Ahead of the Union Budget, several policymakers and economists in India have advocated increasing public spending to spur economic growth. In this article, Gurbachan Singh argues that even if India is facing a slowdown, a larger fiscal deficit is not the solution – more so now that RBI and the government have adopted inflation targeting. The prospect of a fiscal crisis may be farfetched but India may be incurring costs differently.
The growth rate in India has come down from above 9% to a little above 7% more recently. So, the Ministry of Finance, the NITI Aayog and some economists in India are inclined towards increasing public spending and missing the previously laid down fiscal targets. On the other hand, the Reserve Bank of India (RBI) Governor Dr. Raghuram Rajan has come out forcefully against relaxing the fiscal targets in the Fourth C.D. Deshmukh Memorial Lecture on 29 January 2016. Who is right?
Let us label the first view as ‘expansionary’ and the second view as ‘prudential’. While the former is well known, the same cannot be said for the latter. In this article, I focus on the prudential view and go beyond the reasons given by the RBI Governor.
Before we proceed, it is important to point out that the expansionary view presumes that a fall in the growth rate is a case of macroeconomic fluctuation, which is why it needs to be treated as a macroeconomic problem. However, this is not obvious at all. It is quite possible that the rise in the growth rate that occurred some years ago was an unusual and temporary deviation from trend, in which case there is no need for any macroeconomic policy to address the fall in growth rate. Of course, if we aspire to a higher growth rate, there is need for a suitable policy but in that case it is advisable to treat it as a developmental issue rather than a macroeconomic issue. Having said this, let me proceed as if the expansionary view is correct in treating the so-called slowdown as a macroeconomic problem. Even then it is not clear that a larger fiscal deficit is the answer.
Grim fiscal situation
As a percentage of Gross Domestic Product (GDP), the budget estimate for the fiscal deficit and for the public debt for the year 2015-16 in India are 3.9% and 46.1% respectively. While these numbers are not large for a developed country, they can be for an emerging economy like India. To see this, following Reinhart and Rogoff (2009), consider a different metric - the debt-revenues ratio. This ratio is much higher in India than it is in a developed country even if both have the same debt-GDP ratio. The reason is that the revenues-GDP ratio is much higher in developed countries than it is in a country like India.
In the final analysis, what matters for the possibility of a fiscal crisis is the debt-taxes ratio and not the debt-GDP ratio. The reason is simple: the ability of a government to repay its debt or provide confidence in rolling it over depends on its taxes and not on GDP as most of the latter accrues to the public and not to the government.
Consider some data. The budget estimates for the total revenue receipts of the Government of India (GOI) for 2015-16 are Rs. 1,141,575 crores. The public debt for GOI at end-December 2014 was Rs. 5,054,804.17 crores. So, broadly speaking, debt as a percentage of revenues is 442.79. To put this in context, consider a developed country like Denmark. Its debt is 45% of GDP and 93% of revenues. In 2015, the tax-GDP ratio for Denmark stood at 49% while for India, it was 17.7% (for centre and states combined, for comparability with data for Denmark).
The debt-GDP ratios of Denmark and India are similar but the debt-revenues ratio of India is very high in comparison to Denmark, even after accounting for possible different methodologies used. This suggests a grim situation with regard to fiscal imbalance in India. It is also important to keep in mind that the total interest payments as a percentage of revenue receipts for 2015-16 are a staggering 39.96% for GOI!
It can be argued that the RBI (unlike the central bank in a country like Greece which faced a fiscal crisis) can always issue more money and use it to redeem public debt, in which case there would be no fiscal crisis in India. Two observations are in order here. First, though this route has worked in the past, there will be increasing difficulty in the future given the adoption of the new inflation targeting regime by the RBI and the GOI, under which the amount of money that can be issued is constrained by the inflation target. So the RBI may not be in a position to buy government bonds on a large scale and a fiscal crisis cannot be ruled out the way it could be until recently. Second, even if it is decided to suspend inflation targeting for a while to avoid a fiscal crisis, there is still a difficulty. Even if the RBI can buy government bonds by issuing new money on a large scale, it is only a default in nominal terms that is avoided. A default in real terms is not avoided, given higher inflation due to the excess money issued.1 The ultimate bondholders (which include ordinary bank depositors) will lose due to high inflation. And, the higher inflation has costs for the economy that go well beyond mere redistribution from one group to another.
It is true that the typical buyers of government bonds are commercial banks and financial institutions like General Insurance Corporation (GIC) and Life Insurance Corporation (LIC). Now, given the Statutory Liquidity Regulation (SLR) imposed on commercial banks at 21.5% of demand and time liabilities and given the public sector character of GIC and LIC, there is effectively a captive market for government bonds at ‘reasonable’ rates of interest. So, GOI does not have to worry about the demand for its bonds. And so, a fiscal crisis can be ruled out. But wait a moment.
If banks and other financial institutions need to invest more and more in government bonds, then there is less and less availability of funds for industry. This hurts economic growth and job creation. The term for all this in economics is financial repression. People use banking less. This is the deadweight loss due to financial repression. It is not surprising then that bank deposits in India are now less than the stock market capitalisation (and this is when there appears to be no serious bubble there).2 Financial repression is persistent and so the costs are spread out over a long period of time. Hence, the accumulated costs can be significant.
We have, for all practical purposes, not had a fiscal crisis ever since independence despite somewhat large fiscal deficits for a long time. However, we have had persistent financial repression, and high inflation now and then. That is not a coincidence (Singh 2013). So a ‘crisis’ of a different kind has been happening for a long time. The ongoing cost and the long-term dent in the growth rate have not always been considered by policymakers in the past. These need to be remembered – more so now that the RBI and the GOI have accepted inflation targeting.
Let us return to policy to improve the growth rate in the economy. It may be worthwhile considering reduction, if not removal, of financial repression among other policies. This will require a (possibly gradual) reduction in fiscal deficits over time and not an expansion.
- It is true that when the US Fed increased base money substantially, higher inflation did not follow. But that is because the money multiplier fell considerably in the US - an unlikely scenario in India.
- The financial system has two parts – financial markets and financial institutions. The role of the latter has declined in relative terms in India.
- Reinhart, CM and KS Rogoff (2009), This Time is Different; Eight centuries of Financial Folly, Princeton University Press, New Jersey.
- Singh, Gurbachan (2013), “Is India hedged against systemic risk? An attempt at an answer”, Review of Market Integration, 5(1), 83-129.