When windmills tilt: The FRBM debate

In the first of a two-part series, the author discusses if the fiscal correction target should be government debt or primary deficit

The finance ministry recently released the FRBM (Fiscal Responsibility and Budget Management Act) Review Committee Report, the most fascinating part of which is the dissent note by Chief Economic Advisor Arvind Subramanian, and the committee’s rejoinder to the note. At the heart of the disagreement is a rather fundamental issue: Should the fiscal correction target be government debt, as recommended by the committee, or primary deficit (part of fiscal deficit spent on real goods and services), as advocated by Subramanian? Subramanian argues that India should prepare for a situation when growth rate of nominal gross domestic product (GDP) will become roughly equal to interest rate, and debt sustainability would require primary deficit to be zero or less. Fiscal deficit as ‘operational’ target Subramanian objects to the “serpentine path for the Centre’s fiscal deficit”, recommended by the committee: A large 0.5 percentage point reduction in the first year; no change in the following two years; then a gradual reduction of 0.2 percentage points annually for the next three years. Instead, he proposes a “gentle glide path” of 0.2 percentage points per year decline in primary deficit, which would reduce fiscal deficit to two per cent of GDP as against 2.5 per cent over the same period. Why didn’t he recommend an equally gentle glide path of 0.22 percentage points annually for fiscal deficit, which would yield the committee’s target of 2.5 per cent in the terminal year?

In its response, the committee emphasises that “declining primary deficit… is neither necessary nor sufficient for debt ratios to decline”. This is correct — but equally true of fiscal deficit. Besides, the committee is extraordinarily coy about why it recommended the “serpentine path” to begin with. Clearly, this has been dictated by the timing of the next general elections, and the need to provide some flexibility to the government of the day.

By the committee’s recommendation, the fiscal deficit would be three per cent in 2018-19 and 2019-20. If the 2022-23 fiscal deficit target of 2.5 per cent is accepted and a glide path followed, the figures would be be 3.3 per cent and 3.1 per cent respectively, which provide a lot more flexibility. I would bet on the glide path.

However, it is surprising Subramanian doesn’t point out that while his proposal is likely to meet the committee’s objective of reducing the debt ratio, the committee’s proposal would eventually lead to a rise in primary deficit, and thereby enhance the potential vulnerability of the economy. This is because the time paths of fiscal and primary deficits are related. So long as the annual reduction in the Centre’s fiscal deficit ratio is more than 0.1 percentage point (which it is) the primary deficit will reduce. But when fiscal deficit is stabilised at the recommended 2.5 per cent of GDP, primary deficit will start rising and will continue to do so as long as growth rate of nominal GDP stays above seven per cent per annum.

Subramanian wins this round on points. Government debt/GDP ratio Subramanian's main objection to the report is its use of debt/GDP ratio as the “anchor” for fiscal policy. He rightly points out that there is no reason to believe that India’s current debt ratio is undesirable or unsustainable. However, he complicates things by asserting that what matters is not the level of debt, but the direction in which the debt is heading — downwards, good; upwards, bad (what about constant?). This is needed to justify his position of reducing primary deficit until it turns positive. The problem with this argument is that if every year investors want to see the debt ratio declining in order to buy fresh public debt, eventually the debt ratio will have to be driven down to nearly zero. Moreover, as debt reduces, so will fiscal deficit. Simulations suggest that Subramanian’s target of a small positive primary balance will lead to debt becoming 20 per cent of GDP in 15 years — less than half the current level of 47 per cent — and continuing to decline thereafter. Over the same period, fiscal deficit will go down to a mere 0.7 per cent of GDP.

The committee has defended its position by asserting that its target consolidated debt ratio of 60 per cent is a reasoned estimate based on seven different approaches. However, they concede that this number is a ceiling, not a target. They are forced into this concession because for any GDP growth rate of above seven per cent, a stable fiscal deficit of 2.5 per cent will lead to the debt ratio continuing to decrease, much like Subramanian’s primary deficit target, but not to the same extent. There are only two ways to address this: (a) have the courage of conviction to state that once the target central debt ratio of 40 per cent is attained, fiscal deficit may be allowed to rise; or (b) estimate the level at which the debt ratio will stabilise at a constant 2.5 per cent fiscal deficit, and ask whether this level is appropriate for the economy.

Option (a) will certainly ruffle the feathers of fiscal hawks, and perhaps international investors, but that is hardly a good reason not to do the right thing. Option (b) runs into an insuperable problem — there is no analysis that I’m aware of on the minimum public debt or fiscal deficit that a modern economy needs to function properly, nor even the considerations that should go into such an assessment.

If my apprehensions are correct, any proposal that leads to an uncontrolled reduction in debt stock and fiscal deficit takes us into uncharted waters and should be eschewed until we have some sense of how far they can be allowed to fall without creating systemic turbulence. Subramanian’s primary deficit target does exactly that.

This round therefore goes to the committee on substance. In the concluding part that appears tomorrow, the author discusses the “escape clause” proposed by the FRBM Review Committee, and provides recommendations for the FRBM.