#157 Money Matters

Programming Note: It’s just me this time. RSJ will be back next week. - Pranay

India Policy Watch #1: The Indefensibility of India’s Defence Financing

Insights on burning policy issues in India

— Pranay Kotasthane

Government budgets should be seen in the context of on-ground realities and future targets. The immediate context of the latest defence budget is the continuing stand-off between Indian and Chinese troops in eastern Ladakh. Since it began in May 2020, this stand-off has underlined the need to urgently equip India's defence forces to manage the strategic challenge posed by China. More firepower than Pakistan can no longer be the end goal of defence planning. Instead, India needs a decadal plan to effectively block and deter China's salami-slicing strategy.  The other important element underlying the defence budget is the COVID-19 pandemic. Last year's economic downturn further reduced the fiscal space and precluded a substantial rise in defence expenditure. Given that the government expects the economy to cross the pre-pandemic level in the upcoming financial year, it is worth comparing this year's defence budget with the pre-pandemic and pre-Ladakh stand-off year FY20. The traditional approach of comparing expenditures with the last year's budget is not as helpful because the previous year was an anomaly on many counts.First, the overall trend in defence spending is not encouraging. One way to measure the importance of a sector is to analyse the percentage of overall government expenditure it occupies. The Ministry of Defence's (MoD) relative importance has declined on this count. MoD expenditure now comprises 2.02 % of GDP (down from 2.22% in FY20) and 13.3% of central government expenditure (down from 16.7% in FY20). The more worrying part is that this decline is not recent. Since FY10, the MoD's expenditure has been steadily falling as a proportion of government expenditure. The Parliamentary Standing Committee on Defence's 2017-18 exhortation that defence spending of 3% GDP is 'optimal and necessary for ensuring the operational preparedness of the Forces' hasn't had the desired effect.

Next, the change in the composition of MoD expenditure reveals a lot about government priorities. There are some positive signs on this count. The spending on defence pensions has relatively declined. It now comprises 22% of the MoD expenditure, down from 26% in FY20. One reason for this decline is that previous years' pension payments included some arrears. While this is welcome news, the respite is temporary. The five-yearly revision of One Rank One Pension (OROP) is due, and when it gets approved, pension expenditure will swell once again. Effective lateral entry mechanisms and a customised national pension scheme for the armed forces are the only long-term solutions for controlling pension spending.Another vital component of the defence budget is the pay and allowances for the armed forces personnel and defence civilians. Expenditure on this component has increased relative to other items. While salaries made up 29.9% of MoD's allocation in FY20, they are budgeted to be at 31.1% of MoD expense in FY23.The relative decline in pension expenditure has allowed some fiscal space for more capital expenditure on arms, ammunition, and platforms. Capital outlay now makes up 29% of MoD expenditure compared to 24.5% in FY20. For the third straight year, the capital expenditure exceeds the expenditure on pensions, reversing a worrying trend that continued until FY20.

However, this compositional improvement doesn’t translate much in absolute terms, despite the government congratulating itself for increasing the capital outlay. As defence analyst Ajai Shukla observes:

“the MoD announced that military modernisation and border infrastructure development was at the centre stage of the national security and defence planning process. To support this, the MoD pointed to the steady rise in the defence capital outlay from Rs 86,740 crore in 2013-14 to 1.52 lakh crore in 2022-23 – an enhancement of 76 per cent over a period of nine years. While that sounds like a healthy growth rate, it actually amounts to less than 5 per cent, compounded annually – barely enough to cater for inflation and foreign exchange rate variation.”

