The Congress Party announced on January 28, 2019 that it would implement a programme of minimum income guarantee (MIG) for the poor people in India, if it comes to power at the Centre after the 2019 general elections. However, there is an important issue of financing the programme without violating the letter and spirit of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003.Former finance minister P. Chidambaram, who has been appointed chairman of the manifesto committee for the Congress for the 2019 general elections, has indicated that the cost of the programme is expected to be about 1.5% of the GDP. (This is not very different from the recent estimate of 1.3% of the GDP given by Josh Felman, Boban Paul, M.R. Sharan, and Arvind Subramanian.)At 2019-20 prices, 1.5% of the GDP adds up to Rs 2.82 lakh crore per year. Some proposals on raising taxes and/or reducing government expenditures have already been explored by economists like Vijay Joshi and there is considerable merit in these proposals. However, there may be a significant shortfall in funding. What more can be done?Congress president Rahul Gandhi announced his party’s minimum income guarantee programme recently. Credit: ReutersSome out of the box thinkingLet us consider the Reserve Bank of India (RBI). In the last few years, the Centre was interested in a transfer to itself of the retained and accumulated income of the RBI over many years in the past.The proposal in this column involves the RBI, but it is not about such a transfer at all; it is very different. I will explain this and then return to financing the MIG programme.The RBI holds foreign exchange reserves amounting to US$ 396.68 billion as on January 18, 2019. This is equivalent to Rs. 28.19 lakh crore. Do we need such large foreign exchange reserves? This author has elsewhere argued why this level of foreign exchange reserves is too large at this juncture. The gist of the argument is briefly as follows.The need for large foreign exchange reserves is contextual. There was indeed a need for large foreign exchange reserves when the fixed exchange rate regime was in place in India. However, India moved to the flexible exchange rate regime in the early 1990s. It is true that flexibility in exchange rates can quickly turn into high volatility, in which case there is a need for foreign exchange reserves again.Also Read: The Promise of UBI, Minimum Income Guarantee Is a Paradigm Shift in Economic PolicyHowever, this typically happens in the absence of fiscal restraint and/or inflation targeting. Now it is interesting that the FRBM Act came into being in 2003. More recently, India formally adopted inflation targeting in 2016. Finally, the Centre signed a bilateral currency swap agreement with Japan for US$ 75 billion in 2018 (previously, since 2013 India has had a credit line from Japan for a possible borrowing up to US$ 50 billion). So, there has been a sea change in the macroeconomic policy regime over time. But we continue to hold huge foreign exchange reserves.Now the currency market is not inherently volatile; it can become so if it operates within an inappropriate policy and institutional framework. It is interesting that such a framework has, as seen above, changed substantially over time. This is by and large enough to prevent a speculative attack on currency that can force the public authorities to accept a new long-term path of nominal exchange rate.The foreign exchange reserves held by the RBI is too large at this juncture. Credit: Reuters/Shailesh Andrade/File PhotoHowever, it may still not be adequate in preventing large fluctuations around a given path of nominal exchange rates; such fluctuations can be caused by usual international capital flows, which can get volatile at times. So, there is a need for one more policy, which has not yet been adopted by the Centre. If this too is adopted, we indeed have a strong case for substantially reducing foreign exchange reserves at this juncture.What exactly is the new additional policy required?At present, the cost of destabilisation caused by sudden and large international capital flows is borne by the economy unless the RBI intervenes by using its foreign exchange reserves. But the opportunity cost of holding large reserves is high, given that the real yield on such reserves is typically very low. It is interesting that the RBI has to bear the cost even though the desatabilisation is caused by foreign money.But what is the alternative?There is a need to declare ex-ante a policy of imposing a tax on sudden flows of international capital; the tax rate can be calibrated in the light of the extent of volatility in capital flows. This additional policy can lead to more smooth flows of capital. This idea is now acceptable even at the IMF. The theoretical rationale for this policy is that the sudden capital flows can cause negative pecuniary externalities, which