#202 The Debt of the Future

India Policy Watch: Passing the Burden

Insights on burning policy issues in India

— Pranay Kotasthane

As Wilson’s Matrix tells us, concentrated benefits (costs) trump diffused costs (benefits) on most occasions. Organising people around diffuse interests is difficult. As a political articulation of these voices is difficult, they are consigned to being a background hum in the cacophony of politics.

One such diffused interest group is the future generation. Apart from the common difficulty that all diffuse interest groups face, they face a small, little additional problem — they aren’t even in this world to be able to speak for themselves.

Hence, it shouldn’t come as a surprise that governments and societies shortchange future generations by borrowing more than their means for current consumption and passing this burden to the future generation.

India is no exception. Even today, the biggest expenditure item in the union budget is neither defence nor home affairs, but the interest paid by the union government to borrowers on past loans. We are paying for the profligacy of past and current governments. The chart below from this year’s budget tells us that roughly a fifth of the government’s total expenditure is being spent on interest payments.

As we keep living beyond our means, the portion of the future generation’s spending on interest payments keeps growing. This is what a real debt trap looks like.

Most governments run deficits, and so does India. But the quality of deficits matters. If governments borrow to finance physical and social infrastructure, the burden on future generations is mitigated to the extent that the outputs continue to be available to them.

But that’s not the case in India. The union government still runs a sizable revenue deficit, meaning that a portion of the borrowing is being used merely to keep the government running today. In other words, we snatch money from future generations to meet the demands of the current generation’s citizens.

In Studies in Indian Public Finance, Govinda Rao points out that while children in the age group of 0-14 constitute over 35 per cent of the population, investment in the two items that matter most for their capabilities—health and education—continues to be low.

This idea of sharing resources across generations is known as intergenerational equity. I prefer to call it intergenerational balance. A $2500 per capita income country with 20 per cent poverty must accord higher priority to improving the life chances of today’s citizens. Nevertheless, we must push governments to seek a balance between today’s consumption and tomorrow’s choices.

It is for this reason that state governments reshifting to the Old Pension Scheme is a wilful crime against future Indians. At a time when government employees already have better payscales than the median Indian, committing to an ever-growing pension liability is to rob money from the future for the benefit of a select few.

But then, matters of fiscal prudence are not politically savvy. No one ever voted for a government for its fiscal marksmanship. No politician ventures there unless specifically asked. For this reason, it was encouraging that the Prime Minister—at least rhetorically—made a case for intergenerational balance in the Parliament:

“You should not put burden on your children.  Borrowing for present day needs leaving the debt burden on future generations is a matter of serious concern...For the economic well being of the nation, states also have to take the path of discipline... Only then states will be able to benefit from development.”

There’s a lot more the union government could’ve done and can still do. Criticising state governments on the floor of the parliament won’t make the problem disappear. It’s important for the union government to explain to state governments the fiscal impact of such profligacy. Aligning their cognitive maps is important. Back in 2003, a coalition government was able to get states to commit to fiscal consolidation. There’s no reason why it can’t be done now. But it would require collaboration rather than confrontation between the union and the states.

There’s another area of public policy where thinking about intergenerational balance is crucial: governing the use of natural resources. What rules should govern the rate of extraction or utilisation of a limited natural resource is a question that all governments and societies must resolve.

Many States, including the Indian Republic, own forests, rivers, beaches, oceans, and minerals as a trustee, i.e. on behalf of current and future generations. This idea, known as the Public Trust Doctrine (PTD), requires that extraction of the natural resource should go hand in hand with investment in productive assets that can be used by future generations (Hartwick’s Rule). Norway’s Oil Fund is an oft-cited example of the Public Trust Doctrine in action.

Factoring in the opportunity cost incurred by future generations into the current price is a sound mechanism for the sustainable use of natural resources. The main obstacle is often that people might not agree to put any price tag on the natural resource. The resulting logjam harms the intergenerational balance.

Global Policy Watch: US Inflation and its Discontents

Global policy issues and their implication for India

— RSJ

One of the predictions, part of my usual beginning of the year edition, was that in 2023, US inflation would be stickier than most people have forecast, the growth would be stronger in the first half of the year, and employment would remain fairly high - and all of these would mean that Fed would continue to raise rates this year to fight inflation. The slowdown would come later, perhaps in 2024, and it would hurt more than most people imagine.

Well, here’s the latest inflation news from Reuters:

U.S. consumer spending increased by the most in nearly two years in January amid a surge in wage gains, while inflation accelerated, adding to financial market fears that the Federal Reserve could continue raising interest rates into summer.

The report from the Commerce Department on Friday was the latest indication that the economy was nowhere near a much-dreaded recession. It joined data earlier this month showing robust job growth in January and the lowest unemployment rate in more than 53 years.

“Clearly, tighter monetary policy has yet to fully impact consumers and shows that the Fed has more work to do in slowing down aggregate demand," said Jeffrey Roach, chief economist at LPL Financial in Charlotte, North Carolina. "This report all but insures the Fed will continue on its rate hiking campaign for a lot longer than markets anticipated just a few weeks ago.”

