the promised results. It is in this backdrop the study surveys major development projects implemented in this region and the analyses the crisis in Kuttanadu afresh.
The study undeniably displays that there is no pari passu relationship between decrease in paddy cultivation in Kuttanadu and Kerala. The index of area under production to the state as a whole decreased from 100 to 45.9 during the period of 1956-57 to 1999-2000. The index of area under Mundakan and Punja also inscribed a downfall, nevertheless painted a better picture than that of the former. The index stood at 57.4 and 76.6 in 1999-2000 respectively.
But, the index of Virippu crop fared badly and took a tailspin to 31.2 in 1999-2000.Thus it is obvious that crisis in paddy to the state as a whole is chiefly due to the decrease witnessed in the case of Virippu crop. Moreover, Virippu accounted for more than 50% of the area during 1956-57 by declined to near 30% by around 2000. The Punja crop has nothing to do with it as its share almost doubled during the same period.
Furthermore, it found that the factors responsible for the nosedive in area under paddy in Kuttanadu is region specific rather than state specific and wherefore should be dealt accordingly.
It is now pretty obvious that the decrease in area for Punja crop is valid only to Alappuzha district. The area and index to non-Alappuzha districts almost plateaued during the reference period while in case of production they marched towards new heights. The inference is that the reasons for dip in area under paddy in Kuttanadu are quite different to that of the decrease to the state as a whole. Had it been not so, the area under Punja crop in non-Alappuzha district would have been not remained almost unchanged.
Visit at: www.santhoshtv.in
Contents of the Paper
1 Contours of Kuttanadu
1.1 Mythological Roots and Historical Facts
1.2 Different Conjectures and the Term Kuttanadu
1.3 Antiquity and Prominence of Kuttanadu
1.4 Geographical Boundaries and Definition of Kuttanad
1.5 Location
1.6 Formation of Kuttanadu Thaluk
1.7 Climate
1.8 Geology of Kuttanadu
1.9 Soils of Kuttanadu
1.10 Geographical Features of Kuttanadu
1.10.1 The Pamba River System
1.10.2 The Vembanadu Lake
2 Pigeonhole of Land in Kuttanadu
2.1 Taxology of Wetlands of Kuttanadu
2.1.1 Kayal Padsekharams
2.1.2 Padasekharam in Bund Areas
2.1.3 The Kari Lands
2.1.4 Karapadoms
2.1.5 Kolappala Lands
3 A Wee History of Paddy Cultivation: A Detour
3.1 The Cultivation Practices
4 Genesis of Land Reclamation: A Tangent
4.1 Types of Land Reclamation
4.1.1 Natural Reclamation
4.1.2 Passive Reclamations
4.1.3 Deliberate Reclamations
4.2 Prospect of Kayal Reclamation
4.3 Respite in Reclamation
4.4 Kuttanadu Incandescent: The Era of Progressive Reclamations
4.5 The Process of Kayal Reclamation
4.6 Gilt-Edged Vision and Grit –Edged Mission: Anecdotes of Kuttanadan Chaebols
4.7 Economic Features of Kayal Reclamation and Cultivation
4.8 Meier’s “Double Dualism” and Theoretical Underpinnings of Kayal Cultivation
4.9 The R-Block Reclamation or “The Holland Scheme"
5 Freaks Of Nature and the Extent of Damage
5.1 Floods
5.2 Salinity
5.3 Acidity
5.4 Pests and Diseases
5.5 Problem of Weeds
5.6 The Problem of Transportation
6 Attempts to Unlock the Grid Lock of Nature
6.1 The Backdrop
6.2 Kuttanadu Development Scheme (KDS)
6.3 First Stage of KDS
6.3.1 Thottappally Spill Way
6.3.2 Thanneermukkom Salt Water Barrage
6.3.3 A-C Road
6.4 Expected Benefits from the Schemes
6.5 A Broadside on the Benefits
7 From Permanent Bunds to Semi-Submersible Permanent Bunds
7.1 Nature of Temporary Bunds and the Idea of Permanent Bunds 7.2 The Idea of Semi-Submersible Bunds and the KLDC Project
7.2.1 The Necessity of Semi-Submersible Permanent Bunds
7.2.2 Objectives of the Project
7.2.3 The Cropping Season
7.2.4 The Assumption of Kuttanadu Development Project
7.2.5 The Project in a Nutshell
8 Kuttanadu Paddy Cultivation Development Project
9 Second Thoughts on Schemes Implemented In Kuttanadu
9.1 Density of Kuttanadu
9.2 Interface of High Density, Dearth of Cultivable Land and Nature’ Fury
9.3 Food Scarcity and Paddy Development Projects
9.4 Stabilising Agriculture of Kuttanadu: A Mission Unaccomplished
Monday, July 2, 2007
Fiscal Responsibility or Fisc’s Liability? Some Quick Comments on the Impact ofFiscal Targets in FRBM Acts of Sub-National States
[Paper presented at National Institute of Public Finance an Policy, New Delhi, June, 2007]
1 Introduction
From the neoclassical perspective the deficit is an arbitrary accounting construct whose value depends on how the government chooses to label its receipts and payments [Kotlikoff 1989]. However, in an era of Structural Adjustment and Stabilisation Policies, the concept of govt. deficit then and there summons a sceptical closer look and deficit reduction becomes a hallowed objective to be implemented across-the-board. Macro economic and debt stabilization are indeed economic objectives to be aimed at in a developed economy that too in a long run perspective but its relevance in a developing economy like India is in suspicion where the primary concern is development itself rather than the growth rates and its associated trickle-down effects precisely for the reason that there is abject poverty, illiteracy and virtual stagnation of the agricultural sector where still 50 percent of the work force belongs.
Furthermore, the eventual objective of the FRBM Act is highly susceptible given the words of the all-influential Milton Friedman, the champion economist of free market economy who clearly articulated that “A balanced budget amendment . . . is a means to an end. The end is holding down the growth of (or better sharply reducing) government spending” (Wall Street Journal, 4 January 1995, p. 12). It is pointed out that while such an objective may or may not be desirable on its own merits, the statement clarifies that the current budget debate has less to do with solvency and more with preferences over the optimal size of the public sector [Corsetti and Roubini 1996]. The context is irrelevant, given the increasing all-embracing influence of the ideology of free market economy, wherefore reminds to approach the issue askance.
It is in this backdrop the study attempts to dissect the impact of FRBM Acts enacted by selected state governments and its impact upon the developmental interventions and the consequent implications for growth and development prospects of the state economies in particular and the national economy in general.
2 Structure of the Paper
The paper has been divided into eleven parts: the first and second sections are introductory, the third gives a brief note on the international experience, the fourth furnishes the essence of the Act, the fifth explains the backdrop of its extension to the sub-national level, the sixth critically reviews the literature, the seventh, eighth, ninth and the tenth sections deals with the context and analysis of the study and the last section gives the concluding remarks.
