India should worry about its public debt

Why should Indian policymakers worry about rising public debt? Does excessive debt lower economic growth? Does high public debt lead to more uncertainty and volatility in the economy which then leads to capital outflows and a depreciation of the currency?

These questions have become especially pertinent in emerging market economies in a post-covid world that lack the fiscal space for large stimuli. Such governments are worried about the economic repercussions from a debt overhang that a large fiscal stimulus will entail.

In a 2020 paper, economists Larry Summers and Jason Furman argue that the pandemic has depressed real interest rates despite ballooning government debts in the industrial world. They argue that very low interest rates provide a window of opportunity to depart from Washington consensus-style debt orthodoxy. Lower interest rates mean countries are less constrained by fiscal space. Large fiscal expansions can thus improve fiscal sustainability by raising GDP more than they raise debt and interest payments.

The numbers certainly seem to support this. Despite a ballooning US federal debt/GDP ratio from below 50% in 2000 to about 100% in 2020, federal interest payments in the US as a percentage of GDP in the last 10 years have hovered between 1% and 2%. Summers and Furman suggest that a new (rough) guidepost for fiscal policy should be to keep real interest payments less than 2% of GDP.

Some economists, like Olivier Blanchard, refer to this as the “new fiscal consensus", i.e., the notion that in a world of low interest rates, advanced economies can run limited primary deficits and still keep their public debt stable.

Should India adopt this “new fiscal consensus"? We argue that it shouldn’t. Just because interest rates are falling, this does not mean that debt servicing costs are going down due to rising debt. We also find that high levels of public debt in India have historically been associated with fiscal dominance, and more uncertainty and volatility in the economy. Therefore, there are good reasons for India to worry about its public debt.

Debt decomposition

In recent research, described in two pieces in Business Standard, we analyse the components that drove the changes in public debt in India between 1951-2018 using a debt-decomposition exercise.

There are four components that change the debt-GDP ratio: the nominal interest rate, inflation, the real GDP growth rate and a primary deficit/surplus. The interest rate and primary deficit raise debt, while inflation, the primary surplus and real GDP growth reduce debt.

When a rise in inflation reduces public debt, economists typically call this debt liquidation by inflation. Debt can also be liquidated by high real GDP growth, as it did between 2003-08 in our high-growth years, and economists usually see this as a better way to reduce public debt.

Using the debt decomposition exercise on aggregate data between 1951 and 2018, we find that inflation’s negative contribution (liquidation) of public debt was larger than the negative contribution exerted by real GDP growth except for the single sub-period, 1999-2008. Overall, we find that inflation is the dominant component in reducing India’s public debt, although the inflation component has begun to diminish after the de facto adoption of flexible inflation targeting (FIT) in India in 2014.

In Chart 1, we also plot the interest rate component between 1960-2018 calculated from the debt decomposition exercise. The interest rate component here is only based on an effective interest rate, since for historical aggregate public debt data, it is hard to back out the interest rate pertaining to a security for a particular maturity. However, we have granular security-level data only from 2000 onwards that allows us to explicitly calculate an interest rate.

Since 2006, the interest rate component, helped by the enactment of the Fiscal Responsibility and Budgetary Management Act, exhibits a marked decline. This is encouraging. Post 2014, the falling interest rate component is also driven by better inflation management due to FIT.

That said, in magnitude, the interest rate component continues to be high in the post-reform (post 1991) period, averaging close to 15% between 1990-2018. During 2008-18, it is close to 12% (i.e., of the 5% increase in India’s public debt between 2008 and 2018, around 12%, is due to a single factor, the nominal interest rate).

This is worrisome since a large interest rate component means fewer resources for important development goals such as health, education and infrastructure.

Remember that the granular security level data for the Centre and states (sourced from the Reserve Bank of India State Finances and the status papers from the finance ministry) allows us to paint a much more accurate picture of the interest rate component’s contribution to changes in public debt. The maturity structure of public debt allows us to calculate an explicit interest rate that is not possible with aggregate data. This takes care of measurement error in the data and helps in lowering the residuals substantially.

