The living debt

Indian Express, 1 April 2010

The size of public debt is one of the biggest challanges facing the Indian government today. There is a danger that we draw comparisons with the US, UK and some European countries and get lulled into complacency about the large fiscal deficits we are running. We can also get into endless arguments about how much the deficit matters for inflation, interest rates or crowding out of private investment. This is a risk we must avoid. Implementation of the FRBM-II and an independent fiscal council must be given top priority.

India has had a record of not defaulting on its public debt. Also, most of government debt in India is rupee denominated and held by residents, primarily with banks acting as intermediaries. Banking regulations require banks to hold government bonds, thus creating a captive market for them. As a consequence, in the past, an increase in the size of the government borrowing program has not created much concern. It appears to have been absorbed somewhat silently in the system.

The increase in the fiscal deficit since Budget 2009 has, however, not been very quietly absorbed. There has been a sharp and steady increase in the yields on government bonds. Bond holders, even the captive public sector banks now demand a larger premium for holding more government bonds. There can be an long debate about the extent to which this could hurt private investment, and this debate is unlikely to be conclusive. But one thing that there can be little disagreement about, is that larger interest rates today mean larger interest payments tomorrow. This is not to say that no growth enhancing infrastructural investments can be made by the government. But that the level of borrowing today has to take into account future growth rates and interest rates to arrive at sustainable debt/deficit numbers. Today, with rising interest rates on government bonds, the need for the government's commitment to fiscal consolidation is more urgent than ever.

The inadequacies in the Fiscal Responsibility and Budgetary Mangement Act (FRBM) became apparent with the rise in oil prices that created a large off budget deficit. Following that, the sixth pay commission, farmer debt waiver and social sector spending like the NREGA, ended all semblance of fiscal consolidation. The cut in taxes following the global crisis added to the deficit. Despite the high growth rate witnessed over the last decade, the ratio of fiscal deficit to GDP and debt to GDP rose sharply.

The Thirteenth Finance Commission was given the task of recommending a revised roadmap for fiscal consolidation, or an FRBM-II. Among its recommendations the Commission has recommended a target for the debt to GDP ratio (at a combined level of 68 percent for centre and states).The level of deficit for centre and states combined stood at 82 percent in 2008-09. This means that today's level of debt is not sustainable. Reaching the sustainable target will require a reduction in borrowing by both centre and states. An essential element of the roadmap for consolidation includes a golden rule, under which no one should borrow for current expenditure. This translates into a zero revenue deficit and a 3 percent fiscal deficit by 2013-14.

The process by which these would be achieved is envisaged to be a signficiant improvement over how the first FRBM was done. The Commission recommends, first, that there needs to be much greater transparency and detail to make the FRBM effective. A medium term fiscal plan should be put in place containing three year ahead detailed estimates of revenues and expenditures with explanations of how these estimates were arrived at. Recommendations on how to make the fiscal consolidation process transparent include spelling out of contingent liabilities of public private partnerships, revenue consequences of capital expenditures, separate statements of central transfers to states, reporting of compliance costs of major tax proposals, moving all disinvestment receipts to the consolidated fund of India to enable the use of these funds as part of the medium term fiscal planning exercise and the maintenance of inventories (at market prices) of land and building held by government departments.

The second significant change in the FRBM is recommended to be sensitivity to business cycles. In the present downturn the path of fiscal correction was reversed when the government undertook measures to provide a fiscal stimulus. While this was done in an adhoc manner, the Commission has recommended that the medium term fiscal policy should lay down rules for relaxation of fiscal targets. It should specify the bands within which fiscal targets can be changed. Countercylical fiscal policy is needed sometimes, but it should not put an end to the path of fiscal correction.

Finally, the Commission has recommended independent review and monitoring of the implementation of the FRBM. Committees for such review have been set up in the past by some state governments and should now be set up by the centre. There should be a Fiscal Council that acts as an autonomous body reporting to the Ministry of Finance, which should report to Parliament. The role of such an institution will become more important as the size and complexity of the Indian economy evolves. It should help the government in a transparent and professional manner. Countries such as Brazil, Japan, Korea, Mexico and Sweden have such institutions. In today's environment of high public debt and rising deficits, such an institution can play an important role not only in assisting the government in the task of fiscal consolidation, it can also add integrity to the government's medium term plans for fiscal consolidation.

Moving away from the one-size fits all the path of fiscal consolidation recommended for states earlier, the recommendations differ according to the growth and fiscal condition of each state. This would work towards preventing contractionary fiscal consolidation in states. A suitable path to consolidation, combined with state level fiscal councils, would help in achieving the goal of reducing the state debt to 25 percent of GDP over five years.

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