The Fed is expected to deliver two additional rate hikes of 25 basis points in March and May. Traders on Friday raised their bets for another increase in June. The U.S. central bank has raised its policy rate by 450 basis points since last March from near zero to a 4.50%-4.75% range.

This brings me back to a more specific prediction I have which might currently seem bizarre but isn’t outside of the realm of possibility. I suspect we might have the Fed hiking rates all the way to the 6.50%-7.00% range before they declare a win in the war against inflation. Inflation hurts the poor, and no political party likes it. An increase in prices takes wealth away from savers, and it erodes trust in the future for consumers. Price stability, therefore, is the primary role of a central bank. Given that growth hasn’t come off despite a 450 bps rise in rates and the blockbuster US employment numbers that came in last month, I don’t see what will stop the Fed from turning more hawkish in the coming months.

So, what does all of this mean for India? I will suggest the following.

Firstly, we can no longer work under the assumption that the Fed rate hike cycle is nearing its end, and we can therefore expect the rates to stabilise in India, too, after one more round of hikes. We must work out a scenario of what it means to live in a world where the US rates are at 7 per cent or more. The impact of it on the Rupee, our forex reserves and our growth if we continue to retain a differential between the two rates are all important factors to bear in mind. At this moment, we seem to have an uneasy and overwhelming consensus on how the macro will pan out. This recent inflation data from the US should make us pause and relook at our premises.

Secondly, the two variables that can mar India’s decade story are the fiscal deficit - among the highest in the world when you add the union and state numbers - and the current account deficit. It will be useful to stress test scenarios if we have US rates touching 7 per cent. Most global institutional investors have a fine disregard for these two metrics so far as they have built their models with US rates in the 5 per cent range.

Lastly, if there’s going to be an ‘accident’ because of this 7 per cent scenario coming to pass, it won’t be in the public market or a particular currency or sector. The banking sector is at the strongest it has ever been worldwide, and there are few asset bubbles in the conventional sectors. Of course, there are pockets of overvalued assets, especially in real estate sectors in Germany (and Western Europe in general), Canada and Australia. But it isn’t so large that it will create a domino. The likely accident could be in the private market, like the private equity space or in assets like crypto and private tech valuations. Thankfully, these won’t lead to contagion in the usual sense.

My sense is it will be useful for most macro models in India to recalibrate their assumptions to higher interest rates for 2023 and stress test the scenarios at 7 per cent and beyond levels. We might be lulled by the growth and employment numbers in the US, but the real pain could unfurl only in 2024 and beyond.

PolicyWTF: The Tyranny of Import Duties

This section looks at egregious public policies. Policies that make you go: WTF, Did that really happen?

— Pranay Kotasthane

Exhibit 1

Apple phones are costly. But they are beyond costly in India, not because Tim Cook has it in for India, but because our government wants us to buy “Made in India” phones instead.

Imported smartphones attract a 20 per cent basic customs duty. In addition, there’s a social welfare surcharge of 10 per cent of the duty rate. Besides this 22 per cent customs duties, all phones attract a GST of 18 per cent (up from 12 per cent). This 18 per cent rate is applied to the phone cost inclusive of the customs duty. The cascading involved in this tax regime would make public finance specialists hopping mad, but then all is fair in love and atmanirbharta.

As you would anticipate, these high import duties have opened up a new market for smuggled smartphones, estimated to be in the range of ₹15,000 crores.

Apple phones made in India are also not spared. Under the Phased Manufacturing Programme (PMP), the government applies import duties on sub-components as well. The idea is to magically create a local supply chain. But what it ends up doing is increasing the cost of manufacturing in India, making products uncompetitive globally. We have written about this topic on many occasions before. I’ll just link them below for now.

But hey, not all’s lost. Realising that the PMP might be self-destructive, the latest budget has removed the customs duty on the import of certain parts, such as the camera lens. Small mercies.

More on this subject:

* #185 - No Exports without Imports

* #155 - The Problem with Protectionism

* #86 - Production Linked Incentives

Exhibit 2

The Podfather Amit Varma told me (he’d heard it from a friend) the reason behind most DSLR and action cameras’ 30-minute video recording limit is…. import duties!

Not a work of the Indian government, though. Apparently, the EU passed a rule in the nineties that imported video cameras would be subject to a customs duty, while still-cameras would not. A video camera was defined as one that could capture a continuous video of a length greater than 30 minutes at a high quality. And so, even as still cameras became more powerful, they continue to retain the 30-minute limit. Given that the EU was a big market, camera makers found it convenient to follow this restriction in all geographies. This Hacker News conversation has more information. Apparently, the EU disbanded this import duty in 2018. But the 30-minute restriction seems to have a hysteresis.

HomeWork

Reading and listening recommendations on public policy matters

* [Podcast] In this Puliyabaazi episode, we explore the reasons behind China’s technological upgradation.

* [Paper] Rahul Basu of the Goa Foundation explains the Public Trust Doctrine in the context of mining in Goa.

* [Paper] To understand the evolution of the Public Trust Doctrine, read this paper.

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