Mumbai: A mountain of government borrowing has the potential to eventually hurt economic growth and spark off high inflation.
Economists Carmen Reinhart and Kenneth Rogoff have shown in a paper published in January that countries with public debt higher than 90% of the gross domestic product (GDP) tend to see their growth slow in the long run.
India is one of the countries dangerously close to that threshold, though it is far lower than most rich countries whose public debt is now almost equal to the value of their annual economic output.
Yet, the risks are clear. Reinhart and Rogoff estimate that an emerging market economy with high public debt should see growth at around 3 percentage points lower than similar countries with debt of less than one-third of their GDP. Inflation in high-debt emerging economies will be twice as high as in their low-debt peers.
Graphic: Ahmed Raza Khan/Mint
Public debt is what a government needs to borrow to fund its fiscal deficit. Chronic deficits inevitably lead to a growing debt burden that can be reduced either through future tax increases or by engineering an episode of high inflation to reduce the real value of a country’s public debt. Both entail costs to future generations.
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India’s public debt as a proportion of its economy has climbed since 1980, as the chart shows. Public debt here is defined as the domestic and external liabilities of the Central and state governments.
There are several issues to watch. The most immediate question is whether the debt is sustainable. The usual thumb rule is that a country can avoid a debt trap as long as its nominal economic growth is higher than the nominal interest rates. This is broadly akin to asking whether a company earns more than the cost of borrowing to create an asset.
The second issue is whether government borrowing will elbow out private borrowers. A lot depends on the state of the economy. There are times when private demand for funds is weak because of a downturn and government borrowing can sail through. That was the story in 2009.
But there are also times when the private demand for funds perks up and then the rush to collect money pushes up interest rates. That could be the story in 2010, unless finance minister Pranab Mukherjee pushes through a viable programme to cut the fiscal deficit and the government’s borrowing.
The third issue is to figure out the level of debt that is sustainable in the long run. Two economists from the International Monetary Fund estimated in a January working paper for the multilateral lender that a debt-GDP ratio of 60-65% by 2015-16 might be suitable for India.
Petia Topalova and Dan Nyberg argue that such a cut in public debt will send a strong signal to investors that the government is committed to improving public finances and provide room for it to push up public spending during a slowdown.
That last point is important. The one big reason why China could go in for a massive fiscal stimulus in 2009 was that its public debt-GDP ratio was a mere 20%, giving its ample headroom to support domestic demand even as India was held back by a far higher level of public debt.