The recent announcement of the implementation of the Seventh Central Pay Commission (CPC) recommendations was received on expected lines. The media made it out to be an extravaganza for a bloated and inefficient bureaucracy bereft of any linkage between performance and remuneration. On the other hand, government employees felt it fell short of expectations — as is usually the case with any kind of pay hikes.
But the government has a good economic reason to push the increased salaries into the economy: to push up the demand curve and bring about a spurt in expenditure. The increase in salaries is likely to bring in about Rs. 1.02 lakh crore into the economy, of which about a fourth is likely to be consumed by taxes. The remaining amount would create demand in the sectors that would benefit; apart from retail and FMCGs, these are automobile and real estate. The main beneficiary of this increase is the middle class that is still predominantly interested in government jobs.
After the CPC in all probability the State governments will follow suit. Thus funds would be released to the middle class that would in turn create demand by becoming consumers for all the economic activity unleashed on account of additional disposable income in their hands.
Here the middle class is used as a lever to jack up economic activity, and it is not the first time this has been done. Though there is nothing wrong with it, this has had its fair share of trials and tribulations over the seven decades of independent India. We can see how it has since evolved.
Independence was a dream-come-true but it came along with the big blow of Partition. The nascent nation found itself facing the onerous task of building itself, its fragmented polity and the tattered economy. But the post-Independence euphoria was under the spell of idealism, symbolised by the egalitarianism embedded in the theories of socialism and communism. The emerging economies of that time were impressed by the centralised and controlled structures instituted by that thinking to shake the economy in a manner beneficial to all. Indian politicians were no exceptions and took ideas from the controlled economies of the USSR and emerged upon planning our economy in a manner that combined the advantages of socialism and capitalism. We ended up having a mixed economy where initially the focus was more on planning and government spending. This era marked the beginning of the Planning Commission, further continued under the aegis of Professor Mahalanobis (from the Second Five-Year Plan onwards), and we saw different Five-Year Plans being formulated and implemented. The first Five-Year Plan was focussed on agriculture, followed by the second, which emphasised on industrialisation with public spending, that gave rise to many public sector undertakings. These Plans were subsequently followed by the third, fourth, so on, but over a period of time the Planning Commission lost its sting and was becoming more of an advisory body whose suggestions were only selectively heard.
The mixed economy implied equal partnership of the public sector and the private sector. However, the government played the lead role and the private sector the second fiddle. Thus, the major task of shaping the economy was taken over by the government by taking unto itself its planning, direction and focus.
For a planned economy, the government needs to have adequate funds at its disposal so that it can channel those in the sectors which it intends to develop. The government in the initial years tried to arrange these funds through the following means: (i) Borrowing from foreign institutions, (ii) Raising public debt, (iii) Incentivising the public to save by offering bonds and such-like, (iv) Printing more money, and (v) Collecting taxes.
In the decade of the 1950s, the funds arranged in thus were spent on ambitious projects that Prime Minister Jawaharlal Nehru called the Temples of Modern India. However, the pace of industrialisation and the euphoria of independence were short-lived. Over a period of time the bureaucratic red-tapism inherited from the British era took over and the pace of progress was hampered. The public undertakings, where huge amounts of capital and manpower were at stake, got mired in corruption. There were long delays in their completion. There were abnormal gestation periods and they virtually were not able to deliver what they were intended for. These huge losses in the public sector, where there was hardly any accountability, meant loss of precious capital that was arranged through foreign funds, public debt raised at higher rate of interest, and printing more money.
All that meant there was every chance of the economy getting imploded by its own projects that had that become unviable — which is what eventually happened to most of them. The situation became very critical and it was realised that the public debt that was raised for these projects was basically from the middle classes who are tempted into savings by offering higher rates of interest in their savings account and also by incentivising them through a variety of government bonds with attractive interest rates. Because the projects had not delivered, the only recourse left to the government for doing good the public debt was by printing more currency. This tendency of warding off public debt by printing more currency had an inflationary impact because more money was chasing fewer goods on account of failure of the public sectors to deliver. Even the other recourse available of borrowing from foreign institutions had its own perils in non-repayment of loans. The interest burden of these institutions on the government started creating pressure on the expenditure side. With governmental revenues not being able to meet the expenditure, the fiscal deficit increased year on year, taking the government towards a situation of insolvency.
The major burden of contributing to the public exchequer had always been on the fragile shoulders of the middle class. Agricultural income was exempt from taxes and the taxes on the private sector were so high that either there was massive tax evasion or they were availing of tax incentives wherever offered. With the tax rates being as high as 90 per cent, there was a huge deterrence to private enterprise. So there was either large-scale tax evasion, or businesses were centred on sectors offering tax incentives. All this meant the taxes were collected from the salaried class, professionals or small or middle enterprises largely comprising of the Indian middle class. The public debt was also collected mostly through the middle class by incentivising them by offers of treasury bonds such as National Savings Certificates and Kisan Vikas Patras. Even the offer of high deposit rates in the banks, once they were nationalised, was a means of tempting the middle class to save money rather than spending it. Thus, the economy was intentionally made a savings-driven economy where the major chunk was to be used by the government to develop sectors that would kick-start the economy and provide the benefits to all. The assumption was that once the projects started delivering, everything else will fall in place.
