While there is euphoria in government circles after the receipt of the IMF standby credit, let us remind ourselves that only sick countries go to the IMF and our sickness is not cured. The IMF money itself will not provide the cure but their recommendations, agreed to jointly, can help us get over our problems.

As for the private sector, it is hopeful but not confident. Ask any businessman how he is doing, whether his sales are expanding and profit margins improving and the likely response is that conditions are not yet satisfactory but improving very slowly. The Benchmark programme which refers to the survey of business confidence referred to the divided opinion among businessmen about the medium term extending to 6-12 months. Most agreed that the short term outlook is not satisfactory.

We as a nation are prone to euphoria. When the war ended in May everybody thought that foreign tourists and foreign investors would rush in. It has not happened yet although there are signs that tourism will improve next winter. On top of this comes the news that the Non-Performing Loans in the banks have increased from 5% to 9%. What does this mean? It indicates that borrowers are unable to repay the debt.

I was reminded of what Irving Fisher identified in the 1920s as a Debt Deflation condition. The essence of his theory is that debt-deflation was an interactive process whereby falling commodity prices increased the debt burden of borrowers. We have seen the fall in commodity prices but tea prices have improved dramatically. But rubber prices and our subsidiary export prices have still to improve. Internationally of course the prices of metals and minerals are climbing slowly upwards. But if we confine our attention to our economic condition, export prices are yet to improve. If the GSP Plus goes, then we have to cut costs accordingly trimming away that advantage from the cost of production. This must be done to retain market share.

The private sector economy grew in the past through apartment building and vehicle sales. Now there are unsold apartments and a large fleet of unsold vehicles paid for with bank borrowings. Despite the absence of falling prices in the domestic market today, a modified debt-deflation process seems to be on.

As the 1987 stock market crash demonstrated, the modern debt-deflation process encompasses falling asset prices, debt repayment difficulties, a reluctance to lend, a financial crisis, the impact on the banks, and the inter-dependency of the financial system. The accumulation of payments in arrears by the armed forces, government departments and state owned enterprises is playing a disastrous role in the process of deflation. They break the credit cycle and send small companies to the wall. Big companies also delay payments to their suppliers and cause financial difficulties to them. The least the government must do is to settle outstanding payments and allow credit flows to work more smoothly. Otherwise what happened in Russia under Yeltsin may happen here too.

Inflation comes down

Everybody is happy that inflation has come down. It has no doubt come down to 1% or so if we measure it point to point relative to the corresponding month last year. But the average inflation for the year is still around 8-9% while our export markets have negative inflation with prices coming down. Our competitor countries too have low average inflation below 5%. So if our export industries are to remain competitive then our average inflation will have to come down to 5% or below in the present word economic scenario.

Nominal interest rates down but real rates up

Businessmen ought to be happy that the nominal interest rates have come down.  The nominal AWPR which was around 18% is now down to 12 or 13%. But the private sector doesn’t seem to realize that what matters is not the nominal rate of interest but the real rate. With the fall in inflation rates the real rates of interest have actually gone up. They were negative by about 5% earlier but have now become zero. What this means is that the real interest rates have risen making it more difficult for companies to repay debts taken at negative real rates of interest.

Irving Fisher pointed out to this problem of borrowers facing difficulties in repaying debt when real rates of interest go up. It is easier to repay debt when there is inflation for then product prices can be pushed up. When there is "Debt Deflation" asset prices also fall while real interest rates rise. Businessmen who borrowed at high rates of nominal interest when business confidence was high find it difficult to repay debt when the real rates of interest go up. Since asset prices also fell we perhaps entered the debt deflation referred to by Irving Fisher. So we must hope for at least a rise in asset prices- particularly land.

The stock market has risen but there are still not enough signs that permanent investors are entering the market. It is more day traders and short term speculators. One hopes long term investors are not far behind for if stock prices rise the market value of the firm also rises enabling it to borrow cheaper. 

Sustainable economic growth does not come from inflationary finance and inflation. The recent inflow of foreign hedge funds to the government bond market indicates however that the foreign investors have more confidence in the sovereign backed securities. Of course they derive a good bargain by way of higher interest yields and if the rupee appreciates they  will undoubtedly make a killing. The cash strapped government will use the rupee proceeds to fund its ever increasing expenditure. It counters the pre-emption of credit by the government. But if and when the money is repatriated, the monetary over-hang will remain. I wonder if the Central bank will allow foreigners to invest in corporate debt securities although they may not be as attractive as the government bonds. If so the corporate sector may be able to borrow cheaper and this concession may be allowed at least for export industries and plantations.

Corrective action is necessary

But before that it is necessary to bear in mind the underlying fundamentals and see how the debt has arisen. We are probably one of the most debt ridden countries in the world in per capita terms. 

 The main recommendation of the IMF is the reduction in the fiscal deficit. For decades we have run budget deficits. There can be several definitions of budget deficits such as the structural budget deficit, the inflation adjusted budget deficit, the nominal budget deficit, the primary budget deficit, the budget deficit on current account and the overall budget deficit. Each definition has its uses for analysis.

The Primary Account of the Budget considers the over-all budget deficit without interest. If the level of debt is to be stabilized this account must have a balance. If t has a surplus then we can repay debt but if it is in deficit and continues to increase then our debt will keep on increasing. Our primary account deficit has kept on increasing each year. It was Rs 93 billion in 2007 and increased to 128 billion in 2008. The CB Annual Report puts it thus " the higher growth in the non-interest recurrent expenditure which outpaced the growth in revenue was the main reason for the higher primary deficit." In plain English what it means is that the government borrowed more money to fund ordinary expenditure (not development expenditure).  Is our debt too much?

Economists use a Debt Dependency ratio which is the measure of Net Borrowings to Total Government Expenditure. It was 33% in 2008. Since we have both foreign and domestic debt a single measure is not enough to determine the sustainability of debt. The CB has built up a large Foreign Reserve albeit from foreign lenders. Why is the CB keen to buy more dollars? It is to help the government to fund its budget deficit? But the money spent will increase the money supply and cause inflationary pressure sooner rather than later.

Why is it that the public are not much concerned about our high debt level? All borrowing of course is not harmful. If the borrowed money is used to increase capital expenditure and such expenditure provides a return which exceeds the cost of borrowing, then it would be justifiable, But in the case of foreign borrowings the capital expenditure must also increase our foreign exchange earnings to enable us to repay the foreign currency debt. But what is highly objectionable is the borrowings by the Treasury from the central bank and the banking system called money printing.

Belief in the money illusion

The public at large have learned to understand, and I am afraid a whole generation of economists in our universities has been teaching that mantra, that government has the power by increasing the quantity of money rapidly to relieve all kinds of economic evils, especially to reduce unemployment and increase economic growth. Unfortunately this is true only in the short run. The fact is that such expansions of the quantity of money which seems to have a short run beneficial effect, become in the long run the cause of a much greater unemployment and current account deficits in the balance of payments.