In corona fight, mind the debt
The coronavirus pandemic is an exceptional, extraordinary shock, a time that calls for fiscal intervention; directly targeted, such measures are most effective due to propinquity to demand. But, as per FRBM law, there is no space—the escape clause allowing an extra 0.5% of GDP deficit expansion in extreme situations was used up just one month ago. Stretching public balances further is risky given inflation-growth dynamics, and the debt build-up. Normally, a favourable interest rate-growth dynamics overcomes concerns about India’s high level of general government debt. But now, there is reason to worry: The positive dynamics is not giving as much advantage, and the support from inflation is eroding. History advocates caution, which a prudent policy eye would do well to exercise at this point—it may be wiser to create fiscal capacity from budgeted current spending than stretch and stress some more.
Consider the evolving debt profile in the six years from FY15. Growth and inflation averaged 7% and 4.5%, respectively, while the consolidated debt-GDP has risen at least 4.4 percentage points (see graphic). This may not be unduly alarming. However, the eroding support of inflation, and lowered recourse to financial repression suggest that the rising tide of public debt could be difficult to reverse even if growth recovered strongly ahead. The altered dynamics could compel a sharper fiscal compression sooner than later, in order to contain the risk. This would be unfortunate if growth continues to decelerate—a possibility that cannot be brushed aside in the post-coronavirus reality of a world recession.
High inflation and/or growth have historically facilitated public debt reduction (see graphic). In the 1990s, an average 10% inflation and 5.5% GDP growth was matched by a fall in total debt-GDP ratio from 73% to 64.5% (end of the period). This was followed by a cycle of debt accumulation in FY98-FY03, in which total debt-GDP reached 83% by the end while inflation and growth averaged 5.9% and 5.3%, respectively. The next seven years to FY11 saw a combination of high growth (average 8.3%, FY05 GDP series) and 6.3% rate of inflation, with a 17.6 percentage point reduction in debt-GDP ratio to 65.6%. There is little doubt that a lasting increase in the tax base and robust growth in revenues enabled fiscal consolidation during this time, with high inflation contributing as well in the last two years (average 10.7%).
The FY12-14 years stand out because of the negligible decline in debt-GDP, alongside high inflation and slower growth; debt stock levels would have been higher without inflation contribution since the Centre’s deficit alone averaged 5.1% of GDP, while the nominal interest rate-growth differential averaged (-)5.7 points. Despite these favourable dynamics, and debt-GDP averaging 67%, a course correction became inevitable, leading to reworking of the medium-term framework and consolidation plan (Kelkar committee report, September 2012).
In the current debt accumulation cycle, the unidirectional trend evolution of deficits and debt has overturned. From FY15, deficits are moderated but debt-GDP ratio has risen, with a flattering nominal interest rates-growth gap of average (-)3.4 percentage points. The reason for this is well-known: Large-scale public spending was executed off budget, notwithstanding robust growth and persistent oil-revenue bonus. Recent commentary by Subramanian & Felman (Understanding Budget Policy, Business Standard, February 28), and the IMF (Country Report No. 19/385, December 2019) highlight this trend at the Central level, the latter noting that fiscal deficits include flows only from the consolidated fund of India, while debt accumulates not just from deficits but also from liabilities posted in the Public Account, and the financial liabilities of state-owned/controlled entities repayable or serviced by the government.
It follows that if actual deficits exceed official deficits, so must primary deficits, which matter for future debt accumulation as increasing revenue expenditure does not enhance future repayment capacity. Officially disclosed extra-budgetary borrowings from the FY20 budget onwards indicate that outstanding central government liabilities grew faster than nominal GDP in FY19. Probably, though, the growth in actual liabilities’ has outpaced that in nominal GDP continuously from FY18, as the IMF’s debt impact assessment including public sector borrowings estimates this around 1.6% of GDP in FY19, up from 1.2% and 0.6% of GDP in FY18 and FY17, respectively.
Enlarged market borrowings are relevant from a macroeconomic standpoint, i.e., the interest rate-growth differential, because of the crowding-out impact. Bond yields remained elevated in the last few years, insignificantly different from FY11 for example, when inflation was three times higher! Government borrowing cost averaged 7.45% in the period from FY16 to FY19, underlining how interest rates have not fallen proportionate to inflation. Therefore, even favourable interest rate-growth dynamics has not given the advantage that it should have, apart from erosion of inflation support. On average, a quarter percentage of fresh borrowings has gone towards debt-servicing, compared to 15% in the fiscally distressed years of FY12-14; fresh borrowings for repayment of past debt were 27% in FY20.
The deterioration in debt stock position makes it clear that the revised FRBM recommended medium-term ceiling of attaining a general government debt-GDP of 60% by 2023 (40% for Centre, 20% for states) will be unmet. Rather, it has undermined credibility points to further postponement, or revision of debt targets. Should the 60% cap be retained, but shifted further out, it is questionable that a positive debt dynamics of, say, (-)4 percentage points in the next few years, can significantly reduce the stock of debt, or even restrict its further rise without substantial expenditure cutting, and raising of the revenue base and its growth rate.
Expecting a nominal GDP growth above 11% (average 7% GDP growth and 4% inflation) is highly unrealistic. More likely, the nominal GDP growth will be slower, given the marked weakening of domestic and external contexts, unless an inflation surprise upsets the current configuration—historically, deficit expansion, and accompanying debt build-up have been a prelude to inflationary pressures. On the other hand, a setting of weak or falling growth does favour political will or desire for sharp cuts in spending, where the welfare component has risen above pre-2014 subsidy commitments, and spilled beyond budgetary financing.
Subramanian & Felman assess that spending on new welfare schemes ranged Rs 1.5-2.5 lakh crore, or around 1% of GDP in FY20.
Of course, there is nothing sacrosanct about a 60% general government debt-GDP target—typically the debt tolerance threshold for emerging market economies (EMEs) of rating agencies that become uncomfortable if growth prospects dim. For all we know, in a world environment in which policy rules are bypassed or reinvented for the sake of growth, there may not be much cause for alarm—fiscal interventions through further expansion may be acceptable. The question is if this applies to EMEs.
Given the potential risks, the sensible option for funding targeted hand-outs to virus-affected segments would be to redirect budgeted expenditures for welfare schemes and subsidies, supplemented with revenue gains from cheaper oil, in case the government doesn’t intend to lower fuel taxes to support real incomes and margins. Incidentally, research studies find that high debt has a negative effect upon growth; this association is seen in India too, although causality is an empirical matter.
The author is Author is a New Delhi based macroeconomist. Views are personal