3 A Peek on International Experience
The recent kick-starting towards govt. deficit reduction is made by the US enactment of The Gramm-Rudman-Hollings Balanced Budget and Emergency Deficit Control Act of 1985 during the Reagan era. But it could achieve only modest deficit reductions, given the mandatory social security expenditures, which compelled its revision to the Budget Enforcement Act 1990 which did not impose any deficit target but made a distinction between mandatory expenditures (not subject to targets) and discretionary expenditures (subject to targets). Experience shows that the Act has been a success in a limited sense for the reason that it restricted only the discretionary government expenditure and really honoured only in the breach, through shifting many expenditures of the US federal government to off-budget heads [Chandrashekar and Ghosh 2004]. New Zealand enacted The Fiscal Responsibility Act in 1994, but it is a country where the government even gave up control over its central bank, and was fully committed to the policies of economic orthodoxy. Eventually, the Growth and Stability Pact of 1997 read with the Maastricht Treaty for the European Union, which stipulated the member countries to keep their deficits below 3 per cent of GDP. But it is also coming under severe pressure, and France and Germany are already seeking ways to make it effectively meaningless and inapplicable to actual fiscal policy [Chandrashekar and Ghosh 2004] .
4 The Act in Essence
The Fiscal Responsibility and Budget Management (FRBM) Act 2003 came into effect on July 5 2004, following the issue of the notification by the Finance Ministry with a garland of objectives[1]. There are four major requirements in the FRBM Act. First, it requires that along with the Budget the Government has to place before Parliament three statements viz, Medium Term Fiscal Policy, Fiscal Policy Strategy and Macroeconomic Framework. Second, the Act lays down fiscal management principles or the so-called fiscal rules, that the Centre govt. must “reduce the fiscal deficit" (the Rules prescribe 3 per cent of GDP, no target is mentioned in the Act, though) and "eliminate revenue deficit" by March 31, 2008. Third, the Act prohibits the Centre from taking borrowing from the Reserve Bank of India, in effect, bans deficit financing. Fourth, the Parliament must be informed through quarterly reviews on the implementation of the stipulations of the Act to take corrective measures if there are any deviations and no deviation shall be permissible without the approval of Parliament.
There is nothing sacrosanct in the Act, however. The FRBM Act can be amended easily by simply adding a clause to the annual Finance Act and the first amendment has been effected within three days of the Act coming into force, to postpone the date for elimination of revenue deficit from March 2008 to March 2009!
5 The Sub-National Clones of the Act
It is the Eleventh Finance Commission that set the ball to roll. It recommended the contents of the monitorable fiscal reform programme and the role envisaged for the next finance commission in reviewing the monitoring and implementation of the grants given under Article 275 of the Constitution[2]. Prof. Amaresh Bagchi, member of the Eleventh Finance Commission, has given a note of dissent that the commission is not competent to make grants given under Article 275 of the Constitution conditional on implementation of a monitorable programme. But his views were brushed aside[3] by taking shelter in the normative concept of sound finance in the Article 280 (3d) of the Constitution[4] .
As such the Twelfth Finance Commission made the recommendations that state should enact a fiscal responsibility legislation (Chapter 16 of Twelfth Finance Commission, Summary of Recommendations, Item No. 8, Para 4.79)[5] and linked it as a pre-condition for availing debt relief (Item No. 45, Para 12.36)[6]
Thus the stage was set for enacting FRBM Acts across states as a pre-condition for getting debt relief including debt swap with a larger view to furnish an enabling environment for the celestial navigation of the market reform process, ironically enough, brought about through state intervention! By and large, the Acts enacted by state governments religiously follows the spirit of the fiscal prudence rules in the Centre’s Act; small differences in the targets can be observed however.
6 Review of the Literature
In this section a brief review of the various arguments posited in relation to the legislation of FRBM Acts has been attempted. The arguments in support of the Act that may bring about macro economic and debt stabilisation are given in the first part and then the studies that critically dissect it are given.
I
Kopits (2001) argued that India’s public deficit bias and indebtedness cannot be sustained much longer, especially with stepped-up external liberalisation. In these circumstances, the promotion of capital formation, maintenance of market confidence, and high sustained growth, require formulation of a broad strategic approach at fiscal consolidation – with close attention to the quality of adjustment. A central aspect of such a strategy is the adoption of a permanent framework for a rules-based fiscal discipline, as proposed under the Fiscal Responsibility Bill.
Rangarajan (2007 a & b) pointed out that even if we achieve zero revenue deficit and use borrowings only for investment expenditure we still need a control over it since the investments made out of the borrowings do not generate returns sufficient to service the debt and whatever good results it generated in the recent past is only the result of a fortuitous combination of circumstances that are beginning to reverse where the slack in the economy has been fully absorbed and the ‘output gap’ fully bridged. Hence, it is pointed out that the persuasive argument for an expansionary fiscal stance has no space. Hence he argued that it is important to be committed to fiscal responsibility which will strengthen the growth momentum which in turn makes it possible to meet deficit targets and still leave enough resources for meeting the expenditure needs.
Srivastava (2006) mentioned that one important advantage of a deficit ceiling is that it introduces a hard budget constraint and forces the government to prune unproductive expenditures and substitute these by productive expenditures.
II
Patnaik (2001 and 2006) questioned the idea that government expenditure financed by a fiscal deficit either through monetisation or borrowing will necessarily leads to an unsustainable burden of public debt. He accentuated that fiscal deficit will finance by itself by generating an excess of domestic private savings over private investment exactly equal to itself whether the economy is demand or supply constrained. He also pointed out that the target fiscal deficit ratio cannot remain constant as stipulated by the Act as it is not independent of the rate of inflation in the economy.
Bhaduri (2006) observed that since the act was not crisis-driven, but strategy-driven and wherefore it is logical to consider what strategic interests of the Indian economy would be served by this act. He remarked that it is a cruel joke in the present Indian context to talk of inter-temporal optimal choice involving successive future generations when about half of our children remain undernourished, with India heading in the 21st century as the country with the highest number of illiterates and homeless and as such, crippling government action certainly does not serve the interests of the poorer section of the Indian population.
Rakshit (2001) argued that borrowing to finance the govt. expenditure will not necessarily put burden upon the future generations as taxes for servicing public debt and those receiving interest incomes from the government, both belong to the same generation. Moreover, the structural features of the developing countries will render monetary policy relatively ineffective but will make expansionary fiscal policy effective.
The concept of ‘deficit pessimism’ in the literature on reforms has been put under critical scrutiny by Ram Mohan, Dholakia and Karan (2004) [7]. They eventually raised the question whether the Act is required in the first place as they found that a growth rate of 6.5 per cent is enough for the purpose of making central debt position sustainable based on the data on debt that is publicly available[8]; that too at a level of fiscal deficit that is higher than that mandated by the FRBM Act.
At last even the Planning Commission itself realised that the targets in the present form of FRBM Act does not give much attention to the need for counter cyclical fiscal policy and the cyclically adjusted fiscal deficit and suggested that there exist a case for redefining the approach to FRBM [GOI 2006].
7 The Context of the Study
As mentioned above the FRBM Act mandates four requirements to be complied with. The paper, however, zeros in on only the second aspect of the FRBM Act familiarly called as the fiscal prudence rules that the fiscal deficit must be contained to 3 percent of the GDP and zero deficits in the revenue account.
Simply put, fiscal deficit is the expenditure of the govt. made over and above the revenue receipts and the non-debt creating capital receipts of the govt. It is the amount of govt. borrowings needed to finance its expenditure. When the fiscal deficit is in the increase, homilies are often invoked liking it to as running the total home expenditure through borrowing, that it will eventually undermine the financial condition of the home. Hence, fiscal deficit is often approached as a monster that undermines the stability of the economy from a macro perspective. It is pointed out that however that whether the fiscal deficit will lead to instability depends upon a number of factors like how productively the investments are made and how effectively is the govt. mobilizing tax and non-tax revenue from the additional income generated from the investments [Gulati 1993; George 2006].
