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Thursday, May 26, 2022

A post-Covid fiscal framework for India

Government should plan to gradually improve its primary balance. This would protect against the risk of the growth-interest differential turning unfavourable.

Written by Arvind Subramanian , Josh Felman |
Updated: April 7, 2021 8:48:31 am
Any specific target, no matter how well-grounded, sets up perverse incentives, encouraging governments to transfer spending off-budget (as with the ‘oil bonds’ in the mid-2000s and subsidies more recently), while creating one-off revenues (as by selling one public enterprise to another).

For more than a decade, India’s fiscal problem has been on the back-burner, acknowledged as a concern, but excluded from the ranks of pressing issues. Now, however, the problem is back with a vengeance. COVID has upended the fiscal position, and fixing it will require considerable time and effort, even if the economy recovers. This worrisome prospect has prompted calls for the Fiscal Responsibility and Budget Management Act (FRBM) to be dusted off, reintroduced, and implemented — this time, strictly and faithfully. But before we heed them, we need to understand why the previous FRBM strategy failed and how to prevent a repeat. We argue below that the new strategy will look nothing like the current FRBM.

Start by identifying the precise problem: India’s general government debt has soared. It is now close to 90 per cent of GDP — the highest independent India has ever seen (Figure 1). The current ratio is some 10 percentage points higher than its previous peak in the early 2000s, which was the impetus for introducing the FRBM. The debt ratio will come down naturally as GDP normalises. Even so, on current policies, it is likely to exceed 80 per cent for the foreseeable future.

Would such a debt level be sustainable? The answer is spelled out in a new policy paper we have written with Olivier Blanchard of the Peterson Institute for International Economics. Briefly, sustainability depends on two key factors: The primary balance (PB), revenue less non-interest expenditures; and (r-g), the difference between the cost of borrowing and the nominal growth rate.

Graphics: Ritesh Kumar

Simple fiscal arithmetic shows that debt does not explode when the former (primary balance) is greater than the latter (interest-growth differential). In India’s case, PB has been negative as the government has run primary deficits, but this has been counterbalanced over the past decade by favourable differentials, as interest rates have been lower than growth (Figure 2, phase 2). Hence, the broadly stable debt ratio. This equilibrium has now been upset by the sudden increase in debt. In particular, higher interest rates may now be needed to convince investors to hold the much greater amount of debt. If the interest-growth differential consequently turns unfavourable, as occurred during the previous period of high debt in the early 2000s (Figure 2, phase 1), then debt sustainability could only be preserved by shifting the primary balance into surplus. And this would not be easy.

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Consider why. The underlying primary deficit of the Centre and states combined is typically about 3 per cent of GDP (including about 1 percentage point in debt increases from recapitalising banks and assuming public enterprise debt). So, shifting the primary balance into a modest surplus would require an adjustment of 4 percentage points of GDP. But non-interest expenditure is only roughly 20 per cent of GDP. Consequently, if tax increases were ruled out, then a sudden adjustment would require non-interest spending to be cut by no less than 20 per cent (4 divided by 20 times 100). Clearly, this would be politically impossible.

This tension — between the potential need for a sudden, large adjustment and the difficulty of doing so — renders India susceptible to panic and possibly even crises. The government needs to eliminate the tension, undertaking a pre-emptive consolidation to prevent the need for a sudden adjustment. How to do this? The introduction of the FRBM in 2003 reflected the belief that setting strict limits on fiscal deficits, both for the centre and the states, was the solution. But this framework didn’t work. Apart from the initial period, when growth was booming, the deficit targets were largely honoured in the breach, leaving the primary balance essentially unchanged (Figure 2, phase 2).

But is there an alternative? Indeed, there is. The government should start by defining a clear objective, based not on arbitrary targets but on sound first principles: It should aim to ensure debt sustainability. To this end, the government could adopt a strategy based on four principles, as set out in the dissent note by one of us to the FRBM Committee in 2017.

First, India should abandon multiple fiscal criteria for guiding fiscal policy. The current FRBM sets targets for the overall deficit, the revenue deficit and debt. This proliferation of targets impedes the objective of ensuring sustainability, since the targets can conflict with each other, creating confusion about which one to follow and thereby obfuscating accountability.

Second, any future framework should not be fixated on specific numbers. Around the world, countries are realising that deficit targets of 3 per cent of GDP and debt targets of 60 per cent of GDP lack proper economic grounding. In India’s case, they take no account of the country’s own fiscal arithmetic or its strong political will to repay its debt.

More to the point, any specific target, no matter how well-grounded, sets up perverse incentives, encouraging governments to transfer spending off-budget (as with the “oil bonds” in the mid-2000s and subsidies more recently), while creating one-off revenues (as by selling one public enterprise to another). The government has commendably brought subsidies back into the 2021-22 budget, but so long as the pressure remains to achieve a specific target, the temptation to revert to non-transparent transactions will remain.

Turning from what should not be done to a positive agenda, our view is that the government should focus on just one measure for guiding fiscal policy. Recently, some have proposed focusing on the interest-GDP or the interest-revenue ratio. While these ratios have some virtue as measures of fiscal health, they are decidedly unsuitable as operational guideposts. The reason is simple: Interest payments are essentially fixed in the short run, because current year deficits add only marginally to the large historical debt stock. So, for example, if the government enacted an unduly large stimulus that undermined the fiscal position, the interest ratios would actually show an improvement for a few years, because of the temporary boost to GDP and revenues. Only when interest payments rise eventually, but gradually, will the problem be revealed.

Instead, we would propose targeting the primary balance. Admittedly, this concept is new to India, and will take time for the public to absorb and accept. But it is inherently simple and has the eminent virtue that it — much more than the existing or proposed targets — is closely linked to meeting the overall objective of ensuring debt sustainability. Put differently, a primary surplus is a shield that guards fiscal sustainability against the risk of the growth-interest differential turning unfavourable in the future (Figure 2, phase 3). Finally, the Centre should not set out yearly targets for the primary balance. Instead, it should announce a plan to improve the primary balance gradually, by say half a percentage point of GDP per year on average, making clear that it will accelerate consolidation when times are good, moderate it when times are less buoyant, and end it when a small surplus has been achieved.

This strategy has several advantages. It is simple and easy to communicate; it is gradual and hence feasible. And because it is feasible, it will be credible. This credibility will continue to improve as the strategy is implemented, potentially creating a virtuous circle in which growing market confidence will reduce the risk premia on bond interest rates, thereby improving the growth-interest differentials, which in turn will speed the reduction in debt, further improving the prospects for sustainability.

Without doubt, this approach represents a substantial departure from current practices. Most obvious is the change in objective, the emphasis on achieving sustainability, rather than a specific debt ratio. And flowing from this change is an entirely new strategy: The primary balance as the guiding metric, a broad downward trajectory rather than annual targets, flexibility in annual policies depending on the state of the economy, and an end-point consistent with the overall objective. These elements are all radically different from the approach under the FRBM. But persisting with the failed approaches of the past cannot be the right answer.

COVID has upended India’s public finances. It is time to learn from past experience and adapt. Adopting a simple new fiscal framework along the lines we have proposed could be the way forward.

Subramanian is former chief economic adviser to government of India, Felman is former IMF Resident Representative to India

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