Saturday, September 15, 2007

Pay commission could derail government finances

A fresh wave of fiscal profligacy threatens to undermine four years of hard-won improvements in Indian public finances.

The Sixth Pay Commission, set up last year to recalibrate the wages of 5.5 million federal government workers, is scheduled to submit its report in April 2008.

If the panel is anywhere near as generous as its predecessor 10 years ago --

the Fifth Pay Commission recommended a 31 percent increase in base salaries,

effective from 1996 -- the economy will pay a heavy price.


Such wage increases would crimp the Reserve Bank of India's ability to cut interest rates next year, should slowing global growth and rising risk aversion warrant monetary easing.

The ruling Congress Party's alliance with Marxist groups is in trouble over the latter's opposition to an India-U.S. civilian nuclear agreement, and many analysts expect Prime Minister Manmohan Singh to call for elections some time in 2008, one year ahead of schedule.

It's quite likely, therefore, that the budget in February will provide some "interim relief" as a sop to voters.

This may be a major reason why there won't be a quick reversal of the Indian central bank's hawkish monetary-policy stance even though credit growth is slowing, auto sales are falling and inflation is at a 16-month low of 3.8 percent.

The wage increases for federal employees will be matched by the 28 Indian state governments and municipalities, even though the latter two have limited scope to boost their own revenue.

Government-owned companies, too, will have to pay more. Some of them have already begun making provisions for a hefty increase in their wage bills.

The Bangalore-based Bharat Electronics, which makes electronic voting machines for the world's biggest democracy, took a hit on margin when it set aside an extra 13 percent of sales revenue for employee-related costs in the quarter ended June 30.

Steel Authority of India, the biggest state-run Indian steel maker, has made similar provisions for a couple of quarters now.

Within the government, everyone from aerospace scientists to railway engineers has made a case to the Pay Commission for higher remuneration and perks.

"It would not be surprising if the Sixth Pay Commission came out with an award that made the wage structure in government compatible with that of the private sector in order to enable government to attract and retain talent," two economists, Adarsh Kishore and A. Prasad, wrote in a recent study published by the International Monetary Fund.

That realignment should logically lead to wage cuts for clerks and chauffeurs, who are much better paid than they would be in the private sector. Of course, that would never happen. Pay will go up across the board for everyone.

The consolidated budget deficit of the national and state governments in India has narrowed to 6.1 percent of gross domestic product. That's a 3.5 percentage-point improvement from four years ago.

The target, according to a budget-management law that took effect in 2004, is for the deficit to be reduced to 6 percent by 2009. With tax collections booming, that target should be easily achievable. It will be a shame, therefore, if the Pay Commission spoils it all.

The last Pay Commission was responsible for pushing down overall government savings by 2.9 percentage points of GDP between 1996 and 2000.

That kind of slippage, were it to occur now, would leave the government authorities with an additional resource shortfall of about $30 billion. Much-needed public investments in infrastructure - roads, ports, airports, power stations, railways and urban amenities - will suffer.

And just like in the last round of pay increases, states will bleed more than the government in New Delhi.

"The Sixth Pay Commission award would most certainly create a pull effect on states, encouraging them to raise wages," said Kishore and Prasad. "This is bound to create additional stress on the financial position of states."

Given the acute need for investments in infrastructure, estimated at a staggering $475 billion over the next five years, the Indian government's priority should be to pare its budget deficit and improve its credit rating.

The ratio of public debt to GDP in India is about 0.8; and this doesn't include borrowings guaranteed by the government or accumulated losses of state electricity boards. Almost 27 percent of the government's revenue is spent on paying interest.

For more than nine years, Moody's Investors Service has left the local-currency rating of India unchanged at Ba2, two levels below investment grade.

If the Indian government had a better rating, it would be able to borrow rupee funds cheaply from a diversified group of global investors without having to rely on financial repression.

Indian banks would be more competitive if they didn't have to invest a quarter of their deposits in government bonds. That would, in turn, lower the cost of credit for companies, spur economic activity, create jobs and reduce poverty.

A more balanced budget is also a prerequisite for quicker progress toward dismantling capital controls. All of that is now at risk because of a probable wage increase for civil servants.