India’s growth rate has slowed from over 9% to a little over 7% in recent years. So, many economists are inclined towards increasing public spending and missing the fiscal targets previously set (the expansionary view). However, Reserve Bank of India (RBI) governor Raghuram Rajan has come out forcefully against relaxing fiscal targets (the prudential view). I focus on the prudential view and go beyond what Rajan said.
The expansionary view presumes that a fall in the growth rate is a macroeconomic problem. However, this is not obvious. It is possible that the rise in growth rate some years ago was an unusual deviation from trend, in which case there is no need for any macroeconomic policy to address the subsequent fall in growth rate. Of course, if we aspire to a higher growth rate, there is need for suitable policies—but then we should treat it as a developmental rather than macroeconomic issue. Having said this, let me proceed as if the expansionary view is correct in treating the slowdown as a macroeconomic problem. Even then, is a larger fiscal deficit the answer?
As a percentage of gross domestic product (GDP), the budget estimates for fiscal deficit and public debt for 2015-16 are 3.9% and 46.1%, respectively. While these numbers are not large for a developed country, they can be for an emerging economy like India. To see the impact, consider the debt-revenue ratio—a measure suggested by Kenneth Rogoff and Carmen Reinhart in their book, This Time Is Different: Eight Centuries of Financial Folly.
This ratio is much higher in India than in a developed country even if both have the same debt-GDP ratio. This is because the revenue-GDP ratio is much higher in developed countries than in a country like India.
What really matters for the possibility of a fiscal crisis is the debt-taxes ratio, not the debt-GDP ratio. The ability of a government to repay debt or provide confidence in rolling it over depends on taxes and not GDP as most of the latter accrues to the public and not to the government.
Budget estimates for the government of India’s total revenue receipts for 2015-16 are Rs.11.4 trillion. Public debt for the government at end-December 2014 was Rs.50.54 trillion. So, broadly speaking, debt is 443% of revenue. To put this in context, consider a developed country like Denmark. Its debt is 45% of GDP and 93% of revenue. In 2015, the tax-GDP ratio for Denmark stood at 49% versus 17.7% for India (for the centre and states combined, for comparability with data for Denmark). This suggests a grim fiscal situation in India. Also, the total interest payments as a percentage of the government’s revenue receipts for 2015-16 are a staggering 40%.
It can be argued that RBI can always issue more money and use it to redeem public debt, in which case there would be no fiscal crisis. Two observations are in order here. First, though this route has worked in the past, there will be increasing difficulty in the future given the adoption of the new inflation-targeting regime by RBI and the government, under which the amount of money that can be issued is constrained by the inflation target. Hence, RBI may not be in a position to buy government bonds on a large scale and a fiscal crisis cannot be ruled out—the way it could have been until very recently.
Second, even if it is decided to suspend inflation targeting for a while to avoid a fiscal crisis, the purchase of government bonds by RBI will only help avoid a default in nominal terms. A default in real terms is not avoided, given higher inflation due to the excess money issued, under Indian conditions. High inflation could hurt badly.
The typical buyers of government bonds are commercial banks and financial institutions such as the Life Insurance Corporation of India (LIC). Given the statutory liquidity ratio (SLR) regulation imposed on commercial banks at 21.5% of demand and time liabilities and the nature of institutions like LIC, there is effectively a captive market for government bonds at “reasonable” rates of interest. Hence, a fiscal crisis can be ruled out. But wait a moment.
If banks and other financial institutions need to invest more in government bonds, there are fewer funds available for industry. This financial repression hurts the economy. People use banking less than they would have otherwise. This is a deadweight loss due to financial repression. Financial repression is persistent and so the costs are spread out over a long period of time. Hence, the accumulated costs can be significant.
We have not had a fiscal crisis since Independence despite somewhat large fiscal deficits for a long time. However, we have had persistent financial repression, and high inflation every now and then. That is not a coincidence. So, a “crisis” of a different kind has been happening for a long time. The ongoing cost and the long-term dent in growth have not always been considered by policymakers in the past. These need to be remembered—more so now that RBI and the government have accepted inflation targeting. We need to reduce, if not remove, financial repression. This will require a (possibly gradual) reduction in fiscal deficits over time—and not an expansion.
Gurbachan Singh is an independent economist and adjunct faculty, Indian Statistical Institute.
Published with permission from Ideas for India, an economics and policy portal.
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