Forex and infrastructure

The last few days have seen considerable discussion and debate on the feasibility and desirability of utilising the vast and increasing foreign exchange reserves for augmenting the much- needed infrastructure.

The accumulation of reserves at over $122 billion is well above the comfort level required for meeting the external payments and ensuring stability in the exchange rate and therefore, investing the reserves in infrastructure could free the economy from the supply bottlenecks to enhance the growth prospects.

This is considered to be a resource that can be utilised to accelerate the growth rate of the economy. Indeed, the Planning Commission has a serious problem of putting up a reasonable plan size for the Tenth Plan in the wake of severe fiscal problems.

The high level of fiscal deficits makes additional withdrawal from private savings for public investment difficult because it may put pressure on interest rates and crowd out private investments.

In the context of the political difficulties in undertaking the fiscal reforms in the short and medium terms, utilising the reserves could well be a way out.

The critics of the proposal, however, have pointed out that this will increase the fiscal deficit and monetise the deficit if the reserves are spent on domestic goods and services rather than imports.

In addition, the targets for fiscal correction set in the Fiscal Responsibility and Budget Management Act will have to be revised even before the ink has dried. This article argues that, using reserves cannot be a substitute for fiscal correction.

The measure could only help to soften the Budget constraints of the Centre further and will give ample scope for postponing the fiscal reforms indefinitely and this will have serious adverse consequences for both growth and stability in the medium and long terms.

There is considerable merit in utilising the foreign exchange reserves for investing in infrastructure. At a time when the fiscal situation does not allow adequate allocation to infrastructure, ways and means have to be found to augment spending on infrastructure and the idle reserves provide ideal opportunity for the purpose.

Further, having a reasonable plan size for the Tenth Plan in the prevailing difficult fiscal environment is possible only when some such additional resources are available. But the critical question is how this is different from having additional fiscal deficits to finance infrastructure.

In fact, there were quite a few economists in this country who have been arguing that fiscal deficit does not matter and additional borrowing is actually appropriate to increase spending on infrastructure. The arguments put forward are, history is replete with countries with even larger deficits but without any macroeconomic stability problems.

In India itself, despite high levels of fiscal deficits during the last few years, the macroeconomic environment has been stable. Besides, in a country where a significant portion of incomes generated in the unorganised sector is not captured in the GDP estimates, the fiscal deficit ratios calculated on the basis of official GDP estimates are overestimates and the actual ratio would be lower.

The difference between spending on infrastructure by resorting to government borrowing and from borrowing from the reserves is that, first, the former comes within the Budget and the latter is created through a separate fund and thus becomes a contingent liability.

A more substantive difference, however, is the monetisation of deficits. In the case of the former, private savings are drawn into public consumption or investment by the government borrowing from the financial sector.

Thanks to the agreement between the finance secretary and the RBI Governor in the mid-1990s (incidentally, Mr Montek Ahluwalia was finance secretary and Dr Rangarajan was the RBI Governor), the borrowing does not involve monetisation but could impact on interest rates and crowd out private investment.

In the latter case too, so long as the reserves are utilised on imports, money supply is not augmented, but when they are spent on infrastructure involving purchases of domestic goods and services, the result is monetisation.

The ideal way in which the reserves can be used to impact favourably on the economy is to liberalise imports. Indeed, the availability of large reserves provides an opportunity to liberalise imports further and improve the competitiveness of the Indian economy.

This, in fact, provides an opportunity to reduce and rationalise tariffs further. Unfortunately, that route of utilising reserves does not find favour with the government. The second-best situation may be to use the reserves for spending on import-intensive investment on infrastructure.

However, the use of resources on infrastructure spending involving increase in the aggregate demand for domestic goods and services by augmenting money supply is fraught with serious dangers.

In addition to the prevailing cost-push situation created by the increase in crude prices, the demand-pull factor arising from augmented money supply may add to inflationary expectations.

Surely, the best way is to augment infrastructure spending by increasing tax and non-tax revenues and rationalising revenue expenditures. However, the experience of fiscal reforms, particularly since the middle of the nineties, has not been happy in terms of releasing resources for investment.

Therefore, the private sector, particularly the industrial sector, has a legitimate concern as to why it should suffer poor infrastructure and yet face international competition because the government has failed to make fiscal correction.

They would certainly like to have more cost-effective and efficient infrastructure, and that is a legitimate demand to make them internationally competitive.

The critical question to ask is: Would utilising reserves to augment infrastructure spending be a substitute for achieving fiscal correction? If, indeed, infrastructure can be augmented without having to undergo the painful process of fiscal reforms, it will have considerable political appeal.

Unfortunately, the medium-and long-term implications of such a measure, as mentioned above, would be inimical to macroeconomic stability. In fact, it is the captains of industry who can, and should, put pressure on the government to undertake fiscal reforms and provide them with a level playing field in terms of efficient infrastructure.

Using the reserves to augment infrastructure by the proposed route removes an important constituency for fiscal reforms. Ensuring a hard Budget constraint is necessary for efficiency, growth, and stability. Instead, the use of exchange reserves is just another way to soften the Budget constraint and postpone fiscal reforms.

Indeed, this is tempting and political parties find undertaking serious fiscal reforms painful and will always look for short cuts.

But it is necessary to realise that long-term effects of using foreign exchange reserves for infrastructure spending through monetisation are fraught with dangers. Hopefully, the finance minister will not be tempted by the proposal and, instead, will get ready to bite the reform bullet.

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