On the other hand, it is often argued that there should not be any sort of revenue expenditure financed through the borrowed funds since it is tantamount to meeting household consumption out of outside borrowing and it is pointed out that, both at the Centre and in the states, a significant proportion of the borrowed funds are used up for current consumption like payment of salaries, pensions and subsidies [Rangarajan 2007 a].
But it is already illuminated that the distinction between revenue and capital account is not helpful to dissect the effect and purpose of govt. spending [Gulati 1993]. For instance, the spending on education has a much larger revenue component than on many capital outlays that falls under capital account but is highly productive. It is computed that the return on social services that includes education is 7.0 percent much higher than that of many capital outlays [George 2006].
The age old accounting practise of making the distinction between revenue and capital account expenditures is gravitating criticism from various quarters.
Rakshit (2001) punctuated that some important items of government expenditure that are treated as current, benefit the future (by raising the community’s future production potential) rather than the present generation[9] but have a negative impact on the government’s revenue balance, as conventionally measured. For this very reason these types of expenses are considered crucial for long term development of a country and any practice of putting them on the same footing as other items of revenue expenditure cannot but produce gross distortions in budgetary measures.
Recently [GOI 2006] punctuated the necessity to re-define revenue-capital distinction in the govt. expenditures though in the context of grants[10] under various central schemes nevertheless points to the attenuating distinction between revenue and capital expenditures. In addition, it has already been argued that we need to incorporate the concept of Quality of Fiscal Discipline instead of focusing merely on quantity of reduction of deficits as a proportion of Gross Domestic Product [Kannan and Mohan 2003].
What boils down is the present classification of govt. expenditures into revenue and capital account does germinate grave classification problems that have far reaching consequences in titanic dimensions at multiple levels to the nation’s economy in the post FRBM milieu. It is in this backdrop the present study attempts to take a closer look upon the classification of various expenditures of the govt. and attempts to approach the expenditure items from a different angle by giving due importance to that expenditures which are so essential to the economy to raise its productive capacity continuously which will even have inter-temporal benefits. There is an express need to re-classify the expenditure items by taking into account the essence of the discussion already made. Apart from that it is high time to look upon the composition of fiscal deficit rather than focussing robotically upon its absolute quantity.
8 Incongruity between expenditure adjustment and its effects
In elucidating the significance of the twin targets in the FRBM Act, Rangarajan (2007) argued that even a zero revenue deficit would not suffice as still borrowings can be used to finance capital expenditure which will certainly become revenue expenditure tomorrow and therein lays the significance for twin targets. Two options then follows that either the govt. must cut capital expenditure financed by borrowing even in the midst of zero revenue deficits or it must be financed entirely through revenue surplus.
Generating revenue surplus hinge on the space available for revenue mobilisation and the extent by which the revenue expenditure is being cut. Given the fact even a modest rise in tax-GDP ration required at least fifteen years of tax reform process, any dramatic increase could only be expected over a fairly long stint of time that too with in the pale of the tax optimality constraints, it would be safe to place little optimism in this regard. It will compel to take recourse in the inescapable option of revenue expenditure cut and how much it would be cut down hang on how much increase in revenue receipts could be brought about. It is worth noting the fact that there exist obvious limits to the revenue mobilisation given tax optimality constraints, the pinch will be felt certainly by the revenue expenditure.
Be that as it may, the expenditure on social and economic services; where the education, health, irrigation, upon which the formation of human capital and the productivity of the economy so decisively reside; will be the causality at least over a fairly long period of time over which only the tax-GDP ratio would improve even in an optimistic scenario. Since it is the present stock of capital that decisively determines factor productivity of the economy, the growth and development prospects of the future generation is sacrificed so effortlessly at the alter of intergeneration equity. True, the revenue expenditure cut on social and economic services can be reinstated at any point of time when there is an increase in tax-GDP ratio but, disfigurement inflicted upon the human capital formation cannot be restored retrospectively, given its peculiar nature thereby highlights the incongruity between expenditure adjustments and the beneficial effects.
9 Post FRBM Scenario and its effects upon State Finances
Arguments for deficit reduction are often replete with homilies like—the state cannot live beyond its means, often draws an analogy between the state and a household. Whether it is legitimate or not, taking the cue out of it, why does it cannot be argued that; since the household resorts to borrowing to fund higher education of its children even at a higher rate than that offered on luxury cars—what deters the state in resorting to borrowing to finance its education or social service expenditures even under revenue account. Households seldom consider spending on education out of borrowed money or even financing it through selling assets as current consumption. Then why does the same thing done by the state is considered as current consumption[11]?
What boils down is it is instructive to compute how much of revenue receipts and borrowings are spent on current consumption. The study attempts to find out these figures by excluding: (1) the productive expenditures under revenue account for computing the revenue deficit since expenditure on social and economic services are generally considered as developmental and productive and hence not part of current consumption[12], and (2) excluding the total developmental expenditure from the fiscal deficit to arrive at a more meaningful measure to better comprehend the amount of borrowing that is required to meet the current consumption of the govt. They are called as adjusted revenue deficit (ARD) and adjusted fiscal deficit (AFD) just for the sake of convenience in referring them. It is underscored that these are only measures to just find out how much expenditure is incurred out of revenue and borrowings to meet the current consumption of the govt. in the limited context of this paper. Three states are taken into account for the analysis and they are Kerala, Karnataka and Punjab. The first one has remarkable achievement in human development which has a huge revenue component as per the convention, the second is generally considered as the most frugal in fiscal matters and the third one achieved fiscal improvement but one among the richest states of the nation. These peculiarities formed the basis of their selection.
10 The Impact upon Selected States
As mentioned in the above section the study attempts to analyse two facts: (1) how much money is spent from revenue and borrowings on current consumption by focussing upon the ‘adjusted revenue and fiscal deficits’ computed in the limited context of the study and (2) what happened to the developmental expenditure especially in the revenue account and there by computed the ratios of (a) development expenditure in the revenue account to revenue receipts, (b) total development expenditure to total receipts, (c) total development expenditure to total expenditure. To get a fuller view of the process the performance in revenue and fiscal deficit has been juxtaposed along with these results with the help of figures adjoined below.
Regarding the first aspect it is found that, all the three states are not spending for current consumption out of borrowed funds and there is surplus in the revenue account in the limited sense drawn for the purpose of the study (See rows 21 and 22 in tables 2, 3 and 4 adjoined below).
Turning to the second aspect of—development expenditure in the revenue account to the total revenue receipts; it is found that during the last three years there is a considerable squeeze in the development expenditure in the revenue account for the most fiscally improving states of Karnataka and Punjab (See row 27 in tables 2, 3 and 4). In the case of the former it nosedived from 68. 83 percent to 52.84 percent (2002-03 to 2004-05) and in the case of the latter it plummeted from 51. 96 percent to 43.12 percent (2003-04 to 2005-06). Nonetheless, it remained almost same in the case of Kerala however it declined marginally. The fact that to be noticed that, in Karnataka and Punjab, there happened impressive improvement in the reduction of revenue deficit, but it seems that it happened at the cost of development expenditure in the revenue account.