The Indian Navy's share of this capital expenditure has increased to 35%, up from the 27% range between FY16 and FY20. This increase is significant as the response to China's build-up in the mountains might well lie in building deterrence in the oceans. Budgetary allocations indicate that the government is trying to build up India's naval strength but at a slow pace. Ajai Shukla points out how the Navy plans to utilise this allocation:

This increment will be needed to support the acquisition of new platforms, such as six air-independent propulsion (AIP) submarines being acquired under Project 75-I, a second indigenous aircraft carrier (IAC-2), 57 twin-engine deck-based fighters (TEDBFs) and four more P-8I Poseidon long-range maritime patrol aircraft to keep a watch over the Indian Ocean. The navy is also creating operational and strategic infrastructure that will be needed when the tri-service maritime command is operationalised in Karwar, near Goa.

The other small bit of good news was a substantial increase in the capital expenditure budget got the Indian Coast Guard and the Border Roads Organisation. This will help accelerate the buildup of security infrastructure on India’s land and maritime borders in peacetime.

While the capital outlay has increased in monetary terms, it might not immediately translate into better hardware. That's because the government has earmarked 68% of the procurement budget for domestic players through negative import lists. It will take a few years for Indian players to build local manufacturing expertise and meet quality standards. Moreover, an umbrella of protectionism often disincentivises companies from making world-beating products. Aatmanirbharta has its costs; at least in the short term, the armed forces will be bearing a significant chunk of this cost.A disappointing miss is the dedicated non-lapsable fund for modernisation, recommended by the Fifteenth Finance Commission and accepted in principle by the government in FY22. This fund has been a long-standing demand of the MoD to make multi-year payments of defence equipment easier. This fund was to be seeded by transfers from the government, monetisation of defence land, and disinvestment proceeds of defence public sector units. However, there is no indication in the budget about the progress of this critical reform.

The Hour of Reckoning

These discussions on the defence budgets give us a rough idea about the priority that governments accord to defence. Beyond that purpose, these insights have limited value as they merely focus on the relative changes from past years.

The most important question — how much should India really spend on defence given its economic situation and threat perceptions? — is never asked, and hence never answered.

Year after year, the parliamentary standing committee on defence remarks that the MoD be allotted 3 per cent GDP. Although the basis of this 3 per cent anchor has never been explained, it has a debilitating effect on military reforms. Instead of confronting tough trade-offs, the military establishment finds it convenient to blame the government of the day for not raising the defence expenditure to 3 per cent GDP. The government for its part approves unsustainable personnel expenditures such as a One Rank One Pension (OROP) scheme without assessing its long term economic impact on defence preparedness. The net effect is that around the defence budget every year, a “passing the blame” game ensues. The armed forces personnel blame defence civilians for eating into the defence expenditure. The military establishment blames the bureaucracy for financial delays. The government responds to the parliament that “all is well”, not to worry.

In reality, India’s defence planning needs a strong dose of economic reasoning. The defence ministry needs economists and defence planners who can create expenditure plans based on domestic economic conditions, resource constraints, and future threat scenarios. A part of military modernisation has to be about building its financial planning and forecasting capability. Without building this capacity, we would be shooting in the dark against an adversary that’s richer and better equipped.

(A condensed version of this article was published in Hindustan Times, 3rd Feb edition)

India Policy Watch #2: Contextualising the FY23 Union Budget

Insights on burning policy issues in India

— Pranay Kotasthane

By now, you would have already read tens of fine-grained budget analyses. So, here’s something different. Earlier this week, I spoke with Narayan Ramachandran for the Bangalore International Centre’s Podcast. Instead of focusing on sectoral spending, we zoomed out to locate this budget in the context of India’s economic trajectory over the last decade. Here’s the conversation (also available on all podcast apps).

HomeWork

Reading and listening recommendations on public policy matters

* [Podcast] On All Things Policy, I spoke with Aarushi about why many policies end up being less effective than hoped?

* [Article] Pramit Bhattacharya has an excellent take on how to make sense of the big, confusing, and often misleading numbers in the budget. This article should be a mandatory reading before you go through any budget analysis.

* [Article] Resolving municipal distress in India, by Adam Feibelman and Bhargavi Zaveri-Shah on The Leap Blog explore a promising source of municipal finances.

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