Several commentators have argued that the Government of India has very limited fiscal space to provide fiscal stimulus to jumpstart the economy, and spend on the poor and on medical care post Covid-19 lockdown. In this post, Gurbachan Singh contends that there is significant, if not ample, fiscal space, if we use the term more broadly. He shows how fiscal space in terms of government's existing assets can be an alternative way of maintaining aggregate demand in the economy.
After the outbreak of Covid-19, a lockdown was ordered in India on 24 March 2020. The lockdown is, it appears, being lifted now. The economy has been adversely affected all this while. The use of fiscal policy differs in the two phases. During the lockdown phase, output and employment have been low primarily due to supply-side restrictions; and fiscal policy has a limited role in maintaining the aggregate demand (Singh 2020b). However, fiscal policy can have a much bigger role in the post-lockdown phase. The question is: does the Government of India (GOI) have fiscal space for the purpose?
In this post, I will first show that the fiscal space in the conventional sense is indeed very limited for the GOI. Thereafter, I will argue that there is significant, if not ample, fiscal space, if we use the term more broadly. Finally, I will show how such fiscal space can be used for maintaining aggregate demand in the economy once the lockdown in the economy is lifted, and production and supplies are allowed. In what follows, I will abstract from legal and administrative issues; the focus is on the economics involved.
Fiscal space: The conventional wisdom
It is often argued that in India, the rate of interest is less than the rate of growth of GDP (gross domestic product) and that this ensures that the ratio of debt to GDP will stabilise eventually even if it becomes high initially (Blanchard and Johnson, 2013). However, the interest rate is not exogenously given. If we were to allow for a higher fiscal deficit, the risk premium may rise, and so the interest rate can jump well beyond the growth rate. Hence, the inequality can get reversed.
Furthermore, at a higher interest rate, the debt burden rises further. So, the need for borrowing can go up even more. This can require a further increase in risk premium and a further rise in interest rate, which can require even more borrowing, and so on. Soon, the difficulties can get exacerbated enough such that we get into a fiscal crisis (Romer 2012).
This is not the end of the story. Unlike in the theoretical argument above, the interest rate on government bonds is not entirely market-determined in India. The statutory liquidity ratio (SLR) requirement at 18.25% keeps the demand and prices high for government bonds. This lowers the yields on such bonds in India. But it has a cost related to financial repression in the economy.
It is true that the GOI has not defaulted on its debt in the past, but that is partly because of the somewhat unanticipated jumps in inflation rate in the economy (for example, during the oil crisis in 1973-74). However, since 2016, India has adopted inflation targeting. So, the fiscal space is more limited now.
It is common to use the metric debt-to-GDP ratio or deficit-to-GDP ratio. However, Reinhart and Rogoff (2009) emphasised alternative metrics like the ratio of fiscal deficit to total receipts (revenue receipts and capital receipts) or the ratio of public debt to total receipts. The reason briefly is that whether or not fiscal deficit or public debt is viable or sustainable is related to the income or the receipts of the government alone (Romer 2012); it is not related to the income of the country, that is the GDP.
Now let us look at some facts. Even if we keep aside the fact that the fiscal deficit can rise by 3.5 percentage points simply due to a shortfall in revenues for the GOI for 2020-21, and consider the actual figures for 2018-19 – a far more normal year – there is a serious concern. While the fiscal deficit was 3.4% of the GDP in 2018-19, the fiscal deficit was at a mind-boggling level of 39% of total receipts of the GOI (raw data source: Budget at a Glance, 2020-21). Also, while debt is about 70% of GDP currently, it is more than 500% of the total receipts! Consider yet another figure. Interest payments in 2018-19 were 35% of the receipts of the GOI.
All this suggests that the fiscal situation of the GOI is not antifragile, to invoke the term used in Taleb (2012)1. So, it is hardly advisable for the GOI to borrow more and it is hardly advisable for the investors to lend more. Now it is true that the GOI and the Reserve Bank of India (RBI) can always resort to the monetisation of the fiscal deficits (subject to a change in rules). However, given the underlying fragility about the state of finances of the GOI, we may be moving out of the frying pan into the fire. But what is the alternative?
