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Is India's financial market deep enough?

July 16, 2004

Large fiscal deficits are bad and should be cut. This has become the received wisdom now, despite a great deal of evidence to the contrary.

I am one of the few who believe that, first, fiscal deficits don't really matter because a government can always sell off assets to bring them down.

Starting from the Nawab of Arcot, who sold Madras to the East India Company in 1639, down to Jaswant Singh who sold off pieces of the oil companies in 2004, this method has worked. If revenue expenditure is unmanageably large, sale of assets is the only way out.

Second, to the extent that lower fiscal deficits reduce the risk of steep devaluations, the prescription is pure IMF strategy to protect US banks from sudden depreciations in their country exposures.

Fiscal deficits became fashionable only after the Mexican debt crisis of 1982. India, since it does not borrow from US banks, need not worry too much on this count, provided it can sell government assets periodically.

In a recent paper* Ricardo Caballero of MIT and Arvind Krishnamurthy of Kellog have discussed fiscal deficits from a different perspective. How come, they ask, "Belgium or Italy (pre-Maastricht) could run large fiscal deficits and accumulate debts far beyond those of Argentina, without experiencing crises nearly as dramatic as that of Argentina?" Yes, indeed. How come?

The answer, it seems, lies in the differing depths of their financial markets. While Belgium and Italy had a lot of depth, Argentina didn't. "Lack of financial depth constrains fiscal policy in a way that can overturn standard Keynesian fiscal policy prescriptions."

They also argue that "crowding out is systematically larger in emerging markets than in developed economies." What's worse, when there is a crisis, the crowding out coefficient exceeds one in emerging market economies.

This means that a small increase in the fiscal deficit leads to a disproportionate decrease in interest rates and, therefore, private investment. If this diagnosis is correct, the message for Finance Minister P Chidambaram is clear -- cut, cut, cut. Or, at the very least, spend wisely.

There is also the question of timing. How quickly a country responds to an incipient crisis is important (as you would expect it to be in response to any problem).

Thus, say the authors, "one of the factors that set the Argentine experience apart was the poor response of the authorities to the initial phases of the crisis. Argentina was too late in adjusting its fiscal accounts."

In Brazil, President Lula despite having been elected on a populist platform surprised everyone by tightening fiscal discipline. "Markets were positively surprised that the government was not as populist as many feared. The reaction was a sharp reversal of capital outflows."

The evidence presented by the authors also shows that if a country leaves fiscal adjustment till too late, when it does finally make the correction the contractionary effects are severe.

This happened in India in 1991-94. "This, together with the direct impact of capital flow reversals, may explain why fiscal policy is much less countercyclical in emerging market economies than in advanced ones."

The chain of events that occurs when government debt increases is interesting. The authors say that when such debt increases, there is an across-the-board decline in the liquidity of all of the country's assets. This requires a larger liquidity premium in response. But that in its turn further reduces the supply of funds.

This happens because "the aggregate liquidity of a country is ultimately linked to the productivity of its private assets. Government assets may be backed by domestic transfers but they do not themselves generate aggregate returns." But this sounds a bit extreme.

Net result: as crowding out increases, and returns from private assets decrease, the liquidity of the country's assets falls, meaning no one wants to buy the things. Exit foreign capital, followed by crisis.

Or, if you like, the other way round as well, especially if you happen to annoy the US, which can always trigger capital flight by putting out the word that you are, as it were, bad news.

It has happened before, it could happen again.

*Fiscal Policy and Financial Depth, NBER Working Paper No. 10532

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