Alarm Bells: The World Economic Outlook update of July 2023 by IMF projects that global growth is estimated to fall from 3.5 per cent in 2022 to 3.0 per cent in 2023. Further, global headline inflation is expected to fall from 8.7 per cent in 2022 to 6.8 per cent in 2023. The report further notes that for most economies, the priority is to achieve the twin goals of sustained disinflation and financial stability.
Given its financial stability, relatively low inflation and high economic growth rates, India is very well placed in this alarming global situation. However, there is an essential lesson in this global situation for India’s policymakers, because three adverse effects of public borrowing can negatively impact economic growth and fiscal stability. First is the crowding-out effect of government borrowing on private investment due to higher interest rates. Second is ‘Ricardian equivalence’ or the negative impact on consumption, employment and investment due to the expectation that higher taxes will be required to repay the debt in future. Third, high levels of public debt can be unsustainable, especially when interest rates rise, as is being witnessed now.
Optimal public debt ratios have been calculated for several countries at different times, ranging from 10% to 60% of GDP. However, after the global financial crisis in 2009, several high-income countries embarked on public borrowing of unprecedented proportions due to the near-zero interest rates, which were a consequence of the expansionist monetary policy. For the EU countries, the government debt to GDP ratio increased dramatically from 2009 to 2021, when it was highest in Greece (193%) and Italy (151%). These two economies have suffered prolonged economic stagnation as a result.
India Scenario India has a moderately high level of sovereign debt, equivalent to 87% of GDP as of March 2022, which is comparable to the levels of other energy-importing middle-income countries such as China (78%), Brazil (93%), and Egypt (89%). Combined with a stable macroeconomy, robust inward foreign exchange remittances that counterbalance the trade deficit, and moderate inflation rates, there is confidence in the financial stability of the government and the banking sector in India. It must be mentioned that the ‘Fiscal Responsibility and Budget Management (FRBM) Act’ of 2003 had set a limit of 60% for India’s public debt to GDP ratio (consisting of 40% for the Central Government and 20% for state governments’ debt). For four reasons, we argue that a medium-term fiscal consolidation path that achieves this target in 7 years (by 2031) will have the salutary effect of increasing India’s financial stability and economic growth.
First, it will instil confidence in the future fiscal stability of the Government of India and the financial stability of India’s banking sector, which is the largest investor in government bonds. This higher level of confidence will improve the sovereign credit rating of India and the credit ratings of major Indian borrowers (bond issuers), especially banks.
Second, the Government and the RBI can nurture a regime with low inflation and low-interest rates in such an environment of greater fiscal discipline, leading to more investment, employment and economic growth. Collectively, these events can significantly reduce the cost of credit in the economy.
Third, this will stabilise rupee exchange rates, making export financing more competitive and increasing trade and capital flows (foreign investment). Fourth, and most importantly, a healthier budget will enable the government to keep taxes low and, at the same time, devote resources to capital investment, human development and social welfare, all of which are important for economic growth, human development and social stability.
The Fragility As they say, the chain is only as strong as its weakest link. India is a union of states with a quasi-federal arrangement with a great deal of fiscal autonomy for the states. Over time, some states have reached a situation where their fiscal situation can, at best, be described as fragile. To ameliorate their fiscal stress, the XV Finance Commission, in its wisdom, recommended a generous bouquet of revenue deficit grants to 17 of the 28 states of the Union, with 14 states getting substantial support to boost their revenues over the five years from 2021-26. We believe that this has created a moral hazard as it rewards fiscal indiscipline by a state government contrary to the target set by each state legislature under its FRBM Act. Unfortunately, after a dose of generosity from the XV FC, fresh data from RBI inspires no confidence that these states are treading the path of fiscal discipline.
The RBI Report on state finances shows that in 2021-22, five big states (Punjab, Haryana, West Bengal, Kerala and Tamil Nadu) spent more than 20% of their revenue receipts on interest payments. This high cost of debt servicing is unsustainable and will impair the fiscal health of these states (and some others) unless immediate measures are taken to correct the situation. States must move towards lower fiscal deficits (net borrowing) from 3% of GDP to only 1.5%. The following (Sixteenth) Finance Commission, which will make recommendations for the five years from April 2025 to March 2030, can look into the required changes in the allocation of resources between the Centre and the States based on achieving greater fiscal discipline.
Our suggestion is to amend all state FRBM Acts to incorporate agreed transition targets for state debt that enable each state to achieve the medium-term target that state government debt does not exceed 20% of GDP; the current overall state government debt is nearly 30% of GDP. Further, it is essential to limit the revenue expenditure and set targets for state governments' revenue deficits, preferably to zero. States should be encouraged to run a revenue surplus. The anchor deficit indicator in the FRBM Acts should thus be the revenue deficit rather than the fiscal deficit.
At the same time, we must look at how governments utilise the funds they borrow from the market. If government borrowing is used only for public investment and not for purposes of consumption (revenue expenditure) such as payments for salaries, pensions, subsidies, and transfers, in that event, the fiscal deficit is more likely to bolster economic growth and less likely to crowd out private investment. Evidence shows that public investment complements private investment because synergies exist across both investment categories. Ideally, states should borrow only for investment; this will give meaning to the phrase ‘state development loans’, which today is a misnomer. If state paper is issued to achieve financial closure of specific public projects, this will boost the quality of state finances and enhance economic growth.
The 4-4-8 Triad What can the contours of such a time path of fiscal consolidation, low inflation and high economic growth look like? With the current level of public debt at about 87% of GDP in March 2022, and assuming an average interest cost of the public debt of 6.7%, the cost of servicing the public debt comes to nearly 6% of GDP. This does not compare favourably with a tax-to-GDP ratio of about 19% (11% for the central government and 8% for all states).
The first step on this consolidation path is reducing the Debt to GDP ratio. If the public debt is reduced to the FRBM target of 60% of GDP by 2031, and with lower interest rates of about 5%, the interest cost of debt can be reduced to 3% of GDP, thereby enhancing the government’s capacity to invest in public capital, human development and social welfare. This fiscal consolidation will have to be accompanied by a low-inflation regime backed by an appropriate monetary policy of the RBI. A vital benefit of a low-interest rate monetary policy will be higher private investment by domestic players and foreign direct investors. We can look forward to a situation by 2031 when the combined fiscal deficit of the central and state governments is only 4% of GDP ( Centre 2.5% and States 1.5%), inflation is at the RBI target rate of 4%, and rate of economic growth is at least 8%. This must be backed by a higher level of investment which can grow from current levels of nearly 30% of GDP to 40% of GDP.
This 4-4-8 triad of low fiscal deficits, low inflation and high economic growth can enable India to provide high-wage jobs to its growing working population. Current growth rates of tax revenues for direct and indirect taxes give us hope that this path of fiscal consolidation is feasible in the medium term. This will lead to a dramatic change in India’s economy by 2033 since the size of an economy growing at 8 to 9% per annum will be about 30% larger in a decade compared to the current scenario of 6% annual growth. The right mix of fiscal and monetary policy, which provides fiscal stability, will inspire investor confidence and raise consumer expectations for sustained economic growth.
By Karan Avtar Singh & Anirudh Tewari https://government.economictimes.indiatimes.com/amp/blog/fiscal-discipline-how-india-can-tide-over-the-global-crises/102603295
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