The stunning defeat of Prime Minister Vajpayee's National Democratic Alliance (NDA) government in India's recent general elections has opened the door to significant changes in the country's economic policy. Multilateral lenders, foreign analysts and investors universally believe that fiscal consolidation should be the centrepiece of economic policy changes implemented by India's new government headed by Prime Minister Manmohan Singh.
The call for fiscal consolidation is supported by the mistaken conviction that reduction of the fiscal deficit will accelerate long-term economic growth in India. As proven in Latin America over the past 15 years, fiscal consolidation in India will lead to slower economic growth and political and social instability.
If the Singh government hopes to quicken the pace of economic growth it must increase public sector investment and government subsidies. India should use, to the fullest advantage, the economic policy latitude it enjoys as a result of the very limited leverage multilateral lenders hold over the country.
The electoral drubbing dealt on the NDA government by the India National Congress (INC) and India's leftist political parties shocked both government cadres and outside observers. After all, India was enjoying the fruits of strong economic growth and booming asset markets.
That the incumbent should lose the elections under such positive circumstances was almost unthinkable. However, the electoral demise of the Vajpayee government was obvious to anyone acquainted with India's increasingly unstable social environment - a product of rising unemployment, declining wages and deteriorating social conditions.
India was not shining for millions of voters. These voters used their ballots to register their opposition to economic reforms first implemented in the early 1990's and modestly accelerated by the Vajpayee government.
These reforms, which included reduction of public sector investment and government subsidies, trade liberalization and accelerated privatization of public sector companies, benefited only a small proportion of India's population as well as foreign investors. For the bulk of the population these reforms were deleterious.
India's electorate has given the INC-led government, along with its leftist allies, a strong mandate for a revision of economic policy. Inherent to the electorate's expectations are greater government focus on social development through increased public sector investment and government subsidies.
In sharp contrast to the electorate, multilateral lenders, foreign analysts and investors expect changes in economic policy to include tighter fiscal policy implicit to which is further reduction of public sector investment, expenditure on subsidies and the continued decline of social development. In the face of irrefutable evidence to the contrary, these lenders, analysts and investors glibly believe that tight fiscal policy will lead to accelerated economic growth in India. Argentina and Brazil, which have long followed IMF-directed fiscal adjustment policies, provide excellent examples of the negative impact tight fiscal policy has on economic growth and social and political stability.
Over the past 15 years the IMF has conditioned credit for Argentina and Brazil on the maintenance of tight fiscal policy. The IMF assumed that tight fiscal policy would lead to steady decline of the debt burden in these countries, thus supporting accelerated economic growth and underpinning foreign and domestic investor confidence.
However, the outcome has been much different. Tight fiscal policy in both Argentina and Brazil undermined economic growth, leading to rapidly increasing debt burdens in both countries.
Between 1989 and 2003 the average annual rate of GDP growth was 2.9 percent and 2.3 percent in Argentina and Brazil, respectively. Over the same period, the ratio of public sector debt to GDP increased from 28 percent to 140 percent in Argentina and 26 percent to 91 percent in Brazil.
In addition to reducing economic growth and pushing the debt burden much higher, tight fiscal policy produced unprecedented political and social instability and the largest ever sovereign default in Argentina. The probability is high that Brazil will also be forced into default as continued economic weakness leads to further political and social instability, undermining investor confidence.
In comparison to Argentina and Brazil, fiscal policy has been easier in India over the past 15 years. Apart from a short period in the early 1990's following the country's balance of payments crisis, India has not been subject to IMF-directed fiscal adjustment policies.
India's endemically large fiscal deficit, which averaged 8.4 percent of GDP between 1990 and 2003, supported GDP growth, which averaged 5.6 percent annually over the same period. Despite the large fiscal deficit, the ratio of public sector debt to GDP has risen modestly from 60 percent in 1989 to 75 percent in 2003.
Strong economic growth, underpinned by easy fiscal policy, prevented Latin-style runaway buildup of public sector debt in India. Economic growth in India could have been even faster over the past 15 years if public sector investment had not been sharply reduced after the country's balance of payments crisis in 1991.
In that year, Finance Minister Manmohan Singh implemented fiscal reforms that included the reduction of public sector investment as well as rationalization of public sector employment - reductions and rationalizations that were deepened by the Vajpayee government.
The case for increased public sector investment in India is compelling. Between 1989 and 2003, capital outlays by the public sector have plummeted from 6 percent of GDP to 2.5 percent of GDP.
Coinciding with this decline in investment has been the reduction of government subsidies, particularly food subsidies. The consolidation of public sector investment and subsidy payments has had an enormous negative impact on rural India. This has encouraged rural-urban migration, overwhelming the capacity of urban public utilities.
In addition, the steady reduction of import tariffs has further contributed to deteriorating social conditions by subjecting both the agricultural and manufacturing sectors to imports that are often heavily subsidized in their home countries. Doubling the rate of public sector investment, targeting agricultural infrastructure in particular, would sharply increase long-term economic growth in India. Investment in agricultural infrastructure, as well as increased food subsidies, would benefit a very large portion of the population, promoting political and social stability.
Such an increase of investment and subsidies could be financed by a hike in import tariffs. Admittedly, this perspective is quite unconventional, but conventional methods of increasing economic growth, namely fiscal deficit reduction, have proven unworkable.
To avoid Latin-style political, social and economic instability, the Singh government should take advantage of the very limited leverage multilateral lenders and foreign investors have over India and act unconventionally.
Jephraim P. Gundzik is President of Condor Advisers, Inc. Condor Advisers provides emerging markets investment risk analysis to individuals and institutions globally. Please visit www.condoradvisers.com for further information.