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IT is boom time for the Indian economy, Finance Minister P. Chidambaram periodically reminds us. He has figures to back his case. Most recently, the Central Statistics Organisation (CSO) has released "advance estimates" of national income for 2005-06, which place Gross Domestic Product (GDP) growth at 8.1 per cent as compared with 7.5 per cent in 2004-05. This optimistic projection, pointing to the sustained recovery since 2003-04, combined with the rapid climb of the Bombay Stock Exchange's sensitive index (Sensex) to a record-breaking 10,000-plus level, was in his view a "heady mix".
Given the GDP growth figures, one cannot begrudge the current government and its Finance Minister a little intoxication. But what they need to be careful about is the way they interpret these numbers and the lessons they take home from the party. According to media reports, there are at least two conclusions that the Finance Minister has derived from the figures. His view: "The Sensex reflects business confidence and the strong fundamentals of the economy." And to sustain this, "we should continue to remain on the path of tight fiscal control" since it is the adoption of such a fiscal stance that has given India growth of such magnitude.
Clearly then, in the Minister's perception, it is growth that drives the Sensex and it is the government's prudent fiscal policy that drives that growth. That is, we should all be thankful for the prudence exercised by the Finance Minister and his colleagues. However, at the cost of sounding churlish when the balloons are about to pop, a call for sobriety is in order for a number of reasons.
First, as the observant many who have braved the potholes and taken the drive out of Greater Bombay, Bangalore, Chennai, Hyderabad, Delhi, and Kolkata have noted, an overwhelming majority of Indians who populate the rural areas have been largely left out of the party. So have large numbers of the urban poor whose presence cannot be hidden by the sprawling malls of the new mega-cities. Agriculture, rural industry and the urban informal sector have performed poorly for too long, partly because of fiscal "prudence" of a kind that provides tax concessions to the well-to-do, erodes government revenues and cuts expenditures to rein in the fiscal deficit. Curtailed revenue growth and reduced deficits have meant too little money for much needed investments in irrigation, drainage, health facilities and educational infrastructure. Chidambaram himself would recall the many dream Budgets he was personally responsible for. These budgets affected revenue growth adversely and created anomalies of the kind where a lower-middle class salary earner pays taxes on income, whereas speculators in India's booming stock markets are exempt from taxes on the huge capital gains they garner.
When broken down by sector, the figures quoted by Chidambaram point to the sharp variations in growth rates between agriculture on the one hand, and manufacturing and services on the other. Agricultural GDP grew at 0.7 per cent in 2004-05 and is expected to rise by just 2.3 per cent in 2005-06. Distorted growth has significant social implications. The boom sectors are not able to offer employment opportunities that can draw out the large numbers languishing in rural India, and enable them to share in the joys of India's urban buoyancy. If incomes grow in manufacturing and services but employment stagnates or barely rises, it must be true that there are just a few who benefit from the increment in national income. Add to this the fact that even in manufacturing and services, there are a few firms, units or individuals that are doing well, and many others perform indifferently or poorly. That means inequalities must be even wider. Not surprisingly, the list of Indian millionaires and billionaires lengthens while income poverty, malnutrition and illiteracy persist. Maybe it is time to be gracious and inclusive, and widen the invitees to the hitherto restricted celebration.
Second, there is reason to believe that the two ingredients of the Finance Minister's boom cocktail have little to do with each other. Aggregate GDP growth in India has been creditable since the 1980s, even if it is not as spectacular as the CSO projects it to be. But the sustained and rapid rise of the Sensex is much more recent. The Bombay Sensex rose from 3,727 on March 3, 2003, to 5,054 on July 22, 2004, and then on to 6,017 on November 17, 2004, 7,077 on June 21, 2005, 8,073 on November 2, 2005, 9,067 on December 9, 2005, 10,082 on February 7, 2006 and 10,113 on February 15, 2006. The implied price increases of more than 100 per cent over a 19-month period and 33 per cent over the past three and a half months are indeed remarkable.