With respect to the last two aspects in the second question, the remarkable deficit reduction in Karnataka and Punjab did not result in any improvement in the development expenditure (See table 1). In the case of Karnataka the TDE/TR ratio (total development expenditure to total receipts) registered only a marginal rise and in the other cases it declined noticeably. The decline in the case of Punjab is carefully explored further as it is a state that achieved remarkable improvement in fiscal health as per the conventional standards. In Kerala both these ratios declined but slightly.
Tables and Diagrams are excluded. For the full text: http://www.santhoshtv.in/
11 Concluding remarks
The study attempted to analyse the impact of FRBM Act on the developmental expenditures of selected states. It approached the issue by critically discussing and dissecting the backdrop of FRBM initiates and its consequences upon the future growth and development prospects of the economy. For analytical purposes the study used its own measures and explained their relevance in the context elsewhere.
The study found that the popular notion that the govt. is meeting its current consumption out of borrowed funds is not correct. It seems that the remarkable improvement in the fiscal health of Karnataka and Punjab happened at the cost of developmental expenditures in the revenue account. It also found that there is no improvement in the total development expenditure of all the three states even in the midst of improvement in fiscal health as per conventional standards. All this witnessed in the post FRBM scenario and will certainly have consequences upon the economy, whether it is beneficial or detrimental can be answered conclusively only by exploring deeply. If it is detrimental then it would become a liability to the fisc.
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Kopits, George (2001): ‘Fiscal Policy Rules for India?’ Economic and Political Weekly March 3, 2001, pp 749-756
Kotlikoff, Laurence J., (1989): ‘From Deficit Delusion to the Fiscal Balance Rule: Looking for an Economically Meaningful Way to Assess Fiscal Policy’ Working Paper No. 2841, (Massachusetts Avenue Cambridge: National Bureau Of Economic Research)
Patnaik, Prabhat (2001): ‘On Fiscal Deficits and Real Interest Rates’, Economic and Political Weekly, April 14, 2001, pp 1160—1163.
Rakshit Mihir (2001): ‘Restoring Fiscal Balance through Legislative Fiat:The Indian Experiment’, Economic and Political Weekly, June 9, 2001, pp 2053-2062.
Ram Mohan T T, Dholakia H and Karan, Navendu (2004): ‘Is India's Federal Debt Sustainable?-Revisiting an Old Debate’ IIMA Working Papers No. 2004-11-02
Rangarajan C (2007a): ‘Earnest about Fiscal Responsibility’ The Economic Times, Delhi Edition, 19-02-07, pg 15
Rangarajan C (2007b): ‘In Defence of Fiscal Adjustment’ The Economic Times, Delhi Edition, 20-02-07, pg 16
Srivastava D K (2006): ‘FRBM Act and Eleventh Plan Approach Paper’, Economic and Political Weekly November 4, 2006, pp 4553-4559.
Endnotes
[1] It is an Act to provide for the responsibility of the Central Government to ensure inter-generational equity in fiscal management and long-term macro-economic stability by achieving sufficient revenue surplus and removing fiscal impediments in the effective conduct of monetary policy and prudential debt management consistent with fiscal sustainability through limits on the Central Government borrowings, debt and deficits, greater transparency in fiscal operations of the Central Government and conducting fiscal policy in a medium-term framework and for matters connected therewith or incidental (Underline not in the text)
[2] Ar. 275. Grants from the Union to certain States.—(1) Such sums as Parliament may by law provide shall be charged on the Consolidated Fund of India in each year as grants-in-aid of the revenues of such States as Parliament may determine to be in need of assistance, and different sums may be fixed for different States:
Provided that there shall be paid out of the Consolidated Fund of India as grants-in-aid of the revenues of a State such capital and recurring sums as may be necessary to enable that State to meet the costs of such schemes of development as may be undertaken by the State with the approval of the Government of India for the purpose of promoting the welfare of the Scheduled Tribes in that State or raising the level of administration of the Scheduled Areas therein to that of the administration of the rest of the areas of that State:
Provided further that there shall be paid out of the Consolidated Fund of India as grants-in-aid of the revenues of the State of Assam sums, capital and recurring, equivalent to—
(a) the average excess of expenditure over the revenues during the two years immediately preceding the commencement of this Constitution in respect of the administration of the tribal areas specified in Part I of the table appended to paragraph 20 of the Sixth Schedule; and
(b) the costs of such schemes of development as may be undertaken by that State with the approval of the Government of India for the purpose of raising the level of administration of the said areas to that of the administration of the rest of the areas of that State.
(1A) On and from the formation of the autonomous State under article 244A,—
(i) any sums payable under clause (a) of the second proviso to clause (1) shall, if the autonomous State comprises all the tribal areas referred to therein, be paid to the autonomous State, and, if the autonomous State comprises only some of those tribal areas, be apportioned between the State of Assam and the autonomous State as the President may, by order, specify;
(ii) there shall be paid out of the Consolidated Fund of India as grants-in-aid of the revenues of the autonomous State sums, capital and recurring, equivalent to the costs of such schemes of development as may be undertaken by the autonomous State with the approval of the Government of India for the purpose of raising the level of administration of that State to that of the administration of the rest of the State of Assam.
(2) Until provision is made by Parliament under clause (1), the powers conferred on Parliament under that clause shall be exercisable by the President by order and any order made by the President under this clause shall have effect subject to any provision so made by Parliament:
Provided that after a Finance Commission has been constituted no order shall be made under this clause by the President except after considering the recommendations of the Finance Commission.
[3] It is instructive to take note of the fact that he is the only expert in the Eleventh Finance commission on Public Finance and his arguments were summarily rejected. It is often pointed out in the media that it is the politicians alone who sideline economic rationale for their own ‘political’ ends. In the instant case it is economists and non politicians that unloaded the weighty arguments of the expert in Public Economics!
[4] Ar 280 (3d) any other matter referred to the Commission by the President in the interests of sound finance.
[5] Each state should enact a fiscal responsibility legislation, which should, at a minimum, provide for (a) eliminating revenue deficit by 2008-09; (b) reducing fiscal deficit to 3 per cent of GSDP or its equivalent, defined as the ratio of interest payment to revenue receipts; (c) bringing out annual reduction targets of revenue and fiscal deficits; (d) bringing out annual statement giving prospects for the state economy and related fiscal strategy; and (e) bringing out special statements along with the budget giving in detail the number of employees in government, public sector, and aided institutions and related salaries.
[6] Each state must enact a fiscal responsibility legislation prescribing specific annual targets with a view to eliminating the revenue deficit by 2008-09 and reducing fiscal deficits based on a path for reduction of borrowings and guarantees. Enacting the fiscal responsibility legislation on the lines indicated in chapter 4 will be a necessary pre-condition for availing of debt relief.
[7] They subjected this proposition to critical scrutiny in two ways. First, using a decomposition model, they separated out the effects of growth and government behaviour over the past decade. Assuming that government behaviour of the recent past will continue, it asked what growth rate would be required in order to make the central debt position sustainable. Sustainability here means bringing the debt to GDP ratio down to 50 per cent by the end of the decade, that is, 2009-10 from the present level of 56.8 per cent. They found that a growth rate of 6.5 per cent suffices for the purpose. Even if the growth rate falls below this level, the order of fiscal adjustment required would be modest. Next, positing a growth rate of 6.1 per cent in the coming years and making suitable assumptions about revenue buoyancy and other receipts, they empirically estimated the growth in primary expenditure that would be permissible.
