Balancing fiscal responsibility, austerity

Through FRBM, the Budget can take cognisance of how growth, interest rates affect debt levels

Like all Budgets, the upcoming one is also being heralded by a hyperbolic overdrive. Talk of once in a hundred-year budget abounds amidst cross-currents of economic and financial market developments. This Budget definitely arrives at an interesting juncture for India. Abstracting from wish lists about tax and spending proposals, we choose to focus on the Fiscal Responsibility and Budget Management (FRBM) Act and rules.

The FRBM Act is the law of the land. Although it’s more often than not breached, finance ministers tend to pay obeisance to the law and often prepare the initial budget estimates (BE) within the FRBM framework. The current iteration of the law enjoins the central government to bring down its debt to gross domestic product (GDP) ratio to 40% by FY25. This metric, which was 49.4% in FY19, could rise to around 62.5% by the end of FY21, owing to both a rise in the fiscal deficit and contraction in nominal GDP triggered by the pandemic.

Separately, under the FRBM rules, the government had committed to bring down the fiscal deficit to 3.1% of GDP in FY23 from the budget estimate (BE ) 3.5% of GDP in FY21. This was supposed to help achieve the debt target. However, the fiscal deficit is likely to touch 7.5% of GDP in FY21 due to Covid-19 and prospects of hitting 3% in next few years appear remote. As such, the FRBM framework is broken and that presents an opportunity for a do-over.

As was pointed out in a dissent to the FRBM committee report (by Arvind Subramagovernment nian), simply focusing on the fiscal deficit target is not the scientific way to achieve the desired debt target. In particular, the extant targets do not pay attention to the interplay between growth, inflation, interest rates and primary deficits in determining changes to the debt to GDP ratio. Primary deficit, which is fiscal deficit net of interest payments, is essentially the new borrowings taken on by government. Growth, inflation and interest rates affect both the numerator, debt stock and denominator, GDP.

A recent paper by economist Advait Moharir (2020) undertakes a debt decomposition exercise to isolate the impact of primary deficits from those of growth, inflation and interest rates. The three are clubbed together as Fisher Dynamics by the paper. In simple terms, this refers to the impact of growthinterest (g-i) differential on India’s government debt. We replicated the exercise and found that in the five years ending FY19, primary deficits contributed only an average of 12% to change in the Centre’s debt. The balance 88% was due to g-i differential. Indeed, in the last 30 years the only five-year period when primary deficits contributed upwards of 40% to change in debt was between FY09 and FY13. In other words, g-i differential has dominated for the large part in determining trajectory of the Centre’s debt in recent years. This is not surprising as the higher the starting point for debt, greater will be the effect of g-i differential (see chart 1).

It is this insight that should be used when deciding on rules governing debt and deficits. Given that the pandemic shock has reset India’s government debt to relatively higher levels than anticipated earlier, the earlier target of 40% is impractical in our view. A new target, to stabilize debt rather than reduce debt, would be more tractable, in view of the economy’s preexisting conditions even before the pandemic. Such a target would also be able to take advantage of the g-i differential.

As long as the economy’s growth exceeds the interest paid on debt, the government’s debt to GDP will not explode. India has managed to keep this difference positive although the gap has narrowed recently. Thus to stabilize the debt ratio, ensuring a consistent positive g-i differential is more important than containing deficits. (see chart 2).

Our simulations (again replicating the calculations in Advait Moharir, 2020) show that to stabilize the debt to GDP ratio at 60% in 10 years, the

can afford to run a primary deficit of ~1.7% (equivalent to fiscal deficit of ~4.8%), over a reasonable combination of growth (9-11% nominal growth) and interest rate (6-7%) scenarios.

On the other hand, to reduce the debt to 40% of GDP in 10 years, the government would have to run a primary surplus of 0.6% (fiscal deficit ~2.5%). These would compare with an average primary deficit of 0.7% in the five years to FY20. It is likely that the second scenario, which we call austerity scenario, would require even higher primary surplus given that austerity could hurt growth prospects more. In other words, the gap between growth and interest rate could narrow in the austerity scenario and lessen the benefits of that interplay.

We also simulate these scenarios for hitting these debt targets in five years. In the 60% terminal debt case, which we call expansionary scenario, there is not much difference in average fiscal deficit over five and 10 years. Further, the required fiscal deficit would be well in excess of what the government achieved in the last five years. Whereas in the austerity scenario, hitting terminal debt in five years would require a virtually zero fiscal balance, an impossible target (see chart 3).

These scenarios are descriptive, not prescriptive. The government can choose a midpoint between austerity and expansionary scenarios, or mix it up with a few years of expansionary policy followed by a recalibration. The short point is in order to stabilize debt near current levels, it’s not necessary to run lower deficits.

Besides the Centre, the state governments are also mandated to reduce their debt level – which is likely to hit ~30.6% of GDP for all states combined – to 20% of GDP by FY25. To reduce debt to 20% in 10 years (austerity scenario), our simulations show that states would have to run a primary surplus of 0.3% of GDP on an average. On the other hand, to maintain debt to GDP at 30% by end of 10 years, states can afford to run a primary deficit of 0.8% of GDP. In comparison, states ran average primary deficit of 1.3% of GDP over last five years. Again the austerity scenario turns out to be nearly impractical.

More important, a one size fits all approach to states’ FRBM targets is meaningless and counterproductive. Forcing states with different starting debt levels to aim for the same terminal debt ratio would be unfair to some states depending on the target chosen. It would be better to group states into different buckets based on current debt/gdp ratio and then draw targets for stabilizing debt close to current levels, subject to certain bounds. For example, at the upper end, 30% could be fixed as target for high debt states. At the lower end 20% could be a reasonable target for low debt states. Using these bounds and a 10-year period along with two different growth and interest rate combinations, we arrive at target fiscal deficit for a number of states in different debt buckets.

Our exercise shows that tailoring the deficit targets to states’ current debt stock as well as the likely impact of g-i differential would be a sound approach. While selling this to states would be a tough proposition, pairing these targets with appropriate Finance Commission grants and other concessions could clinch the issue (see chart 4).

Figures in parentheses, next to state names, are debt-togsdp ratios (end-march 2020)

10-year debt/gsdp target: {Maha, Kar, Guj = 20%}, {MP, TN, Har = 25%}, {UP, WB, PB = 30%}

To sum up, the Covid shock to the economy, in particular to the balance sheets of the Centre and states should be used as an opportunity to revise the FRBM framework in order to stabilize debt. Such an approach would not penalize growth and would stand greater chance of success rather than a misguided turn to austerity.