India must reduce its public debt ratio to build economic resilience

Photo: Mint
Photo: Mint


This effort should be led by the Centre crunching its primary deficit as we can’t count on automatic debt-reducing dynamics

The new Union budget presented by finance minister Nirmala Sitharaman last week has a credible plan to further reduce the fiscal deficit as a proportion of India’s gross domestic product (GDP). However, one uncomfortable fact did not get enough attention in its immediate aftermath. The ratio of public debt to GDP is expected to increase over the next financial year, despite this fiscal correction.

Why does that matter? A high public debt ratio has three main implications for macro-economic policy over the medium term. First, the interest costs of servicing this public debt leave the government with less money to spend on essential items such as infrastructure, the green transition, welfare programmes, defence and social security.

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Graphic: Mint

Second, the government’s ability to respond to the next shock is restricted when the public debt ratio is already high. Third, the Reserve Bank of India’s ability to conduct an independent monetary policy to control inflation is compromised when it also has to worry about managing a mountain of public debt on behalf of the government. The goal of fiscal policy over the rest of this decade should be to bring down the public debt ratio to more reasonable levels.

The public debt ratio had begun to inch up during the second half of the previous decade. However, it was the need to respond to the dislocations during the early months of the pandemic that threw public finances off-track. The government had to spend heavily to protect households whose incomes had dried up, prevent enterprises from collapsing during lockdowns, and make vaccines available to citizens. All this had to be done through extra borrowing, since tax collections had fallen sharply. The consolidated Indian public debt ratio of the Union government and states shot up by 15 percentage points to reach levels never seen before. The same story played itself out in most other countries.

A strong fiscal response was essential during those painful months. As the pandemic threat has retreated and the economy has recovered, more attention needs to be paid to gradually bringing down the public debt ratio over the rest of this decade. There are no quick fixes.

The economics of public debt dynamics tells us that any strategy to reduce the burden of public debt needs to be built on three pillars. One, an acceleration in nominal GDP growth can bring down the public debt ratio by ensuring that the denominator is growing faster than the numerator. Two, the acceleration in nominal GDP growth needs to be seen in the context of the average borrowing costs of the government; the gap between the two (r-g) should be seen as an indication of how easily India can grow out of its public debt problem. Three, fiscal policy will have to play a role by not just reducing the headline fiscal deficit, but more specifically the primary deficit, or the gap in the government budget once interest costs on existing public debt are removed.

So, the trajectory of public debt over the next few years depends on the growth in economic output, inflation, interest rates and fiscal policy. The experience of the first decade of this century provides us with some useful context. The public debt ratio came down by around 17 percentage points between 2002-03 and 2010-11. This period can be broken into two. The first part of the success was because India had a spectacular growth acceleration that also led to a sharp fall in the primary deficit. This ended once the impact of the North American financial crisis hit our shores. Growth began to slow down, while the fiscal situation deteriorated. Yet, the public debt ratio continued to drop because high inflation kept nominal GDP growth well above borrowing costs, though this same combination of fiscal profligacy plus high inflation led to a run on the rupee in mid-2013.

What now? Nominal GDP growth in the coming years is likely to be in very low double digits, unless there is a structural shift in potential growth as well as inflation. The gap between interest rates and nominal GDP growth will also be modest. What this means is that these automatic drivers of lowering the public debt ratio cannot do the job on their own. The government needs to use fiscal policy to bring down the primary deficit in the coming years.

The International Monetary Fund has estimated in its recent report on the Indian economy that the primary deficit consistent with stabilizing the public debt ratio is 2.3% of GDP. Seri Lanau, deputy chief economist of the Institute of International Finance, estimates that India’s projected primary deficit for the next financial year is 1 percentage point higher than what is needed for public debt stabilization, assuming real growth of 5.5%, inflation of 4% and average borrowing costs of 6.5% in the medium term.

India has managed its public finances well during these troubled few years, but the public debt ratio needs to get back to at least pre-pandemic levels in order to build more economic resilience for the years ahead.

Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics


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