Shedding more light on the debt dilemma

General Studies Paper 3

INTRODUCTION

• The elevated levels of India’s fiscal deficit and public debt have been a matter of concern for a long time in India. Even before the COVID-19 pandemic, debt levels were among the highest in the developing world and emerging market economies. The pandemic pushed the envelope further and relative to GDP, the fiscal deficit in 2020-21 increased to 13.3% and the aggregate public debt to 89.6%. As the economy recovered after the pandemic, the deficit and debt ratios have receded to 8.9% and 85.7%, respectively.

FINANCIAL REPRESSION

• The debt-dynamics equation states that when there is no primary deficit, if the growth rate of GDP exceeds the effective interest rate paid on government bonds, the overall debt will decline.
• However, what is missed in these discussions are the distortions caused by financial repression to keep the interest rates on government borrowing low to reduce the cost.
• The statutory liquidity ratio (SLR) stipulated by the Reserve Bank of India (RBI) requires the banking system to hold 18% of their demand and time liabilities in government securities.
• Besides, the RBI intervenes in the market through open market operations around the time when government borrowing is taken up to keep the interest rates on government borrowing repressed.
• When the interest rate on government debt is lower than the growth of GDP, the debt may decline but the financial market gets distorted.
• Thus, even when the sustainability of debt may not be threatened in the medium term, the costs of carrying high deficits and debt to the economy are heavy.
• First, on average, interest payments constitute over 5% of GDP and 25% of the revenue receipts, this is more than the government expenditure on education and health care put together.
• Second, high levels of debt make it difficult to calibrate counter-cyclical fiscal policy and constrain the ability of the government to respond to shocks.
• Third, the debt market in India is largely captive with mainly the commercial banks and insurance companies participating in it to meet SLR requirements.
• Furthermore, the rating agencies keep the sovereign rating low when deficits and debt are higher, and this increases the cost of external commercial borrowing.
• Finally, ‘today’s borrowing is taxing tomorrow’ and the burden of large deficits and debt will have to be borne by the next generation.

ON THE DEBT BURDEN

• It is clear that in the present fiscal environment, even achieving a consolidated debt-to-GDP ratio of 58.2 recommended by the 14th Finance Commission for 2019-20 would be unfeasible in the medium term.
• The Finance Commission had recommended that the Union government bring down its deficit relative to GDP from 43.6% in 2015-16 to 36.3%, and the States maintain their deficit at about 22%.
• The issue is of critical importance; therefore, the fast pacing of fiscal consolidation is imperative.
• Fortunately, after six years, Goods and Services Tax (GST) has stabilised and has shown high growth potential.
• The technology has helped to improve tax administration and improved compliance.
• With the cross-matching of GST returns with income-tax returns, income-tax compliance too is expected to improve.

ROLE OF STATE AND CENTRE

• In terms of policy interventions, this is the time to rethink the role of the state and vacate activities that should really belong to the market rather than competing with it.
• At the central level, even after much talk about disinvestment, progress has been slow.
• Equally disturbing are the employment melas to fill so-called vacant posts which have been found to be redundant.
• At the State level, it is important to guard against the return to the old pension scheme and indulge in large-scale giveaways for electoral reasons.
• Of course, redistribution is a legitimate government activity, and that is best done through cash transfers rather than subsidising commodities and services.
• Giving subsidies alters relative prices, resulting in unintended resource distortions.
• Equally important is the need to impose hard budget constraints by enforcing Fiscal Responsibility and Budget Management rules in allowing States to borrow.

WAY FORWARD

• Macroeconomic stabilisation is predominantly a Union government responsibility. Therefore, the Union government should follow the rules it makes, and enforce the rules on the States effectively.