[8] There is an inexplicable accretion to debt of around Rs 100,000 crore every year in the Kelkar Task Force (KTF) projections. Their projections were based on the data on debt available in the public domain and reflected in the estimates of Rangarajan and Srivastava (2003), CMIE and the CAG. They further pointed out that if there is some hidden component to the debt that is known only to those in government and that is impacting on the whole question of sustainability, that is a obviously a matter on which they cannot comment at this point.
[9] The most important of these items are education, health, grant for supporting (public or private sector) R and D and costs incurred in connection with setting up institutions for improvement in the working of the economic system.
[10] For example, the entire budgetary expenditures on Bharat Nirman, the National Employment Guarantee, the Backward Regions Grant Fund, the Jawaharlal Nehru National Urban Renewal Mission, and all new schemes in agriculture such as the National Horticulture Mission are classified as revenue expenditure since they are in effect grants to implementing agencies in the states, even though they finance asset creation on the ground.
[11] Whether the state can recoup the money spent on education in the revenue account is another issue that should be dealt in another plane given the fact that these types of expenditures generate wide ranging pecuniary externalities spread across the nation. It all depends upon the efficiency of the tax administration and collection machinery of the state since it is axiomatic that proper education will certainly raise factor productivity through human capital formation and if wages are equal to marginal product there will be a corresponding increase in the income of the individual.
[12] It is true that some sort of wastage can still be observed even in this classification, but by and large these developmental expenditures are safe to be considered as developmental expenditures.
[Paper presented at National Institute of Public Finance an Policy, New Delhi, June, 2007]
1 Introduction
From the neoclassical perspective the deficit is an arbitrary accounting construct whose value depends on how the government chooses to label its receipts and payments [Kotlikoff 1989]. However, in an era of Structural Adjustment and Stabilisation Policies, the concept of govt. deficit then and there summons a sceptical closer look and deficit reduction becomes a hallowed objective to be implemented across-the-board. Macro economic and debt stabilization are indeed economic objectives to be aimed at in a developed economy that too in a long run perspective but its relevance in a developing economy like India is in suspicion where the primary concern is development itself rather than the growth rates and its associated trickle-down effects precisely for the reason that there is abject poverty, illiteracy and virtual stagnation of the agricultural sector where still 50 percent of the work force belongs.
Furthermore, the eventual objective of the FRBM Act is highly susceptible given the words of the all-influential Milton Friedman, the champion economist of free market economy who clearly articulated that “A balanced budget amendment . . . is a means to an end. The end is holding down the growth of (or better sharply reducing) government spending” (Wall Street Journal, 4 January 1995, p. 12). It is pointed out that while such an objective may or may not be desirable on its own merits, the statement clarifies that the current budget debate has less to do with solvency and more with preferences over the optimal size of the public sector [Corsetti and Roubini 1996]. The context is irrelevant, given the increasing all-embracing influence of the ideology of free market economy, wherefore reminds to approach the issue askance.
It is in this backdrop the study attempts to dissect the impact of FRBM Acts enacted by selected state governments and its impact upon the developmental interventions and the consequent implications for growth and development prospects of the state economies in particular and the national economy in general.
2 Structure of the Paper
The paper has been divided into eleven parts: the first and second sections are introductory, the third gives a brief note on the international experience, the fourth furnishes the essence of the Act, the fifth explains the backdrop of its extension to the sub-national level, the sixth critically reviews the literature, the seventh, eighth, ninth and the tenth sections deals with the context and analysis of the study and the last section gives the concluding remarks.
3 A Peek on International Experience
The recent kick-starting towards govt. deficit reduction is made by the US enactment of The Gramm-Rudman-Hollings Balanced Budget and Emergency Deficit Control Act of 1985 during the Reagan era. But it could achieve only modest deficit reductions, given the mandatory social security expenditures, which compelled its revision to the Budget Enforcement Act 1990 which did not impose any deficit target but made a distinction between mandatory expenditures (not subject to targets) and discretionary expenditures (subject to targets). Experience shows that the Act has been a success in a limited sense for the reason that it restricted only the discretionary government expenditure and really honoured only in the breach, through shifting many expenditures of the US federal government to off-budget heads [Chandrashekar and Ghosh 2004]. New Zealand enacted The Fiscal Responsibility Act in 1994, but it is a country where the government even gave up control over its central bank, and was fully committed to the policies of economic orthodoxy. Eventually, the Growth and Stability Pact of 1997 read with the Maastricht Treaty for the European Union, which stipulated the member countries to keep their deficits below 3 per cent of GDP. But it is also coming under severe pressure, and France and Germany are already seeking ways to make it effectively meaningless and inapplicable to actual fiscal policy [Chandrashekar and Ghosh 2004] .
4 The Act in Essence
The Fiscal Responsibility and Budget Management (FRBM) Act 2003 came into effect on July 5 2004, following the issue of the notification by the Finance Ministry with a garland of objectives[1]. There are four major requirements in the FRBM Act. First, it requires that along with the Budget the Government has to place before Parliament three statements viz, Medium Term Fiscal Policy, Fiscal Policy Strategy and Macroeconomic Framework. Second, the Act lays down fiscal management principles or the so-called fiscal rules, that the Centre govt. must “reduce the fiscal deficit" (the Rules prescribe 3 per cent of GDP, no target is mentioned in the Act, though) and "eliminate revenue deficit" by March 31, 2008. Third, the Act prohibits the Centre from taking borrowing from the Reserve Bank of India, in effect, bans deficit financing. Fourth, the Parliament must be informed through quarterly reviews on the implementation of the stipulations of the Act to take corrective measures if there are any deviations and no deviation shall be permissible without the approval of Parliament.
There is nothing sacrosanct in the Act, however. The FRBM Act can be amended easily by simply adding a clause to the annual Finance Act and the first amendment has been effected within three days of the Act coming into force, to postpone the date for elimination of revenue deficit from March 2008 to March 2009!
5 The Sub-National Clones of the Act
It is the Eleventh Finance Commission that set the ball to roll. It recommended the contents of the monitorable fiscal reform programme and the role envisaged for the next finance commission in reviewing the monitoring and implementation of the grants given under Article 275 of the Constitution[2]. Prof. Amaresh Bagchi, member of the Eleventh Finance Commission, has given a note of dissent that the commission is not competent to make grants given under Article 275 of the Constitution conditional on implementation of a monitorable programme. But his views were brushed aside[3] by taking shelter in the normative concept of sound finance in the Article 280 (3d) of the Constitution[4] .
As such the Twelfth Finance Commission made the recommendations that state should enact a fiscal responsibility legislation (Chapter 16 of Twelfth Finance Commission, Summary of Recommendations, Item No. 8, Para 4.79)[5] and linked it as a pre-condition for availing debt relief (Item No. 45, Para 12.36)[6]
Thus the stage was set for enacting FRBM Acts across states as a pre-condition for getting debt relief including debt swap with a larger view to furnish an enabling environment for the celestial navigation of the market reform process, ironically enough, brought about through state intervention! By and large, the Acts enacted by state governments religiously follows the spirit of the fiscal prudence rules in the Centre’s Act; small differences in the targets can be observed however.