Fiscal space: The more general concept
The concept of fiscal space has evolved in developed countries where funds are raised primarily by taxes or borrowings. However, the conditions in a country like India are quite different. The public authorities in India have a good amount of shares in public sector undertakings (PSUs), public land, and foreign exchange reserves. There is scope and anyway a need for reducing public holdings of these assets.
The market return on investments in PSUs is very low and it is doubtful if even the social returns are large; there is a rationale for disinvestment or privatisation (Dutta 2010). Indeed, the GOI has been engaged in a disinvestment programme for quite some time. And there were targets even for this fiscal year. However, the GOI has paused it – possibly due to a fall in the stock prices in the aftermath of the outbreak of Covid-19. However, there is a misunderstanding here.
Though the strong overreaction element was present to begin with, there are reasons to believe that the stock prices are now also reflecting the deterioration in earnings due to the Covid-19 (the residual earnings of firms are hit much harder than the aggregate GDP is). But even if the stock prices are currently lower than what is warranted by the (new) fundamentals, this applies for ‘retail’ trades. If there are bulk deals, private placements, and dilution of managerial control, the prices can be negotiated at levels higher than those in the stock market. So, there is scope for disinvestment even at this stage.
Next, consider public land. Gangopadhyay (2016) has shown that the public authorities in India hold excess land; 13 major port trusts have 100,000 hectares of land, the International Airports Authority of India has 20,400 hectares of (additional) land, the Ministry of Defence has 283,280 hectares of land, and the Indian Railways has 43,000 hectares that is valued roughly at a whopping Rs. 3 trillion, which is significantly more than the true fiscal component of the big financial package of about Rs. 21 trillion announced in May 2020. So, here again, we have a way to mobilise funds by selling excess land – more so when the market price of land in India is more than the fundamental value of land (Singh 2017 and the references therein).
It is true that land is an illiquid asset. However, all that this implies is that there is a need to incur some marketing costs. But who can be the buyers? Fortunately, India has some very large corporations in real estate business, and these corporations are, in fact, on the lookout for large quantities of contiguous land in good locations. It is also fortuitous that banks in India are sitting on cash of about Rs. 8.5 trillion and they are in search of good borrowers. Under the circumstances, the banks can lend some of their money to real estate firms which may be interested in buying land from the public authorities (though this may require some change in bank regulations; fortunately, the GOI has been very flexible on such matters of late).
Finally, let us come to the foreign exchange reserves with the RBI. These stand at US$ 487 billion or Rs. 36.95 trillion as on 15 May 2020 (this is about 20 times the size of the initial relief package announced by the GOI in March 2020). It has been argued that these reserves can be reduced significantly without endangering macro-financial stability (Singh 2020a and the references therein). But who can be the buyers? It is interesting that most households in India hold assets in India only. They are not well diversified in the sense that they hardly hold assets abroad. This kind of ‘home bias’ is widely prevalent. However, it is far more serious in a country like India where the tax laws and practices discourage investment abroad. This needs to change.
Under the proposed policy, the RBI can reduce its foreign exchange reserves, and pay an extraordinary dividend to the GOI. The foreign exchange can be sold to the public and the latter can buy assets abroad. Observe that, in the aggregate, India’s holding of foreign assets and its balance of payments account more generally are unaffected under this proposed policy; there is, at the end of the day, merely a change from public holding to private holding of foreign assets, and there is a change in the kind of foreign assets held.
All this suggests that the public authorities have considerable fiscal space if we consider their assets (and not just cash flows). An interesting issue arises at this stage. Why can the GOI simply not borrow more if it is indeed so rich in assets? The difficulty is that the GOI is unable to credibly commit itself to repay the loans on the basis of the assets. This is because there is a long history of the GOI holding on to or even expanding its assets like land and foreign exchange reserves. It is only the shares in PSUs that have been sold to some extent over time. But even here, the successive governments have been dragging their feet.
As the saying goes, the proof of the pudding is in the eating. For the investors in government securities, the proof of the pudding is in the flows and not in the stocks (of assets). However, the cash flows (revenue receipts and capital receipts) are, as we have seen in the previous section, weak relative to the debt that the GOI already has. So, there is hardly any alternative for the GOI but to sell some of the assets in order to raise funds. But how does all this help in maintaining aggregate demand in the economy, which is the main issue at hand?
