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The International Monetary Fund estimated in January that governments across the world have collectively spent $14 trillion to soften the economic impact of the pandemic. The size of the global economy in 2019 was $88 trillion. This extra spending, combined with a collapse in tax revenues, has led to a huge increase in fiscal deficits. Central banks have also stepped in by unleashing a wave of liquidity. Regulators have also tweaked rules to ensure that banks are not brought to their knees by a wave of bankruptcies. Some governments have provided credit guarantees to small enterprises.

This is not the time for premature austerity, as a second wave of covid infections in India makes it clear that the battle against the virus is still on. However, the risk of fiscal stress over the longer term cannot be denied. Finance minister Nirmala Sitharaman indicated in her budget speech that fiscal policy will remain expansionary till at least the end of 2025-26. The annual fiscal trajectory is important, but the anchor of fiscal policy should be to stabilize the ratio of public debt to gross domestic product (GDP). In that sense, the current decade promises to be a challenging one.

It is quite likely that public debt will remain high even as the annual fiscal numbers improve in tandem with an economic recovery. The interest costs of higher public debt will weigh on government finances. The 15th Finance Commission has said in its report that the consolidated public debt/GDP ratio of both the Union government and states is likely to be 85.7% at the end of 2025-26, marginally down from the current 89.8%. This is the highest in several decades, and around 25 percentage points higher than the target set for 2023 by the committee reviewing the Fiscal Responsibility and Budget Management (FRBM) framework. India is thus in unchartered fiscal waters.

Much of the discussion on the sustainability of Indian public debt revolves around two key variables—the rate of economic growth and the interest rate at which the government borrows from the market. India should not worry too much about public debt as long as the government is borrowing at an interest rate that is lower than the rate of economic growth. The logic is impeccable, but misses out on a third variable that is also important in public debt sustainability analysis—the primary deficit, or the annual fiscal balance once interest payments are ignored.

The more standard way of thinking about the sustainability of Indian public debt is as follows. The government can continue to run a primary deficit as long as economic growth is higher than sovereign borrowing costs. However, the government will have to ensure it maintains a primary surplus in case sovereign borrowing costs are higher than the rate of economic growth. In reality, the government will have to figure out how the burden of lowering the ratio of public debt to GDP is shared among higher economic growth, a lower interest rate and a change in the primary deficit/surplus.

The most attractive option is for a country to grow out of the problem. India brought down its public debt/GDP ratio by 18 percentage points from 2002-03 to 2010-11. There was a primary surplus in the government budget in only two of these eight years, when nominal economic growth was high. India can grow out of its public debt challenge over the next decade in case the economy regains its old momentum while interest rates are kept low through inflation control.

A walk through history illustrates some of these problems. The UK exited World War II with a public debt/GDP ratio of over 250%. It had fallen to 62% by 1971, or 25 years later. Nicholas Crafts of Warwick University has shown that around 60% of this fall is explained by the growth-interest rate differential and 40% by primary budget surpluses. India has a far more modest public debt/GDP ratio right now, and is not on the edge of a fiscal cliff. It can hopefully bring it down through higher nominal GDP growth in the coming decade.

But what if the recovery in economic growth is modest? The choices will then be more politically difficult. Two of them are worth mentioning here.

One, interest rates are artificially suppressed through some form of financial repression. It is unclear how an inflation targeting central bank in an economy with capital flows can manage such financial repression.

Two, taxes are increased to support the government budget. The US seems to be already going down that path. In the past few years, India has seen a cut in the corporate tax rate but increases in the income tax rate for those at the top of the pyramid as well as higher import duties on a range of items.

In June 2015, two years after the taper tantrum that almost led to a run on the rupee, the Indian government had begun to reduce the fiscal deficit in a bid to stabilize the economy.

This column had then commented: “The risks to economic stability have shifted from the government to the business sector." The question worth asking right now is: Will we see a mirror image in the coming years, of a deterioration in public finances but an improvement in private-sector balance sheets?

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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