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Economic recovery – A retrospective view

May 24, 2000

The finances of the government of India are in a mess. Using the old method of calculation, the fiscal deficit (in FY00) was as big as that recorded earlier in the decade when the country was grappling with a fiscal crisis. In fact, even on a consolidated basis (central and state governments), the deficit is close to the high recorded earlier this decade. However there still seems to be optimism in the air. We recently met with the Deputy Managing Director of one of India’s leading financial services companies to seek his views on this.

The problem for the Indian economy commenced in 1997 with the Southeast Asian crises. Then followed the Pokhran nuclear blasts. These factors coupled with the crash in stock and property prices had an adverse wealth effect on the Indian masses. Therefore, even as Indians on an average were earning more, they were unwilling to spend due to an erosion in the value of their assets. Money shifted from stock markets to banks (savings increased). Overall consumption slumped, pulling down the entire economy.

The turning point was the budget for FY00 (presented in February 1999). The government took two major steps – hiking the tax benefit for investors in housing property from Rs 30,000 to Rs 75,000 and introducing tax incentives for investing in equity mutual funds.

The first of these measures resulted in a tremendous saving for the retail investor, as a tax benefit had the effect of an increase in his post tax income (also contributing to this were the lower tax rates introduced in 1997, which raised level of savings). This among other factors contributed to the rise in demand for housing, which in turn led to a rise in demand for cement and steel among others. This got the wheels of the economy turning again. It could rightly be said that this triggered the economic recovery.

The second measure contributed in no small measure to a change in sentiment on the domestic bourses. This created a wealth effect (this time a positive one) and consumers were once again spending. The recovery was on.

The reasoning was impeccable. The recovery would itself take care of the fiscal situation of the government, as tax collections would rise (if of course the government took measures to control its expenditure).

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