Ahead of Budget 1999 — the one marking the change from the colonial-era timing of 5 pm — Finance Secretary Vijay Kelkar met with RBI Governor Bimal Jalan to discuss ideas that could be incorporated in the document. For the Vajpayee government, the economic challenges were huge. Just a year earlier, the Pokhran tests had been conducted, triggering limited sanctions from advanced countries. Overseas borrowings, too, were difficult to access for a while, given the continuing overhang of the East Asian currency crisis. There was a growth slowdown, accompanied by public sector banks piling up huge bad loans.
Kelkar and Jalan discussed lowering interest rates. But the central bank chief wanted a commitment from the government that it would generate a primary surplus — i.e. there would be no fiscal deficit after netting out the interest paid on its outstanding debt. The central bank also sought a reduction of government debt itself over a period of time.
With prime minister Vajpayee backing the proposal, the Budget for 1999-2000 presented by finance minister Yashwant Sinha signalled the start of a medium process of fiscal consolidation that would release resources for the government to undertake capital investments. At that point, unlike now, there was no explicit fiscal responsibility legislation capping the government’s fiscal and revenue deficits. Yet, the RBI governor then — just as Raghuram Rajan recently — had sent out a clear a message on fiscal prudence, which, he stressed, would have a bearing on both macroeconomic stability and overseas investor sentiment.
It helped that Sinha and his team were convinced about the RBI’s line of thinking. Unlike today, there was also a convergence of views that the key to reviving growth was reducing interest rates and the cost of borrowing. So, to signal the lowering of long-term interest rates, the government announced a cut in small savings rates, which had been kept unchanged at 12% for decades, by half a percentage point, as recommended by an expert committee headed by RBI deputy governor R V Gupta. And progressively over the next year or two, it slashed the rates by 2 percentage points. It was a politically difficult decision given the resistance from savers, especially the middle class that had warmed to the BJP. But the Vajpayee government decided to go ahead.
This was done to prompt banks to reduce their lending rates after they argued that high interest rates on small savings with tax incentives meant they had to keep deposit rates high to attract funds. Banks had to lower rates soon — as the RBI kept its part of the promise by announcing a reduction in the bank rate by 1 percentage point, and in the cash reserve ratio by 50 basis points, early in March that year. All that had an impact on the government’s books too, as the high interest rates paid on small savings schemes was a drag — considering that a bulk of these were going back to states that mobilised them. The prime lending rates were high — but by October that year, they fell to 13.5% and, over the next two years, as the government kept reducing small savings rates and the RBI its key policy rates, more liquidity was ensured.
A package for housing with tax incentives for buyers was announced, leading to a housing boom down the line, as interest rates started sliding. By raising the tax deduction amount on the interest paid on home loans, and with lower interest rates, the government was able to attract the middle class — whose numbers were growing — to invest in a home, in turn boosting demand in sectors such as construction, cement and steel.
The issue of pile-up of bad loans too was addressed in that Budget. With the second part of the report of the committee headed by M Narasimham, the former RBI governor, in hand, the government announced more debt recovery tribunals, strengthening of the law on recovery of debts owed to banks and financial institutions, and settlement advisory committees for banks. The sweetener for banks trying to clean up their balance sheets by setting aside capital against loans whose recovery was doubtful came in the form of tax incentives. The government allowed tax deductions of the provisions made by banks against debts whose recovery was considered doubtful, subject to a maximum of 5% of such debt per year. This encouraged banks to tackle the problem of bad loans. The process of restructuring of some of the weak state owned banks too started that year.
A package for the capital market in the form of tax incentives for equity mutual funds and India’s largest mutual fund, UTI, which was struggling — and based on the recommendations of a committee headed by Deepak Parekh — too proved to be useful.
As Finance Minister Arun Jaitley gets ready to present his Budget, there appear to be some parallels from then — the banking sector crisis, a slowdown at home and abroad, a similar dilemma on cutting interest rates on small savings schemes given political sensitivities and, whether to continue on the path of fiscal consolidation. That Budget signalled fiscal consolidation over the medium term along with booster measures that were accompanied by secular interest rate cuts by the RBI that appeared to plump for growth. The results showed in less than three years — a year before the Vajpayee government completed its term. We will have to wait for three weeks to see if the Modi government charts a similar course, even though there seems to be little convergence of views between the Finance Ministry and the RBI right now. The former wants lower interest rates along with flexible fiscal deficit targets; the latter does not favour either monetary or fiscal accommodation.