need to be corrected by a Pigouvian tax. This obviates the need for large foreign exchange reserves – more so when India has the new combination of safeguards like flexible exchange rate regime, the FRBM Act, inflation targeting and currency swap agreement.Financing the programmeWe can now return to the main issue, which is financing the MIG programme. The policy suggestion here has two parts. First, the Centre adopts the proposed policy of imposing a tax on sudden and large capital flows. Second, the foreign exchange reserves may be reduced in a big way. This, as we will see, paves the way for financing the MIG programme.Strictly speaking, there is hardly any rationale for any foreign exchange reserves at all, given the existing safeguards (spelt out earlier) and the proposed additional policy of taxing capital flows to the extent that these are volatile.However, all said and done, many may feel more comfortable if a major shift in policy towards foreign exchange reserves is implemented in a phased manner. Accordingly, this column considers it advisable to reduce foreign exchange reserves by, say, half but only after the proposed new policy to impose a tax on volatile capital flows is in place already.Watch: Can Rahul Deliver His Promised Minimum Income Guarantee?Suppose that the amount of foreign exchange reserves (US$ 396.68 billion or Rs 28.19 lakh crore) is reduced by half. Then, US$ 198.34 billion or Rs 14.095 lakh crore can be invested as a sovereign wealth fund. This may be, in turn, invested in assets that have high expected returns. Such investments can be in the equity market and residential real estate. The long-term average real return on such assets is about 7%.Now there is a need to subtract the opportunity cost as funds are shifted from low yielding foreign exchange reserves to the market where the average real returns are much higher. An estimate for the opportunity cost is 0.98%, which is the historical long-term real yield on short-term bills. This implies that the additional average real return expected as a result of a shift from foreign exchange reserves to a sovereign wealth fund is 6.02%. This works out to an additional return of Rs 0.87389 (6.02% of 14.095) lakh crore per annum.This is about 31% of the annual requirement for funds needed for financing the MIG programme ( = 0.87389/2.82). This can go a long way in meeting any substantial shortfall in the funding requirement after a change in taxes and/or government expenditures have been considered for financing the MIG programme.Investments in the equity market and residential real estate have higher returns. Mumbai’s skyline. Vidur Malhotra/Flickr CC BY-SA 2.0Some observationsI would like to make a few observations to better understand what is involved in the calculations.First, the calculations are in real terms. So, adjustment for future inflation is already incorporated.Second, the figure of 7% real return on investments used earlier is based on data for 16 developed countries. If we consider investments in faster growing emerging market economies (EMEs), the expected returns for the proposed sovereign wealth fund are likely to be higher. So, the above estimates are conservative.Third, it is true that the higher expected returns come with volatility. However, this matters much less for a long-lived institution such as the government of India than it does for individual investors who have effectively a short horizon for investing.Fourth, the proposed financing of the MIG programme is conceived by increasing the return on assets and not by selling the assets. So, there is no sale of family silver involved here at all. If I allow for even a partial sale of assets (and this could be justified for various reasons), there is considerable scope for financing the MIG programme (and perhaps other schemes as well).Fifth, as GDP per capita rises over time in India, there will be, going forward, less and less need for a programme like MIG which is targeted at removing extreme poverty. In contrast, the calculation above assumed that the long-term return from the proposed sovereign wealth fund needs to be used forever to finance the MIG programme. This implies that the funding requirement is considerably exaggerated. Accordingly, calculations above for financing the MIG programme are very much on the conservative side.Concluding remarksThis column has considered only one possible new way of partially financing the funding requirements of the proposed MIG programme. But there can be other novel ways as well. There is, it appears, reason to believe that the proposed MIG programme can indeed be financed, given the willingness to take a holistic view of economic policy. It seems then that the main issue is political and administrative, not financial.Gurbachan Singh is visiting faculty, Indian Statistical Institute (Delhi Centre) and Ashoka University.