Chart 2 plots the nominal weighted average interest rate for all outstanding central securities from 2000 onwards based on hundreds of securities that we have data for. For all outstanding central securities, the weighted average nominal return continues to be high and has averaged around 7% in the last five years.

Chart 3 does the same for all outstanding state securities (SDLs) from 2005. For all outstanding state-level securities, the weighted nominal return is around 5% in the last five years. Coupled with rising debt, this calls for caution.

The link to volatility

We argued earlier that we find that inflation is the dominant component in reducing India’s public debt historically. We now ask: Does debt liquidation by inflation in India historically lead to more volatility and uncertainty in the economy? And if India’s adoption of FIT de facto in 2014 reduced the extent of debt liquidation by inflation, would this imply that uncertainty and volatility in the economy had fallen?

We focus on three variables that could be distorted by inflation-induced fiscal dominance: households savings (in financial and physical assets) as a percentage of GDP, the REER (real effective exchange rate), and an uncertainty index (following the seminal work of Nicholas Bloom of Stanford University and his co-authors), which is available for India on the FRED database since 2003.

We compare the volatility in the pre-FIT (2003-2014) period compared with the post-FIT period (2014-2018) in these variables. In addition, we look at co-movements of these variables with the inflation and growth components over the entire period, 2003-2018, estimated from the debt-decomposition exercise.

The findings: in the pre-FIT (2003-2014) regime, the volatility in all the variables was higher when compared to the post-FIT (2014-2018) years. The drop in volatility is considerably higher in the inflation component and the uncertainty index in the post-FIT years when compared with the pre-FIT years.

This suggests that since 2003, higher values of the inflation component have been associated with more uncertainty in the Indian economy. We also find that the relation between the growth component and the uncertainty index is negative. This means that higher growth in the Indian economy has been associated with lesser uncertainty in the period 2003-2018.

These results suggest that while debt liquidation by growth tends to bring down uncertainty, debt liquidation via inflation led to more uncertainty in the economy.

There are two other findings of significance. We find a positive co-movement between REER and the growth component, but negative co-movement between the inflation component and REER. This suggests inflation-induced pressure on the Indian rupee to depreciate.

Also, in the post-FIT period, the growth component co-moves positively with household savings. This suggests that higher economic growth in India has been associated with a rise in household savings in physical and financial assets in the last 15-odd years.

In conclusion

Debt stabilization is the proper objective of fiscal policy. The recently-tabled N.K. Singh Finance Commission report gets this right. However, a long period of high public debt-to-GDP ratios in emerging markets like India can alter the interactions between monetary policy, fiscal policy and government debt management.

A long period of high public debt raises the spectre of fiscal dominance. As our research shows, since 1951, inflation’s growing contribution to lowering public debt shows how the sustainability of Indian public debt has been helped by debt liquidation in an environment of fiscal dominance.

Encouragingly, the interest rate component on public debt in India has begun to trend down in recent years. This can be seen in Charts 2 and 3. Using aggregate debt data (on just the consolidated fund), the interest payments/GDP ratio has averaged about 1% of GDP in the last few years according to our calculations.

This may suggest there is fiscal space, but this view is misleading. The interest rate component of public debt, despite trending down, continues to remain elevated. Debt servicing costs will remain a cause of concern especially in a post-covid world when public debt in India is expected to rise substantially.

It is a travesty of justice that both public health and education allocations will suffer with rising debt-servicing costs given that in recent years the spending on these items as a share of GDP are already abysmally low.

India really needs to worry about its public debt.

Piyali Das is a Visiting Assistant Professor in the Economics Area at IIM Indore. Chetan Ghate is a Professor of Economics at the Indian Statistical Institute. He was a member of the first Monetary Policy Committee of the RBI.