Monetary policy and public debt

A new Reserve Bank of India governor is about to take charge. Newspaper reports deliberate upon the incumbent’s monetary policy stance with regard to inflation, by referring to various avian species—dove, hawk or owl. Yet, the underlying conundrum rests not in inflation targeting per se, but in the challenges to fiscal-monetary coordination posed by issues of financing public debt. Governor-designate Urjit Patel, with his views on the ‘fiscal dominance over monetary policy’ (See his 2010 paper Fiscal Rules in India: Are They Effective?) is well aware of the challenges to monetary policy implementation imposed by an unsustainable public debt.

To understand whether or not India’s public debt is sustainable, we need to understand the complex issue of debt sustainability. The sustainability of public debt can be assessed using several methodologies. The classic disposition by Evsey D. Domar (1994) stated two necessary conditions for public debt sustainability. One, nominal gross domestic product (GDP) growth rate should be greater than the growth rate of public debt. Two, the real rate of interest should be lower than the real rate of growth. The sufficient condition for such sustainability requires the generation of primary balance and primary revenue balance surpluses.

We (the authors) carried out a simple indicator analysis to assess public debt sustainability in the post-Fiscal Responsibility and Budget Management (FRBM) period (2003-15). We find that while the necessary conditions have been met, the current operation of the government reflected by the trends in primary deficit (PD) and primary revenue balance (PRB) clearly question debt sustainability. For example, during most of the FRBM period, primary deficit relative to GDP remained in the range of 0.37% to 2.7%. In addition, primary revenue surplus during the FRBM period has been substantially lower than the interest outgo from the budget. For example, during 2014-15, only 11% of the interest payments were financed by primary revenue surplus as against at least 100% financing required.

Further, the debt-dynamic wedge, (defined as real GDP growth – real interest rate – primary deficit relative to GDP, g-r-p), should be equal to zero for debt-to-GDP ratio to remain stable. The FRBM period has witnessed a non-zero debt dynamic wedge, rendering the debt–to-GDP ratio potentially unstable. Thus, it questions the sustainability of public debt, even though the conventional Domar conditions have been satisfied. A non-zero revenue deficit, absence/inadequate surplus in primary balance and negative/low real interest rates resulting out of high inflation have contributed to such a non-zero debt-dynamic wedge.

A 2014 International Monetary Fund (IMF) paper Debt and Growth: Is There a Magic Threshold? further indicates that the time-path of debt is a more important factor affecting growth than the absolute level of public debt. Specifically, countries with rising public debt ratios experience slower growth than those where it is falling—even if their absolute debt levels are already very high, perhaps on account of the greater vulnerability to economic stability posed by budget deficits.

The Fourteenth Finance Commission report, the economic survey, as also the IMF consider the general government (centre plus states) debt, while analysing public debt sustainability. Current IMF estimates of gross debt indicate that India’s debt-to-GDP ratio of 67.2% in 2015 is higher compared to all its emerging market peers, except Brazil. Moreover, such debt-to-GDP ratio has actually increased over the 2013-15 period.

The moot question in this context is monetary-fiscal coordination in the face of unsustainable public debt concerns. In particular, it is the financing of debt, rather than the level of debt, which raises greater concerns in such fiscal-monetary coordination.

FRBM 2003, with its borrowing rule prohibiting RBI’s subscription to government bonds in the primary auction with effect from 1 April 2006, has addressed to an extent the issue of fiscal dominance over monetary policy.

The FRBM Act, 2012, the successor framework to FRBM 2003, seeks to achieve the fiscal sustainability required for macroeconomic stability. However, as evidence suggests, the persistence of government cash surplus/deficit has led to serious liquidity management issues for RBI. Though it carries out periodic auctions of cash surplus, ineffective and inefficient cash management by the government hampers effective liquidity management by RBI.

An FRBM committee was set up in May to review the working of the FRBM Act. The committee will need to advise the government on the need to monitor the financing of fiscal deficit, thereby ensuring fiscal-monetary coordination.

The credibility of the monetary policy will rest on such monetary-fiscal coordination. Otherwise, in Urjit Patel’s own words, albeit in a different context, “…The markets become doubting Thomases, for whom seeing is believing”.

Tulsi Jayakumar and R.K Pattnaik are professors of economics at the S.P. Jain Institute of Management and Research, Mumbai.

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