6 Review of the Literature
In this section a brief review of the various arguments posited in relation to the legislation of FRBM Acts has been attempted. The arguments in support of the Act that may bring about macro economic and debt stabilisation are given in the first part and then the studies that critically dissect it are given.
I
Kopits (2001) argued that India’s public deficit bias and indebtedness cannot be sustained much longer, especially with stepped-up external liberalisation. In these circumstances, the promotion of capital formation, maintenance of market confidence, and high sustained growth, require formulation of a broad strategic approach at fiscal consolidation – with close attention to the quality of adjustment. A central aspect of such a strategy is the adoption of a permanent framework for a rules-based fiscal discipline, as proposed under the Fiscal Responsibility Bill.
Rangarajan (2007 a & b) pointed out that even if we achieve zero revenue deficit and use borrowings only for investment expenditure we still need a control over it since the investments made out of the borrowings do not generate returns sufficient to service the debt and whatever good results it generated in the recent past is only the result of a fortuitous combination of circumstances that are beginning to reverse where the slack in the economy has been fully absorbed and the ‘output gap’ fully bridged. Hence, it is pointed out that the persuasive argument for an expansionary fiscal stance has no space. Hence he argued that it is important to be committed to fiscal responsibility which will strengthen the growth momentum which in turn makes it possible to meet deficit targets and still leave enough resources for meeting the expenditure needs.
Srivastava (2006) mentioned that one important advantage of a deficit ceiling is that it introduces a hard budget constraint and forces the government to prune unproductive expenditures and substitute these by productive expenditures.
II
Patnaik (2001 and 2006) questioned the idea that government expenditure financed by a fiscal deficit either through monetisation or borrowing will necessarily leads to an unsustainable burden of public debt. He accentuated that fiscal deficit will finance by itself by generating an excess of domestic private savings over private investment exactly equal to itself whether the economy is demand or supply constrained. He also pointed out that the target fiscal deficit ratio cannot remain constant as stipulated by the Act as it is not independent of the rate of inflation in the economy.
Bhaduri (2006) observed that since the act was not crisis-driven, but strategy-driven and wherefore it is logical to consider what strategic interests of the Indian economy would be served by this act. He remarked that it is a cruel joke in the present Indian context to talk of inter-temporal optimal choice involving successive future generations when about half of our children remain undernourished, with India heading in the 21st century as the country with the highest number of illiterates and homeless and as such, crippling government action certainly does not serve the interests of the poorer section of the Indian population.
Rakshit (2001) argued that borrowing to finance the govt. expenditure will not necessarily put burden upon the future generations as taxes for servicing public debt and those receiving interest incomes from the government, both belong to the same generation. Moreover, the structural features of the developing countries will render monetary policy relatively ineffective but will make expansionary fiscal policy effective.
The concept of ‘deficit pessimism’ in the literature on reforms has been put under critical scrutiny by Ram Mohan, Dholakia and Karan (2004) [7]. They eventually raised the question whether the Act is required in the first place as they found that a growth rate of 6.5 per cent is enough for the purpose of making central debt position sustainable based on the data on debt that is publicly available[8]; that too at a level of fiscal deficit that is higher than that mandated by the FRBM Act.
At last even the Planning Commission itself realised that the targets in the present form of FRBM Act does not give much attention to the need for counter cyclical fiscal policy and the cyclically adjusted fiscal deficit and suggested that there exist a case for redefining the approach to FRBM [GOI 2006].
7 The Context of the Study
As mentioned above the FRBM Act mandates four requirements to be complied with. The paper, however, zeros in on only the second aspect of the FRBM Act familiarly called as the fiscal prudence rules that the fiscal deficit must be contained to 3 percent of the GDP and zero deficits in the revenue account.
Simply put, fiscal deficit is the expenditure of the govt. made over and above the revenue receipts and the non-debt creating capital receipts of the govt. It is the amount of govt. borrowings needed to finance its expenditure. When the fiscal deficit is in the increase, homilies are often invoked liking it to as running the total home expenditure through borrowing, that it will eventually undermine the financial condition of the home. Hence, fiscal deficit is often approached as a monster that undermines the stability of the economy from a macro perspective. It is pointed out that however that whether the fiscal deficit will lead to instability depends upon a number of factors like how productively the investments are made and how effectively is the govt. mobilizing tax and non-tax revenue from the additional income generated from the investments [Gulati 1993; George 2006].
On the other hand, it is often argued that there should not be any sort of revenue expenditure financed through the borrowed funds since it is tantamount to meeting household consumption out of outside borrowing and it is pointed out that, both at the Centre and in the states, a significant proportion of the borrowed funds are used up for current consumption like payment of salaries, pensions and subsidies [Rangarajan 2007 a].
But it is already illuminated that the distinction between revenue and capital account is not helpful to dissect the effect and purpose of govt. spending [Gulati 1993]. For instance, the spending on education has a much larger revenue component than on many capital outlays that falls under capital account but is highly productive. It is computed that the return on social services that includes education is 7.0 percent much higher than that of many capital outlays [George 2006].
The age old accounting practise of making the distinction between revenue and capital account expenditures is gravitating criticism from various quarters.
Rakshit (2001) punctuated that some important items of government expenditure that are treated as current, benefit the future (by raising the community’s future production potential) rather than the present generation[9] but have a negative impact on the government’s revenue balance, as conventionally measured. For this very reason these types of expenses are considered crucial for long term development of a country and any practice of putting them on the same footing as other items of revenue expenditure cannot but produce gross distortions in budgetary measures.
Recently [GOI 2006] punctuated the necessity to re-define revenue-capital distinction in the govt. expenditures though in the context of grants[10] under various central schemes nevertheless points to the attenuating distinction between revenue and capital expenditures. In addition, it has already been argued that we need to incorporate the concept of Quality of Fiscal Discipline instead of focusing merely on quantity of reduction of deficits as a proportion of Gross Domestic Product [Kannan and Mohan 2003].
What boils down is the present classification of govt. expenditures into revenue and capital account does germinate grave classification problems that have far reaching consequences in titanic dimensions at multiple levels to the nation’s economy in the post FRBM milieu. It is in this backdrop the present study attempts to take a closer look upon the classification of various expenditures of the govt. and attempts to approach the expenditure items from a different angle by giving due importance to that expenditures which are so essential to the economy to raise its productive capacity continuously which will even have inter-temporal benefits. There is an express need to re-classify the expenditure items by taking into account the essence of the discussion already made. Apart from that it is high time to look upon the composition of fiscal deficit rather than focussing robotically upon its absolute quantity.
8 Incongruity between expenditure adjustment and its effects
In elucidating the significance of the twin targets in the FRBM Act, Rangarajan (2007) argued that even a zero revenue deficit would not suffice as still borrowings can be used to finance capital expenditure which will certainly become revenue expenditure tomorrow and therein lays the significance for twin targets. Two options then follows that either the govt. must cut capital expenditure financed by borrowing even in the midst of zero revenue deficits or it must be financed entirely through revenue surplus.