However, the projects did not come up to expectations, and there was a major rethink on the future of the economy that started appearing to be in a shambles towards the late-1980s. This failure had a major impact on the middle class, which was bearing the burden of this development. In India there is no social security as there is in some western economies. Earlier the undivided joint family used to be a sort of social security but with nuclear families becoming the norm post-Independence, this social security also disappeared. The only recourse left to the middle class was to fend for itself. And since savings was in vogue in those days, the salaried persons, professionals and others planned for their retirement on the basis of the interest rates offered by banks. In the 1970s and 1980s, interest rates on fixed deposits ranged from 10 to 15 per cent and people were happy to have their money deposited in banks and make a living from the interest accruing on the deposits in the twilight years of their life.
However, with the increasing fiscal deficit and with the government being unable to balance its expenditure with revenue, it was gradually moving towards bankruptcy. Meanwhile, during the late-1980s most of the centralised economies of the world such as the USSR and Yugoslavia were breaking up. The obsession with centralised economies was over and the spell of socialism was in for a major jolt. In India also there was the realisation among the planners that perhaps the fate of the planned economy is now sealed and therefore it is time to give a chance to market forces to revive the beleaguered economy. It is a matter of regret that in the early-1990s the fiscal deficit of the government had reached a level where there were hardly any funds to import petroleum products. It was nearly a crisis when the government was required to mortgage its gold reserves to raise needed funds. All this was a consequence of not being able to manage public funds towards the required goals and thus falling far short of expectations. Things virtually came to the verge of an economic collapse. Thus, the savings-driven economy where the government was the spearhead of giving direction and impetus came to a standstill and under the influence of World Bank, the International Monetary Fund and others, India had to resort to opening up its economy to the market forces. Then started the era of liberalisation, privatisation and globalisation (LPG), unleashed in 1993 by the then Prime Minister and Finance Minister duo of P.V. Narasimha Rao and Manmohan Singh.
This era of LPG envisaged that capital and funds, instead of being vested with the government be made available to the market forces, that is, the private players, and the norms and regulations be liberalised for private enterprise to flourish. The strangulating hold of permits and quotas was to pave the way for an open environment bringing together the forces of demand and supply for an efficient and effective market where their benefits are shared by the consumer and the producer.
Again, the genesis of any economic activity is finance, and the same is even more true in a market economy. It may be seen that most of the savings were blocked in the bank accounts of individuals and Government Bonds, and with the interest rates being tempting, there was no incentive to part with the savings. This implied that if the funds are not to be made available to private players, then these funds would have to be had at the prevailing savings bank or fixed deposit rates. This in turn meant that capital would be too costly for private players and it was a big disincentive for private players to go for public funds. The market model functions on the premise of free trade with consumers and suppliers interacting in the marketplace. The consumers need to spend and suppliers need to service the demand. For such interaction to take place, the funds need to come out of the closet.
The savings habit espoused so far was therefore not to be encouraged. Thus, another rethink was to move the savings-driven economy towards a market-based, expenditure-driven economy, that is, to incentivise persons to spend rather than to save. Figuratively it can be put as a transformation from a Recurring Deposit-person to an Equated Monthly Instalment-person. There is a school of thought in economics that states that expenditure brings with it forward-and-backward linkages of economic activity that propel the economy.
The first step for this expenditure-driven economy was towards making the money, that is, finance, being made available to the players of the market at a reasonable rate. This was done by the stroke of the pen by slashing bank rates by about more than half for fixed deposits. It is strange but true that market forces were unleashed not by the market itself but by the government. Even the savings bank account rates were reduced to about 3 per cent. This move suddenly made the savings and fixed deposit accounts non-lucrative vis-a-vis the prevalent rate of inflation — keeping money in banks over a period of time would mean its value depreciating in real terms. It was thought that the cheap and easy finance now available to the private sector would give the private sector adequate funds to kickstart the economy. The savings and fixed deposit accounts were no longer lucrative. Incentives were given to channel the available money towards the capital market by way of incentivising investments in equity and share capital. During that time, many private enterprises came out with IPOs or offers of investment in the capital markets promising huge returns that lured people to give them their savings. The money that goes to the equity market is available to the company at face value. There is an assurance to the investor of an uncertain but higher rate of return in future in the shape of dividends. Also if the company does well, the value of the share appreciates in the secondary market.