Fiscal space, and macroeconomic stability
Let us, as a benchmark and hypothetical case, consider fiscal space in the usual sense that the government is in a meaningful position to borrow more for the purpose of maintaining aggregate demand in the economy. The argument, as is well-known, is that the government can issue and sell additional securities, and it can use the proceeds for public consumption or investment. So, the aggregate demand goes up in the economy. Those who save but cannot find firms that are directly or indirectly interested in capital formation can instead get an alternative asset like the new government securities (Koo 2018); these may be held directly or indirectly (through banks and mutual funds). So, in the absence of adequate private investment, the private savings need not lead to a fall in GDP.
Now let us consider the proposed policy and see how fiscal space in terms of the existing assets can be an alternative way of maintaining aggregate demand in the economy. Under the proposed policy, the public authorities can sell existing assets. Such assets may be bought by the private sector. The government can use the proceeds for consumption (including spending on the poor and on medical care), or for public investment (including investment in medical infrastructure). So, the aggregate demand goes up in the economy. Those who save but directly or indirectly have difficulty in finding firms that are interested in using the funds for capital formation can instead get an alternative asset that takes the form of an existing asset, which is, to begin with, a ‘public’ asset. So, again, as in the previous case, in the absence of adequate private investment, private savings need not lead to a fall in the GDP.
It is true that sales of assets can take a few months while the need for funds can be urgent. However, what this implies is a need for funding within the fiscal year rather than over the years.
To the extent that the sale proceeds garnered by the public authorities are used for public investment (and not for consumption), it becomes, in the aggregate, a case of change in portfolio of assets rather than privatisation of assets; the GOI builds and owns new assets by giving up existing assets, and maintains aggregate demand without endangering financial stability (and improves growth prospects as public investment picks up and returns on existing assets improve).
Given the overall benefits of the proposed policy, it is hoped that the leaders in charge at different levels will indeed provide the much needed leadership to coordinate and persuade various stakeholders to accept the policy (there may or may not be a need to compensate a few who may, in the process, lose temporarily or permanently, at the individual level or at the family level, at the level of the current generation or the future generations – economically, psychologically, or politically). I may, however, quickly add that “The ideas of economists and political philosophers ... are more powerful than is commonly understood. ... the power of vested interests is vastly exaggerated ...” (Keynes 1936). In any case, even if there are issues of acceptability – as Philbrrok (1953) emphasised – the competition among economists to be seen as realists can dilute economics, policy formulation, and, more generally, economic progress. So, it may not be a bad idea – at least for an academic (though concerned) economist – to abstract from political issues involved.
- Singh (2010) shows why the investors have confidence in government bonds or they have confidence in banks that invest in such bonds, even if the fiscal situation is really bad.
- Blanchard, O and DR Johnson (2013), Macroeconomics, 6th edition, Pearson Education, Essex.
- Dutta, B (2010), ‘Disinvestment, the Economics of’, in K Basu and A Maertens (eds.), The Concise Oxford Companion to Economics in India, Oxford University Press, 351-353.
- Gangopadhyay, S (2016), ‘India needs to manage its publicly held land holdings with more diligence and data’, Economic Times, 19 December 2016.
- Keynes, JM (1936), The General Theory of Employment, Interest and Money, Macmillan. Available here.
- Koo, RC (2018), The Other Half of Macroeconomics (and the Fate of Globalisation), John Wiley & Sons, Sussex.
- Philbrook, Clarence (1953), “‘Realism’ in policy espousal”, American Economic Review, 43(5):846-859.
- Reinhart, CM and KS Rogoff (2009), This Time Is Different – Eight Centuries of Financial Folly, Princeton University Press.
- Romer, D (2012), Advanced Macroeconomics, 4th edition, McGraw Hill, New York.
- Singh, G (2010), ‘Seemingly adequate capital in banks in an emerging economy’, 6th Annual Conference on Growth and Development, 16-18 December 2010, Indian Statistical Institute, Delhi Centre.
- Singh, Gurbachan (2017), “Land price, bubbles, and Permit Raj”, Review of Market Integration, 8(1&2):1-33.
- Singh, G (2020a), ‘Covid-19: Reserves to the rescue’, Ideas for India, 4 April.
- Singh, G (2020b), ‘Covid-19: Getting fiscal policy right’, Ideas for India, 7 May.
- Taleb, NN (2012), Anti-fragile, Allen Lane.