Generating revenue surplus hinge on the space available for revenue mobilisation and the extent by which the revenue expenditure is being cut. Given the fact even a modest rise in tax-GDP ration required at least fifteen years of tax reform process, any dramatic increase could only be expected over a fairly long stint of time that too with in the pale of the tax optimality constraints, it would be safe to place little optimism in this regard. It will compel to take recourse in the inescapable option of revenue expenditure cut and how much it would be cut down hang on how much increase in revenue receipts could be brought about. It is worth noting the fact that there exist obvious limits to the revenue mobilisation given tax optimality constraints, the pinch will be felt certainly by the revenue expenditure.
Be that as it may, the expenditure on social and economic services; where the education, health, irrigation, upon which the formation of human capital and the productivity of the economy so decisively reside; will be the causality at least over a fairly long period of time over which only the tax-GDP ratio would improve even in an optimistic scenario. Since it is the present stock of capital that decisively determines factor productivity of the economy, the growth and development prospects of the future generation is sacrificed so effortlessly at the alter of intergeneration equity. True, the revenue expenditure cut on social and economic services can be reinstated at any point of time when there is an increase in tax-GDP ratio but, disfigurement inflicted upon the human capital formation cannot be restored retrospectively, given its peculiar nature thereby highlights the incongruity between expenditure adjustments and the beneficial effects.
9 Post FRBM Scenario and its effects upon State Finances
Arguments for deficit reduction are often replete with homilies like—the state cannot live beyond its means, often draws an analogy between the state and a household. Whether it is legitimate or not, taking the cue out of it, why does it cannot be argued that; since the household resorts to borrowing to fund higher education of its children even at a higher rate than that offered on luxury cars—what deters the state in resorting to borrowing to finance its education or social service expenditures even under revenue account. Households seldom consider spending on education out of borrowed money or even financing it through selling assets as current consumption. Then why does the same thing done by the state is considered as current consumption[11]?
What boils down is it is instructive to compute how much of revenue receipts and borrowings are spent on current consumption. The study attempts to find out these figures by excluding: (1) the productive expenditures under revenue account for computing the revenue deficit since expenditure on social and economic services are generally considered as developmental and productive and hence not part of current consumption[12], and (2) excluding the total developmental expenditure from the fiscal deficit to arrive at a more meaningful measure to better comprehend the amount of borrowing that is required to meet the current consumption of the govt. They are called as adjusted revenue deficit (ARD) and adjusted fiscal deficit (AFD) just for the sake of convenience in referring them. It is underscored that these are only measures to just find out how much expenditure is incurred out of revenue and borrowings to meet the current consumption of the govt. in the limited context of this paper. Three states are taken into account for the analysis and they are Kerala, Karnataka and Punjab. The first one has remarkable achievement in human development which has a huge revenue component as per the convention, the second is generally considered as the most frugal in fiscal matters and the third one achieved fiscal improvement but one among the richest states of the nation. These peculiarities formed the basis of their selection.
10 The Impact upon Selected States
As mentioned in the above section the study attempts to analyse two facts: (1) how much money is spent from revenue and borrowings on current consumption by focussing upon the ‘adjusted revenue and fiscal deficits’ computed in the limited context of the study and (2) what happened to the developmental expenditure especially in the revenue account and there by computed the ratios of (a) development expenditure in the revenue account to revenue receipts, (b) total development expenditure to total receipts, (c) total development expenditure to total expenditure. To get a fuller view of the process the performance in revenue and fiscal deficit has been juxtaposed along with these results with the help of figures adjoined below.
Regarding the first aspect it is found that, all the three states are not spending for current consumption out of borrowed funds and there is surplus in the revenue account in the limited sense drawn for the purpose of the study (See rows 21 and 22 in tables 2, 3 and 4 adjoined below).
Turning to the second aspect of—development expenditure in the revenue account to the total revenue receipts; it is found that during the last three years there is a considerable squeeze in the development expenditure in the revenue account for the most fiscally improving states of Karnataka and Punjab (See row 27 in tables 2, 3 and 4). In the case of the former it nosedived from 68. 83 percent to 52.84 percent (2002-03 to 2004-05) and in the case of the latter it plummeted from 51. 96 percent to 43.12 percent (2003-04 to 2005-06). Nonetheless, it remained almost same in the case of Kerala however it declined marginally. The fact that to be noticed that, in Karnataka and Punjab, there happened impressive improvement in the reduction of revenue deficit, but it seems that it happened at the cost of development expenditure in the revenue account.
With respect to the last two aspects in the second question, the remarkable deficit reduction in Karnataka and Punjab did not result in any improvement in the development expenditure (See table 1). In the case of Karnataka the TDE/TR ratio (total development expenditure to total receipts) registered only a marginal rise and in the other cases it declined noticeably. The decline in the case of Punjab is carefully explored further as it is a state that achieved remarkable improvement in fiscal health as per the conventional standards. In Kerala both these ratios declined but slightly.
Tables and Diagrams are excluded. For the full text: http://www.santhoshtv.in/
11 Concluding remarks
The study attempted to analyse the impact of FRBM Act on the developmental expenditures of selected states. It approached the issue by critically discussing and dissecting the backdrop of FRBM initiates and its consequences upon the future growth and development prospects of the economy. For analytical purposes the study used its own measures and explained their relevance in the context elsewhere.
The study found that the popular notion that the govt. is meeting its current consumption out of borrowed funds is not correct. It seems that the remarkable improvement in the fiscal health of Karnataka and Punjab happened at the cost of developmental expenditures in the revenue account. It also found that there is no improvement in the total development expenditure of all the three states even in the midst of improvement in fiscal health as per conventional standards. All this witnessed in the post FRBM scenario and will certainly have consequences upon the economy, whether it is beneficial or detrimental can be answered conclusively only by exploring deeply. If it is detrimental then it would become a liability to the fisc.
Visit at www.santhoshtv.in
References
Bhaduri, Amit (2006): ‘The Politics of ‘Sound Finance’’ Economic and Political Weekly November 4, 2006, pp 4569-4571
Chandrasekhar C P and Ghosh, Jayati (2004) ‘Fiscal Responsibility and Democratic Accountability’ The Hindu, Friday, Jul 23, 2004.
Corsetti Giancarlo and Roubini Nouriel (1996) ‘European versus American Perspectives on Balanced-Budget Rules’ The American Economic Review, Vol. 86, No. 2, Papers and Proceedings of the Hundredth and Eighth Annual Meeting of the American Economic Association San Francisco, CA, January 5-7, December. 1996, pp. 408-413.
George, K K (2006): ‘Major Issues in State Level Fiscal Reforms’, in Srivastava, D K and Narasimhulu, M (2006): State Level Fiscal Reforms in the Indian Economy, (New Delhi: Deep and Deep Publications)
GOI , (2006): ‘Towards Faster and More Inclusive Growth: An Approach to the 11th Five Year Plan’, (New Delhi: Planning Commission)
Gulati, I S (1993): ‘Taackling the Growing Burden of Public Debt’, Economic and Political Weekly, May 10, 2006.
Kannan K P, Mohan R (2003): ‘India's Twelfth Finance Commission. A View From Kerala’, Working Paper 354 December, (Trivandrum: Centre of Development Studies)
Kopits, George (2001): ‘Fiscal Policy Rules for India?’ Economic and Political Weekly March 3, 2001, pp 749-756
Kotlikoff, Laurence J., (1989): ‘From Deficit Delusion to the Fiscal Balance Rule: Looking for an Economically Meaningful Way to Assess Fiscal Policy’ Working Paper No. 2841, (Massachusetts Avenue Cambridge: National Bureau Of Economic Research)
Patnaik, Prabhat (2001): ‘On Fiscal Deficits and Real Interest Rates’, Economic and Political Weekly, April 14, 2001, pp 1160—1163.