Market observers, the financial media and a range of analysts concur that Foreign Institutional Investor (FII) investments have been an important force, even if not always the only one, driving markets to their unprecedented highs. Having amounted to $2.84 billion during 2001, net FII investment dipped to $740 million during 2002. The surge began immediately thereafter and has yet to come to an end. Inflows rose to $6.59 billion during 2003, $8.52 billion in 2004, 10.70 billion in 2005 and are estimated to have exceeded $1.5 billion (or an annualised $12 billion) during the first one and a half months of 2006.
Going by data from the Securities and Exchange Board of India (SEBI), while cumulative net FII flows into India since the liberalisation of rules governing such flows in the early 1990s until end-March 2003 amounted to $15,804 million, the increment in cumulative value between that date and the middle of February 2005 was $26,924 million.
If the Finance Minister is to argue that this surge in FII flows is the result of strong economic fundamentals, then he is suggesting that for more than a decade the accelerated economic liberalisation, launched initially by a Congress government, has not been able to deliver the fundamentals needed to attract adequate capital flows. Moreover, since the National Democratic Alliance was in power in the period prior to and at the beginning of the surge, he is possibly also unconsciously suggesting that it needed a non-Congress government to shape the necessary fundamentals. Fortunately for him, we can save him the embarrassment of facing up to his implicit confessions, since it is clear that what underlies the surge is not changed economic fundamental but an engineered stimulus in the form of the rules governing FII investment: its sources, its ambit, the caps it was subject to and the tax laws pertaining to it.
Even before the Budget of 2002-03, the cap which was to apply on FII investments in individual companies had been relaxed. FIIs could invest in excess of 24 per cent of the paid-up capital of a company with the approval of the general body of shareholders granted through a special resolution. The 2002 Budget went further and declared that FII (portfolio) investments would not be subject to the sectoral limits for foreign direct investment (FDI) except in specified sectors. These changes obviously substantially expanded the role that FIIs could play, even in a market that was still relatively shallow in terms of the number of shares that were available for active trading. Further, inasmuch as the process of liberalisation keeps alive expectations that the caps on FDI in different sectors will be relaxed over time, acquisition of shares through the FII route today paves the way for the sale of those shares to foreign players interested in acquiring companies as and when FDI norms are relaxed. This creates the ground for speculative forays into the Indian market. Figures relating to end-December 2005 indicate that the shareholding of FIIs in Sensex companies has been increasing at the cost of promoters and stood at 29.2 per cent. The latter's holding has decreased from 51.5 per cent to 49.7 per cent between December 2004 and December 2005. Given variations across companies this would imply ownership of a controlling block by the FIIs in some firms that can be transferred to an intended acquirer at a suitable price.
That such speculators are present here is clear from the type of investors who are making investments through the FII route. Market observers have noted the growing presence in India of institutions such as hedge funds, which are not regulated in their home countries and resort to speculation in search of quick and large returns. The hedge funds, among other investors, exploit the route offered by sub-accounts and opaque instruments like participatory notes to invest in the Indian market. FIIs registered in India are permitted to undertake investments on behalf of clients who themselves are not registered in the country. These clients are the so-called `sub-accounts' of registered FIIs. Other investors use instruments such as participatory notes sold by FIIs registered in the country to clients abroad. These are derivatives linked to an underlying security traded in the domestic market. They not only allow the foreign clients of FIIs to earn incomes from trading in the domestic market, but also allow them to trade these notes themselves in international markets. By end-August 2005, the value of equity and debt instruments underlying participatory notes that had been issued by FIIs amounted to 47 per cent of cumulative net FII investment. Through these routes, entities not expected to play a role in the Indian market can have a significant influence on market movements. In October 2003, The Economist reported that: "Although a few hedge funds had invested in India soon after the country began liberalising its financial markets in the early 1990s, their interest has surged recently. Indust
The interest of speculative forces of this kind was whetted by a major decision taken in the Budget for 2003-04 to render the speculative gains registered by them free of capital gains tax. The Finance Minister's Budget speech of 2003-04 declared: "In order to give a further fillip to the capital markets, it is now proposed to exempt all listed equities that are acquired on or after March 1, 2003, and sold after the lapse of a year or more, from the incidence of capital gains tax. Long-term capital gains tax will, therefore, not hereafter apply to such transactions. This proposal should facilitate investment in equities." Long-term capital gains tax was being levied at the rate of 10 per cent up to that point of time. The surge was no doubt facilitated by this significant concession. What needs to be noted is that the very next year, Chidambaram as Finance Minister of the current United Progressive Alliance government endorsed this move. In his 2004 Budget speech, he announced his decision to "abolish the tax on long-term capital gains from securities transactions altogether". It is no doubt true that he attempted to introduce a securities transactions tax of 0.15 per cent to partially neutralise any loss in revenues. But a post-Budget downturn in the market forced him to reduce the extent of this tax and curtail its coverage, resulting in a substantial loss in revenue. In the event, fiscal extravagance rather than fiscal prudence finally triggered the speculative surge in stock markets that still persists.
