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Crowding Out Effect ~ India’s Present Situation.

crowding out effect, infoclusters.com
Reading time: 6 min

CROWDING OUT EFFECT:

The crowding out effect is an economic theory arguing that rising public sector spending drives down or even eliminates private sector spending. The increase in public spending or government spending results into decrease in private spending because of following reasons:

  • Government spends money by borrowing it from Banks. Larger the borrowing, lower the stock at bank. Thus, the Interest rate is increased. So, the private sector stop investing or spending by borrowing loan from banks because of higher interest rate and tough competition with public sector spending.
  • When governments raise taxes in order to introduce or expand welfare programs, individuals and businesses are left with less discretionary income, which can reduce charitable contributions. In this respect, public sector expenditures for social welfare can reduce private sector giving for social welfare, offsetting the government’s spending on those same causes.
  • Another form of crowding out can occur because of government-funded infrastructure development projects, which can discourage private enterprise from taking place in the same area of the market by making it undesirable or even unprofitable. This often occurs with bridges and other roads, as government-funded development discourages companies from building toll roads or from engaging in other similar projects.

Example of the Crowding Out Effect

  • Suppose a firm has been planning a capital project that with an estimated cost of $5 million and a return of $6 million, assuming the interest rate on its loans remains 3%. The firm anticipates earning $1 million in net income. Due to the shaky state of the economy, however, the government announces a stimulus package that will help businesses in need but will also raise the interest rate on the firm’s new loans to 4%.
  • Because the interest rate the firm had factored into its accounting has increased by 33.3%, its profit model shifts wildly and the firm estimates that it will now need to spend $5.75 million on the project in order to make the same $6 million in returns. Its projected earnings have now dropped by 75% to $250,000, so the company decides that it would be better off pursuing other options

Short term and Long-term Effect due to Crowding Effect:

A recent study, however, shows that crowding out effect is usually short-term and there is crowding-in and an increase in private investment in the long run if public investment is increased in infrastructure, with lesser allocation to non-infrastructure segments such as industrial and commercial activities that directly compete with private enterprises.

The analysis, by Jagannath Mallick of State Bank Institute of Leadership, is based on annual investment data from FY1961 to FY2018.

pubic private investment, infoclusters.com

Using quarterly data in the post-reform years (1991 onwards), the study shows that increasing overall public investment (both infrastructure and non-infrastructure) also has a negative effect on private investment in the short run. Such negative effect turns to be positive in the medium term. The main explanation is that a rise in public investment raises government expenditure which drives the fiscal deficit, which is mainly financed by domestic borrowing from private sector.

 

Government Expenditure (Infrastructure only, Union Budget 2019-20)

  • Ministry of Railways have been allocated Rs 94,071 crore (US$ 14.11 billion) in 2019-20.
  • The government has suggested the investment of Rs 5,000,000 crore (US$ 750 billion) for railways infrastructure between 2018-2030.
  • Metro rail network has reached to 657 Km.
  • Operating ratio improved by 95 per cent in 2019-20.
  • Government has announced to invest Rs 10,000,000 crore (US$ 1.5 trillion) in infrastructure over the next five years
  • To upgrade 1,25,000 kms of road length over the next five years, the estimated cost of Rs 80,250 crore (US$ 12.03 billion) is envisaged under Pradhan Mantri Gram Sadak Yojana-III (PMGSY)
  • 30,000 kms of PMGSY roads have been built using Green Technology, Waste Plastic and Cold Mix Technology.

Excess spending of government in Infrastructure is one of the reasons for crowding out effect. Increase in public sector spending affect the private sector in short as well as in long turn. But the short-term are more disastrous to the private sector. Like, the above spending of government in Infrastructure would need a lot of money that the government will borrow from banks results into two consequences:

  • Fiscal Deficit :

India’s fiscal deficit in the first 10 months through January stood at Rs 9.85 lakh crore ($137.05 billion), or 128.5% of the revised budgeted target for the current fiscal year. It is an increase from Rs 7.70 lakh crore in the same period in the previous financial year.

This much fiscal deficit would decrease the FDI in the country as well as domestic private investment because the latter would not get money from the banks as government had already borrowed much money, and the earlier invests in any country where the fiscal deficit is low and economy is stable.

  • Shortage of Opportunities:

The Government spend large amount of money in any sector like above in Ministry of Railway alone it has allocated Rs 94,071 crore. Any private investor would not be able to compete with this much public investment and this would seem as an unprofitable investment for private investors.

Current Situation of India

After various economic policies implemented by Government of India like, Demonetisation, GST, the economy of India has slowed down to half of its before these policies. There are a lot of pressure on government to revive the economy via any means. Other Private sectors are also suffering because of these policies, as a result, the private sectors like Automobile Industry, IT industry are facing slowdown and hence unemployment is high, and economy is unstable.

Thus, to revive the economy of India, Government of India has started investing in large amount in many sectors, one of these i.e. Railways is mentioned above. The Public spending is increased many folds to revive the economy that there is a possibility of Crowding out Effect in the country. No Official institution like RBI have come up with any comment on this effect. This is because there is a low possibility for this effect to affect the economy of India because of following reasons :

  • Government has invested a large amount of money in Infrastructure like Railways, but also providing private partners to support the investment by allowing the latter to invest in Railways i.e. some kind of Railway Privatisation is in progress in India.
  • Government is spending more on roads construction, this would help the private sector in long turn. As, the road is connecting every part of the country, this would help the industries like Automobile to grow in higher rate.
  • The New tax table which was presented in Union budget 2019-20, has provided relaxation to the taxpayer. Thus, it would help the government to get the maximum tax and thus it would not need to borrow money from banks in long run.
  • Most part of the budget of India is spend on Revenue expenditure than Capital expenditure. This would help the private sector to re-emerge in short span of time.
  • Government has provided various relaxation to Banks as well to provide loans to investors. This include, Banks can now give the security money as a loan to its customer which were earlier submitted to RBI as a Security Money.
  • To borrow the money, Government is selling its public assets than taking more from banks. This would be beneficial for private sector as the rate would not increase.

Due to COVID-19, the economy has fallen to 30 year low after LPG(Liberalization, Privatisation, Globalization). In response, Government will spend more again to revive the economy. So, this double attack would harm the private sector and Crowding Effect may occur. This could be understanding through various points:

  • Presently, all the public and private sector are closed in fear of COVID-19, so all are facing double loss, as there are no work and they must pay their employee as well.
  • Various economic policies and then COVID-19 has shut many factories and industries. This would again force the government to spend the maximum, which could result into CROWDING OUT EFFECT.
  • The PMC scan, HDFC scan and IL&FC scan has forced the banks to take precaution while giving loan, this results into low borrower from banks, as a result less spending by private sectors.

Written by Vivek Kumar

Hello! I am Vivek Kumar, a Computer Science Engineer.

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