Here again it could be seen that the money that came to be used by the big business houses was again being offered by the same middle class that was earlier being used by the government by offering them high interest rates. Our middle class that does not have any social security buffer is on a constant and eternal search for some succour towards its latter stage of life. This time the hope had come from very tempting returns from investment in capital markets, from IPOs, as well as secondary markets. But this phase of transition from a savings-driven economy to an expenditure-driven economy had its own share of victims, who were largely pensioners. Many pensioners who retired in the late-1980s had planned their retirement life and their medical expenditures based on their pension coupled with interest earned from fixed deposits. However, suddenly one day in 1993, these savings were slashed remorselessly by more than a half. That upset their retirement plans and they were virtually in the doldrums. The avenues that were offered in lieu of bank accounts were mostly share markets and IPOs that were beyond the comprehension of these senior citizens who had mostly spent their lives without any exposure to market forces. And wherever they tried to venture out to capitalise on the market forces by investing in share markets and IPOs they had burnt their fingers in the various scams that have hit our share markets. Many a time, it is infested with insider-trading. Most of the small investors are eventually the losers and the bigger fish swell by devouring the smaller ones. Whether any of the victims of these share-related scams that ran into thousands of crores of rupees have got their money back is anybody's guess.
The rules and regulations of providing loans and extending capital were eased — meaning easy availability of credit, less strict underwriting and easier monitoring. And with funding costs already reduced by lowering the interest rate, there were business houses making a beeline for availing the opportunity. The banking industry in India has been a monopoly of public sector banks, and with the prodding of the government and different schemes unveiled, a large amount of funds could be made available to private players for investment in all aspects of the economy ranging from small retail businesses to industrial giants, infrastructure projects to big software companies. In a way, to give due credit to liberalisation, the software industry is a consequence of these policies. However, with reports emerging from banking sources regarding increasing non-performing assets (NPAs) that are nothing but bad loans, the same story of non-retrieval of money is perhaps repeated in the manner the public sector faltered earlier.
After nearly about two decades of liberalisation when the time has come to pay back the money even some prominent private players are found faltering before the financial institutions. As a consequence, most of the public sector banks have huge NPAs, that is, loans that are not being recovered. The extent of these NPAs at the national level stands at Rs.5.91 trillion, which constitutes around 10.2 per cent of the total loans given (Source: Reserve Bank of India, March 2013). When this kind of money stands locked and out of the system, again the burden of completing the money cycle falls upon the government by supporting the public sector banks. Otherwise the base of the economy gets eroded. The government tries to do this by (a) re-capitalising the banks, (b) taking loans from foreign institutions, (c) allowing foreign direct investments, (d) raising tax rates or imposing more taxes. Till now the government was trying to bridge this gap by again printing money, increasing the number of indirect taxes, thus again giving rise to inflation. Mostly the middle class and the poorer sections of society take the hit.
On the other hand, you have much-feted big business tycoons who created their empires out of these loans and fled when it was time to pay back. And banks to their surprise found that their assets were not enough to clear the loans. The history of debt recovery from private enterprises is replete with all kinds of scams. There are many cases of bank officials colluding with private companies and extending dubious loans against over-invoiced machinery or over-priced property. The borrower goes incognito after repaying a few instalments, and banks end up with dud assets.
The other impact was that many of these loans were invested in real estate and properties where the rate of appreciation is substantially higher than normal inflation. With more money chasing less property the rates of property soared and the middle class ended up as borrowers entrapped in the EMI net. The builders then made money or ran away (there being no safeguards for the customer). Builders having links with big business, politicians and bureaucrats remain out of reach. This way, even by not doing anything, these builders and business houses have multiplied their money and been able to beat the inflationary pressure. The middle class, which has either invested in the shares of these enterprises or whose funds have been channelled to these businesses through banks have borne the brunt of the inflation. If we see the real interest rate in this transaction (the rate of interest an investor, saver or lender receives or expects to receive after allowing for inflation) it will be observed that the big business houses have, in fact, availed money at negative interest. Meanwhile, the middle class has lost money because their interest income is lesser than the inflation rate.
None other than the former RBI Governor, Raghuram Rajan, remarked on this situation: “We had gotten used to decades of moderate-to-high inflation, with industrialists and governments paying negative real interest rates and the burden of hidden inflation tax falling on the middle-class saver and the poor.”
Coming to the current situation it can be seen that government spending has drastically come down (more by the concerns of fiscal deficit) and the private sector because of its risk aversion is not keen to invest without any guarantees. Thus lack of investment has led to slackening of demand, and that can impact the GDP growth rate. Now the other alternative on the horizon is foreign direct investment. It is thought that FDI would bring in substantial investment and in its wake create job opportunities and kick-start the economy for a sustained period with benefits accruing to all sectors of the economy. But that may have a longer gestation period. Therefore, in that context again the chance of redemption is given to the middle class, this time in the shape of a pay hike again, with incentive to spend. This money will directly enter the market and speed up the economy. The government is banking on the forward and backward linkages that the circulation of this money would create and bring cheer to the economy. Let us hope it does.
This track record of using the middle class by incentivising them either to save or to spend has after seven decades of independence started giving them an eerie feeling. “Are we being tricked to part with our hard-earned money?" Or, "Do we create our own parasitic monsters?" Or, "Are these devious designs and mechanisms, euphemistically meant for the larger public good, really so?" Or, "Is the situation one of our giving them money to create jobs and then beg for employment from them?"
It is better that the market forces succeed this time and deliver; otherwise no one can stop cynical thinking taking over. That can be dangerous for not only the economy but also for society at large.
(The author, an officer of the Indian Revenue Service, is a Commissioner of Income Tax.)