The implications of this extravagance can be assessed with a back-of-the-envelope calculation, which, even while unsatisfactory, is illustrative. Market capitalisation in the Bombay Stock Exchange stood at Rs.16,85,989 crores at the end of 2004. This rose by more than Rs.803,000 crores to Rs.24,89,386 crores at the end of 2005. If we assume for purposes of our illustration that this is indicative of the gains registered by everyone who traded shares after holding them for a year, the capital gains tax they would have had to pay would have amounted to Rs.80,000 crores. This is equivalent to the total receipts from corporation tax in financial year 2004-05 and a quarter of the gross tax revenue of the Centre in that year. While the actual transactions in the market would not have yielded capital gains of this magnitude and while it may be true that the surge in the market may not have occurred if India had not been made a capital gains tax haven, these numbers point to the kind of losses we are possibly talking about. They make nonsense of the claim that it is fiscal prudence and strong fundamentals that have ensured buoyancy in the stock market. Rather, fiscal extravagance in the form of a huge tax concession to the domestic and foreign super-rich has delivered the "bonanza". The attendant implication is that resources that could have been mobilised for employment programmes, for social expenditures and for much needed capital investment have been squandered. Chidambaram is, of course, intelligent enough to have recognised all this, especially since he played a role in the unfolding game. If he has yet chosen to use GDP growth figures to whitewash the nature and sources of the speculative boom, there must be adequate reasons. One is that he can use these numbers to justify in the name of "fiscal prudence" his "inability" to provide adequately for much-needed social and capital expenditures. Another, is that he, along with the Prime Minister and the Deputy Chairman of the Planning Commission, can use the ruse that liberalisation has delivered India's "heady" economic performance to press ahead with liberalisation measures that allies and supporters of the current government oppose.
The evidence for the latter is overwhelming. Besides privatisation of airports, FDI in retail and opening up a host of new sectors for 100 per cent foreign investment through the automatic route, it is being reported that formal moves are afoot to launch over the next four months a series of initiatives to provide "a significant push to economic reforms". These initiatives include relaxing environmental restrictions on construction in metro areas, introducing legislation at the State level that can facilitate contract farming, removing 250 items reserved for the small-scale sector from the currently reserved list, modifying labour laws to allow for an increase in the work week from 48 to 60 hours, amending the Industrial Disputes Act to give units flexibility to hire seasonal workers and amending the Contract Labour Act to increase labour flexibility.
Fortunately, there are forces within and outside government that are bound to strongly oppose indiscriminate liberalisation of this kind justified on specious grounds. Unfortunately, however, battles of this kind are making clear that economic policy is being hijacked by a few who do not stand for the programme that the electorate voted for in the last election and on the basis of which this government was installed in power. The energy lost in these battles may set back the development agenda to an extent where the current government may find it difficult to return to power, even if it manages to complete its term.
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