India’s Debt Challenge

Historical Context

Historically, high fiscal deficits since the mid-1980s have been a perennial problem impacting India’s macroeconomic stability. It is well known that the Balance of Payments (BOP) crisis of 1991 was triggered by high fiscal deficit in the years preceding the crisis. Post the 1991 reforms, although  the fiscal deficit was reduced, it could not be sustained in the longer run. The government’s financial condition deteriorated again in the beginning of the mid-1990s. By the mid-2000s the general government debt (the sum total of the debt of the Central Government and the State Governments) had climbed up to 85% of the GDP, a debt-to-GDP ratio which in the Indian context is very high.  

With persistently high  general government fiscal deficit averaging at around 9% for six-year NDA government under Prime Minister Vajpayee, general government debt went above 80% of the GDP. This was alarming and the government passed the Fiscal Responsibility and Budget Management Act  2003 to restore fiscal health.

An Act to provide for the responsibility of the Central Government to ensure inter-generational equity in fiscal management and long-term macro-economic stability  – FRBM Act 2003

Subsequently, all state governments passed their respective FRBM acts. These acts together had two-fold aims – to attain revenue surplus and reduce fiscal deficit in order to achieve fiscal stability. This was to allow the Reserve Bank of India (RBI) the required flexibility to do monetary policies to deal with inflation in the long run. It had a secondary aim to bring in transparency in India’s fiscal management systems. These laws prescribed a framework to establish discipline in government’s spending to eliminate revenue deficit by the financial year 2007-08 and achieve revenue surplus thereafter in order to reduce the general government fiscal deficit to 6% of the GDP. 

A year wise target was set for both the state and the central government to progressively move fiscal deficits toward a ceiling of 3% of GDP each. Thus, aiming for a general government fiscal deficit ceiling of 6%, consistent with available household financial savings. The total financial savings available for borrowing was estimated at 12% of the GDP where 10% was constituted by household savings and the remaining 2% was foreign savings, reflected in the current account deficit. It was decided that the total financial savings should be distributed equally between the private sector and public sector.

Has the FRBM Act worked?

The important question that one is looking to analyse is whether the targets set under the FRBM Act were met. Data shows that the government has not been able to achieve the envisaged goals (Figure 1). 

 Data Source: RBI

Post the enactment of the FRBM Act in 2003, fiscal condition improved dramatically and the revenue deficit reached “zero” in the year 2007-08 as set out in the law. The general government deficit also declined sharply below 6%, reaching 4.1% in the same year. The debt to GDP ratio also fell to below 70%. However, following the financial crisis in the year 2008-09 the fiscal consolidation deteriorated again and the government strayed from its initial objective of reducing fiscal deficit. 

Following a sharp decline in GDP growth rate, the central government raised spending as a counter cyclical measure by increasing the deficit by 3.5 percentage points to 6.1% of GDP in FY 2008-09. In FY 2009-2010, the fiscal deficit had reached a high of 9.5% GDP with a central government deficit of 6.6% of GDP. However, the state government deficit  remained under the prescribed fiscal deficit of 3% of GDP and continued to remain so until FY 2016-2017. 

Even though the central government has tried to reduce its deficit gradually since FY 2010-11, the fiscal deficit remained high at an average of 7.8% of the GDP till the FY 2012-13.  The debt similarly remained at an average of 66% of the GDP. This divergence from the envisaged path of fiscal consolidation is associated with macroeconomic instability that was said to have led to the “taper tantrum” crisis of 2013 during which the economy almost came to the brink of another balance of payments crisis. 

The other objective was to generate a  revenue surplus since FY 2008-09 was also not met, even though the revenue deficit was brought down from 6.3% of GDP in FY 2003-04 to 0.2% of GDP in FY 2007-08. Following the financial crisis, revenue deficit witnessed a steep increase to 4.9% of the GDP in FY 2009-10 and on an average remained in that similar range till FY 2011-12. In 2013, the government introduced  the concept of “effective revenue deficit”. An effective revenue deficit would be equal to revenue deficit minus grants to states for the creation of capital assets. Although this reduced the revenue deficit, it still failed to meet the objective of the FRBM Act of 2003. 

From deficit to debt as the new anchor

The new government under Prime Minister Modi perceived the FRBM act 2003 to have set rigid targets and was  ambiguous about their effectiveness as guidelines for consolidation of government finance. In 2016, the FRBM review committee under N K Singh was set up to suggest changes to the Act. The committee recommended a change in the anchor for medium term fiscal policy from fiscal deficit to debt with an intermediary target of fiscal deficit. It emphasised the focus to be brought to debt stability. Furthermore, it suggested removal of the objective of eliminating revenue deficit from the FRBM act. 

This was particularly relevant as an effective communication channel with the public could be established,  since debt as a concept was already embedded in the psyche of the citizens. It had some significant advantages for the economy as well. The standard government solvency constraint suggested that debt was the ultimate objective of fiscal policy and the primary goal of debt and operational target of fiscal deficit gave a robust fiscal paradigm. Lastly, India had an average public debt that was close to 70% of GDP, which was higher than other emerging market economies, and public debt was a factor used by rating agencies for evaluation. 

In accordance with the committee’s recommendation, a ceiling on debt at 60% of the GDP for the general government was suggested in which the debt ceiling of 40% of the GDP was set for the central government and 20% of the GDP was set for all states by 2023.These changes were accepted by the government and the law was amended under the government in 2018. 

Post COVID-19- Fiscal health could be under stress

Since the amendment in 2018, India’s debt to GDP ratio has remained stable at around 69.5% until FY 2019-20. However, post-COVID-19 the GDP is expected to contract, government’s tax revenue to fall and fiscal deficit to expand sharply in FY 2020-21. This could have triggered a fall in rating by Moody’s on June 1st 2020, which estimated India’s debt to GDP ratio to rise sharply to 84%. Research by State Bank of India (SBI) also indicated that the debt to GDP ratio could rise to 87.6% in FY 2020-21, due to the contraction of GDP as well as the higher level of borrowing. 

The higher debt amount estimated for 2021 is expected to push the FRBM target (combined state and government debt of 60% of GDP) by seven years- from 2023 to 2030. This is a cause for concern, as a report issued by Credit Suisse explains that it would take almost 10 years to bring the debt to GDP ratio down by 10 percentage points. 

Additionally, it is not just the government debt that is expected to rise, but contingent liabilities (including guarantees by the government) are also expected to rise. The FRBM act allows for 0.5% of the GDP for incremental guarantees in a year. It is expected that the target will be breached in the coming year after the government has promised the extension of guarantees, for example, 3 lakh crore in loans for MSMEs,etc., as a response to Covid-19. 

Conclusion

As COVID-19 continues to impact the economies of several countries, governments across the world have stepped up expenditure to support their people. Naturally, the ability to spend depends on the fiscal space available to the respective governments. In India’s case, failure to maintain sufficient fiscal discipline has left it with limited fiscal space to support the economy. If India had been a market economy with debt-to-GDP ratio at 60% , as was envisaged in the amended act, it would have had enough fiscal space to mitigate the fallouts of the virus. Unfortunately, with the deterring growth even at the outstanding debt  the debt-to-GDP ratio would have been estimated to be high and with an increase spending to about an excess of 1% of GDP by the central government the debt burden will rise further, putting stress on the government’s ability to spend in the coming years.

Diya Chadha is a third year undergraduate student at Ashoka University pursuing a bachelor’s degree in Economics and Finance. Aliva Smruti is a third year undergraduate student pursuing Economics Honours at O.P. Jindal Global University. 

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