The government will have to ensure its spending improves economy-wide productivity, and its own revenue-generating capacity, to avoid a stagflationary trap
After dithering on a fiscal stimulus package for nearly a year, India’s finance minister Nirmala Sitharaman has declared that she will not allow the fiscal deficit number to worry her too much as she pushes spending to revive growth in the upcoming budget.
The government hopes that growth will generate higher tax revenues which will help meet its debt obligations in the coming years. Most economists say that the government does not have any other choice at the moment but caution that the borrowed funds need to be well-spent. Else, the stimulus would be wasted, growth would remain weak, and India could end up in a stagflationary trap. In such a scenario, burgeoning debt would weigh down Asia’s third largest economy amid weak growth and high inflation.
According to estimates prepared by the International Monetary Fund (IMF) in October, India’s public debt-to-GDP ratio has jumped to 89%, and would remain at similar levels till at least 2025, making India one of the most indebted countries among large emerging markets.
Most of India’s sovereign debt is owned domestically. That protects us from the risk of defaults and a full-blown sovereign debt crisis, which several developing economies could face in the coming months and years. Yet, the contagion from a global sovereign debt crisis could roil Indian markets, especially if India’s debt level remains elevated.
“In 2021-22, you don’t have a choice: the debt will balloon," said public finance expert and former Finance Commission member Govinda Rao. “Subsequently, when the economy gets back to normalcy, the big macroeconomic challenge will be to contain debt by containing the deficit."
Weak domestic demand, anaemic export growth, and subdued private investments mean that three of India’s growth engines are malfunctioning today. Government spending remains the last engine of hope for the economy.
The solution, as such, may not be to spend less but to spend wisely. As far back as in 2014, the finance ministry’s chief economic adviser, Arvind Subramanian had articulated the need for public investments to drive growth as the private capex cycle had already slowed down by then. However, the years since then have seen only a half-hearted effort at driving public investments, with most government spending directed towards current or revenue expenses.
This means that higher borrowing and spending over the past few years have added to public debt levels without raising growth or productivity significantly. More than the elevated fiscal deficit, it is the rise in revenue deficits (current receipts less current expenses) that worries experts, since it indicates that the government has borrowed to meet current expenses rather than to invest in the future.
Government spending failed to create future revenue streams and that finds reflection in the growing revenue deficit numbers, said Ananth Narayan, associate professor of finance at the SP Jain Institute of Management and Research.
The government should rejig its spending priorities in the upcoming budget to focus on productive investments, and indicate a glide path to bring down revenue deficits to zero over the next few years, wrote D. Subbarao, former governor of the Reserve Bank of India (RBI) in a recent Mint article.
To the extent that the government has tried to raise capex (capital expenditure) levels, the burden has been shifted to public sector undertakings, who have been compelled to resort to off-budget borrowings. This has helped the government report rosier deficit numbers but public sector agencies such as NHAI are reeling under debts.
It may not be possible for the government to continue to depend on weakened public sector outfits to drive the capex cycle in the country. Nor can the government lend much support to such enterprises, since the government itself is cash-strapped now.
Instead, it may make sense for the government to sell stakes in public sector units to garner budgetary resources and to drive productivity gains in such firms by bringing in private management. This would help limit public borrowing even while allowing the government to raise funding for public investments, wrote Sajjid Chinoy, India economist at J.P. Morgan and a member of the Economic Advisory Council to the Prime Minister (EAC-PM), in a note to clients last week.
So far, the RBI has accommodated the need for higher public borrowing at cheap rates by keeping the liquidity spigots open, and policy rates low. But such a stance may not be tenable for long, said Renu Kohli, a Delhi-based economist and former central banker. Once credit growth and demand picks up, excess liquidity will pose a much more serious threat to inflation and become harder to justify, she added. Already, inflation is hurting consumers (who have lost purchasing power) and savers (who face negative real interest rates on their savings).
Excess liquidity can also endanger financial stability. Faced with rising liquidity, banks are outbidding each other to offer loans at rates lower than bond market rates. This could lead to asset-liability mismatches and raise systemic risks if the liquidity taps aren’t tightened in time. That means RBI’s ability to facilitate ever-increasing public borrowings may be approaching its limits. On Friday, the RBI took baby-steps towards normalization but more such steps could follow.
The upshot: the Indian government needs to borrow carefully, sell aggressively, and invest wisely, if India has to get back to a sustainable growth trajectory.
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