2 min read.Updated: 12 Apr 2021, 10:42 PM ISTLivemint
To keep public debt in control, the Centre should aim to reduce its primary deficit bit by bit once the pandemic is over. But our FRBM law should be amended to drop all specific targets
That our Fiscal Responsibility and Budget Management (FRBM) Act is in need of rework has been rather obvious over the past year. Ever since the law’s enactment in 2003, successive governments have moved one step forth and two steps back on the fiscal deficit goal of 3% of gross domestic product (GDP) specified by it. Till this year’s budget, ‘off-balance sheet’ expenses were the standard workaround. Even so, that target was seldom achieved. In this year’s budget speech, the finance minister said that the Act would be amended. This is a good time, though, for us to review the law. Its premise is fine. A sovereign state does need to be kept from spending too much beyond its means. Else, public debt could spin out of control and the repayment burden could exhaust its resources. In India’s case, the covid crisis has raised our consolidated debt—of both the Centre and states—to almost 90% of GDP, our highest ever. While benign rates of interest allow this to be serviced comfortably, should rates start rising at some point, the pile-up will get difficult to bear. To pre-empt this, we need both the economy to expand robustly and add-on debt to reduce gradually over the years. What the Centre should aim to contain, specifically, is its primary deficit. This refers to the annual gap between its inflows and outflows shorn of interest payments.
By conventional wisdom, public debt is sustainable so long as nominal GDP grows at a faster clip than the rate of interest paid on it, as this usually implies state coffers filling up faster than the claims of creditors on it. Rapid growth also spells a decline in debt as a proportion of GDP even if the absolute burden stays constant. Our pace of GDP expansion, however, need not stay above interest rates in perpetuity. Post-pandemic prudence, therefore, would require the Centre to start closing its fiscal gap. But, if the focus of this exercise remains the overall deficit, as has been the case all these years, then we would be vulnerable to the deceptive comfort of relatively light interest expenditure. Globally, the cost of capital is peculiarly low, thanks to ultra-loose monetary and fiscal policies around the world. This covid splurge has been experimental, mostly, which means that interest rates could suddenly turn volatile if and when its adverse effects kick in. So, in order to track our progress on debt sustainability, the number we should watch most closely is the extent to which expenditure exceeds revenues without interest taken into account. With our primary deficit shrinking, we would be better assured of safety.
As of now, the government’s fiscal deficit for 2021-22 is pegged at 6.8% of GDP and its primary deficit at 3.1%. Both are too high. Yet, this does not mean we need deficit-reduction targets specified by our fiscal law. Economic circumstances can change quickly, as we saw last year, and we need policy flexibility to adapt. Every administration, though, must make it a point to achieve the compression needed. While tax increases are one way to do it, asset sales and spending cuts would need to play larger roles. A worst-case scenario would emerge if inflation is allowed to trend higher in an attempt to raise nominal GDP growth and lower the real burden of debt. Such a game of financial repression (via ‘the money illusion’) won’t escape the notice of bond investors, and the cost of money would then be even harder to push down. It’s always best to focus squarely on the basics of economic stability.