How much public debt is too little?

Govt debt is the only interest-yielding risk-free asset in any country and therefore central to a wide range of key economic variables and decisions. Unless these aspects are taken into account while assessing the ‘optimal’ level of public debt, any fisca

Govt debt is only interest yielding risk-free asset in any country and, therefore, central to a wide range of key economic variables and decisions.

In a recent article, I had examined the recommendations of the Fiscal Responsibility and Budget Management Act (FRBM) Review Committee through the prism of the debate contained in the note of dissent by Chief Economic Advisor Arvind Subramanian, a member of the committee, and the rejoinder of the committee to the note. Despite their differences on several important counts, both protagonists implicitly agreed that a secularly declining public debt-to-GDP (gross domestic product) ratio was unambiguously a good thing, and indeed recommended fiscal rules, which led to precisely such an outcome.

Intuitively, I found this view seriously problematic, despite it being entirely in consonance with the established view of the economics profession. Virtually the entire literature is on determining how much public debt is too much, beyond which it becomes a systemic threat to the economy. My discomfort primarily stems from the fact that government debt is the only interest-yielding risk-free asset in any country, and is therefore central to a wide range of key economic variables and decisions in a modern economy. Unless these aspects are explicitly taken into account while assessing the “optimal” level of public debt, any fiscal rule would be seriously flawed, perhaps even dangerous.

The purpose of this article is to outline some of the considerations, which should be taken into account while determining the desirable stock of public debt and of its flow counterpart, fiscal deficit. Monetary considerations In all modern economies, national currencies are backed by some form of sovereign debt. Central banks such as the Reserve Bank of India (RBI) issue currency on the basis of their holdings of sovereign bonds and sometimes of gold. In an autarchy, therefore, the minimum level of public debt held by the central bank would be equal to the value of the national currency in circulation minus the value of gold holdings. In India this would amount to roughly 14 per cent of GDP. In an open economy, however, this tight relationship between currency and public debt can be loosened by the central bank holding sovereign assets of other countries, that is, foreign exchange reserves.

As things stand, the rupee is backed almost entirely by foreign assets as per the RBI’s balance sheet. Nevertheless, the RBI always needs to hold a certain amount of central government debt instruments in order to carry out its monetary management responsibilities in a credible manner. There is no hard and fast rule governing how much public debt a central bank should carry in its books; but as a rule of thumb, if the currency is not convertible, then the more open the country is to foreign portfolio flows, the higher should be the quantum. At present, the RBI holds 15 per cent of the stock of central government securities, which is 10 per cent of all government securities. This does not seem excessive for the roles that the RBI has to perform. Fiduciary considerations In any country, a large part of household wealth is held for precautionary purposes and for meeting post-worklife consumption needs. For such investments, the return is less important than the security of the principal. By and large, countries with low risk thresholds and poor or non-existent social security systems, like India, will tend to place much more importance on and have a higher share of such assets in the total household financial wealth.

All countries recognise this imperative and impose fiduciary status on institutions offering specific forms of assets. The common forms are life insurance, pension/provident funds and certain types of mutual funds and asset management company products. In India, there is an additional asset class called small savings instruments for which the government itself is the fiduciary, that is, it bears 100 per cent of the liability. This amounts to about 11.5 percentage points in the total public debt stock of 68 per cent of GDP.

The other assets, which bear fiduciary protection, comprise another 25 per cent of GDP. The laws governing these assets, which take into account the fiduciary commitment, specify that at least 50 per cent of the value must be invested in public debt instruments, which includes both central and state securities. Therefore, just for compliance with the law, the stock of public debt must be a minimum of around 12.5 per cent of GDP on this count alone.

Although legally, commercial banks are not fiduciaries, the perception of the depositors is usually quite different and they tend to view bank deposits as a form of low-yield secure assets. Therefore, even if banks don’t have legal fiduciary status, they certainly bear a moral fiduciary responsibility. Most governments recognise this tension between the legal and the moral/perceptual status of banks, and address it through “prudential regulations”. In India, prudential regulations stipulate that 20 per cent of the total net liabilities of banks (called the statutory liquidity ratio or SLR) must be held in government bonds, which works out to 18 per cent of GDP.

Therefore, if we add up the minimum amount of public debt required by law to meet fiduciary responsibilities in India, it comes to 42 per cent of GDP, comprising 11.5 per cent for small savings instruments; 12.5 per cent for insurance, provident funds, etc; and 18 per cent for commercial banks.