Rakshit Mihir (2001): ‘Restoring Fiscal Balance through Legislative Fiat:The Indian Experiment’, Economic and Political Weekly, June 9, 2001, pp 2053-2062.
Ram Mohan T T, Dholakia H and Karan, Navendu (2004): ‘Is India's Federal Debt Sustainable?-Revisiting an Old Debate’ IIMA Working Papers No. 2004-11-02
Rangarajan C (2007a): ‘Earnest about Fiscal Responsibility’ The Economic Times, Delhi Edition, 19-02-07, pg 15
Rangarajan C (2007b): ‘In Defence of Fiscal Adjustment’ The Economic Times, Delhi Edition, 20-02-07, pg 16
Srivastava D K (2006): ‘FRBM Act and Eleventh Plan Approach Paper’, Economic and Political Weekly November 4, 2006, pp 4553-4559.
Endnotes
[1] It is an Act to provide for the responsibility of the Central Government to ensure inter-generational equity in fiscal management and long-term macro-economic stability by achieving sufficient revenue surplus and removing fiscal impediments in the effective conduct of monetary policy and prudential debt management consistent with fiscal sustainability through limits on the Central Government borrowings, debt and deficits, greater transparency in fiscal operations of the Central Government and conducting fiscal policy in a medium-term framework and for matters connected therewith or incidental (Underline not in the text)
[2] Ar. 275. Grants from the Union to certain States.—(1) Such sums as Parliament may by law provide shall be charged on the Consolidated Fund of India in each year as grants-in-aid of the revenues of such States as Parliament may determine to be in need of assistance, and different sums may be fixed for different States:
Provided that there shall be paid out of the Consolidated Fund of India as grants-in-aid of the revenues of a State such capital and recurring sums as may be necessary to enable that State to meet the costs of such schemes of development as may be undertaken by the State with the approval of the Government of India for the purpose of promoting the welfare of the Scheduled Tribes in that State or raising the level of administration of the Scheduled Areas therein to that of the administration of the rest of the areas of that State:
Provided further that there shall be paid out of the Consolidated Fund of India as grants-in-aid of the revenues of the State of Assam sums, capital and recurring, equivalent to—
(a) the average excess of expenditure over the revenues during the two years immediately preceding the commencement of this Constitution in respect of the administration of the tribal areas specified in Part I of the table appended to paragraph 20 of the Sixth Schedule; and
(b) the costs of such schemes of development as may be undertaken by that State with the approval of the Government of India for the purpose of raising the level of administration of the said areas to that of the administration of the rest of the areas of that State.
(1A) On and from the formation of the autonomous State under article 244A,—
(i) any sums payable under clause (a) of the second proviso to clause (1) shall, if the autonomous State comprises all the tribal areas referred to therein, be paid to the autonomous State, and, if the autonomous State comprises only some of those tribal areas, be apportioned between the State of Assam and the autonomous State as the President may, by order, specify;
(ii) there shall be paid out of the Consolidated Fund of India as grants-in-aid of the revenues of the autonomous State sums, capital and recurring, equivalent to the costs of such schemes of development as may be undertaken by the autonomous State with the approval of the Government of India for the purpose of raising the level of administration of that State to that of the administration of the rest of the State of Assam.
(2) Until provision is made by Parliament under clause (1), the powers conferred on Parliament under that clause shall be exercisable by the President by order and any order made by the President under this clause shall have effect subject to any provision so made by Parliament:
Provided that after a Finance Commission has been constituted no order shall be made under this clause by the President except after considering the recommendations of the Finance Commission.
[3] It is instructive to take note of the fact that he is the only expert in the Eleventh Finance commission on Public Finance and his arguments were summarily rejected. It is often pointed out in the media that it is the politicians alone who sideline economic rationale for their own ‘political’ ends. In the instant case it is economists and non politicians that unloaded the weighty arguments of the expert in Public Economics!
[4] Ar 280 (3d) any other matter referred to the Commission by the President in the interests of sound finance.
[5] Each state should enact a fiscal responsibility legislation, which should, at a minimum, provide for (a) eliminating revenue deficit by 2008-09; (b) reducing fiscal deficit to 3 per cent of GSDP or its equivalent, defined as the ratio of interest payment to revenue receipts; (c) bringing out annual reduction targets of revenue and fiscal deficits; (d) bringing out annual statement giving prospects for the state economy and related fiscal strategy; and (e) bringing out special statements along with the budget giving in detail the number of employees in government, public sector, and aided institutions and related salaries.
[6] Each state must enact a fiscal responsibility legislation prescribing specific annual targets with a view to eliminating the revenue deficit by 2008-09 and reducing fiscal deficits based on a path for reduction of borrowings and guarantees. Enacting the fiscal responsibility legislation on the lines indicated in chapter 4 will be a necessary pre-condition for availing of debt relief.
[7] They subjected this proposition to critical scrutiny in two ways. First, using a decomposition model, they separated out the effects of growth and government behaviour over the past decade. Assuming that government behaviour of the recent past will continue, it asked what growth rate would be required in order to make the central debt position sustainable. Sustainability here means bringing the debt to GDP ratio down to 50 per cent by the end of the decade, that is, 2009-10 from the present level of 56.8 per cent. They found that a growth rate of 6.5 per cent suffices for the purpose. Even if the growth rate falls below this level, the order of fiscal adjustment required would be modest. Next, positing a growth rate of 6.1 per cent in the coming years and making suitable assumptions about revenue buoyancy and other receipts, they empirically estimated the growth in primary expenditure that would be permissible.
[8] There is an inexplicable accretion to debt of around Rs 100,000 crore every year in the Kelkar Task Force (KTF) projections. Their projections were based on the data on debt available in the public domain and reflected in the estimates of Rangarajan and Srivastava (2003), CMIE and the CAG. They further pointed out that if there is some hidden component to the debt that is known only to those in government and that is impacting on the whole question of sustainability, that is a obviously a matter on which they cannot comment at this point.
[9] The most important of these items are education, health, grant for supporting (public or private sector) R and D and costs incurred in connection with setting up institutions for improvement in the working of the economic system.
[10] For example, the entire budgetary expenditures on Bharat Nirman, the National Employment Guarantee, the Backward Regions Grant Fund, the Jawaharlal Nehru National Urban Renewal Mission, and all new schemes in agriculture such as the National Horticulture Mission are classified as revenue expenditure since they are in effect grants to implementing agencies in the states, even though they finance asset creation on the ground.
[11] Whether the state can recoup the money spent on education in the revenue account is another issue that should be dealt in another plane given the fact that these types of expenditures generate wide ranging pecuniary externalities spread across the nation. It all depends upon the efficiency of the tax administration and collection machinery of the state since it is axiomatic that proper education will certainly raise factor productivity through human capital formation and if wages are equal to marginal product there will be a corresponding increase in the income of the individual.
[12] It is true that some sort of wastage can still be observed even in this classification, but by and large these developmental expenditures are safe to be considered as developmental expenditures.
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