DEFICITS AND DEBT

The Problems

1. India’s government spends more than it earns. The combined fiscal deficit of the state and the Centre is about 7 per cent of GDP – among the highest of any emerging market.

2. States in particular have overspent in recent years. Their budgeting is sometimes not sufficiently clear and their finance commissions are generally short of capacity.

3. A high fiscal deficit means that the economy is more vulnerable. More government borrowing means that private investment is ‘crowded out’. While growth may increase in the short run following a fiscal expansion, it can collapse soon thereafter.

4. The government has made many other promises and guarantees that may require it to spend money in the future – these ‘contingent liabilities’ are also growing.

Responsible Growth: The Way forward for India

Prachi Mishra

Background

While India fares well and has shown significant progress on several macroeconomic indicators like growth, inflation and the current account, its fiscal performance remains an outlier among emerging markets (EMs). As shown in Table 1, the consolidated fiscal deficit (for the Centre and the states combined) has consistently been reported at around 7 per cent for most of this decade, which stands as the second highest across EMs (Brazil, which went through a fiscal crisis, being the highest).

Why is sticking to a path of fiscal prudence important for India (see Mishra, et al. 2018)?

1. Higher general government deficits in India tend to be associated with higher costs of borrowing for both the Centre and the states, reduced capital inflows and lower private investment (so-called crowding out).

2. Fiscal and external vulnerabilities are also closely related.¹ It is widely accepted that an unsustainable fiscal deficit was the primary cause of the 1991 BoP crisis. The years following the global financial crisis when India did not adhere to the envisaged path of fiscal consolidation were also associated with external instability – leading to the taper tantrum episode of 2013 (see the FRBM Review Committee Report, 2017).

3. Adverse real effects of large fiscal expansions: What can we learn from past experience? The two largest episodes of fiscal expansion in India’s history were during the financial years 1998–99 and 2009–10.² While growth picked up temporarily following both these episodes, it slowed down remarkably thereafter. Therefore, any immediate stimulative effects of large fiscal expansions on economic activity in India appear to be outweighed over time by crowding out, and/or the effect of reduced confidence.

Table 1: Key macroeconomic indicators across emerging markets

Way forward

1. Implement the recommendations of the FRBM Committee, which entails reducing India’s overall debt to 60 per cent of GDP by 2022–23. The Centre’s debt should be reduced to 40 per cent of GDP, and overall states’ debt to 20 per cent of GDP by that year.

2. The key operational target should be the headline fiscal deficit. As envisaged by the FRBM, the Centre’s fiscal deficit and the overall states’ fiscal deficit should each be reduced to 2.5 per cent of GDP by 2022–23.³

3. Set up an independent fiscal council (FC) as recommended by the FRBM Review Committee. The FC can serve both an ex-ante role – providing independent forecasts on key macroeconomic variables like real and nominal GDP growth, tax buoyancy and commodity prices – and an ex-post monitoring role. It could also serve as the institution to advise on triggering the escape clause from fiscal requirements and also specify a path of return.

4. Reining in state finances will need to be prioritized. The fiscal trajectories of the Centre and the states have diverged, with state finances worsening in recent years. Ultimately it is the consolidated fiscal deficit that matters for the real economy, as well as for the markets.

5. Therefore, it is imperative to get a comprehensive handle on, and solution to, the contingent liabilities of the sovereign as a whole, including pension liabilities (see details below).

6. Each state should review its state-level FRBM Act and align it with the recommendations of the FRBM Review Committee, which have been accepted by Parliament.

7. Beef up the capacity of the state finance commissions so they can dig into the details of finances at the state level and be able to engage fruitfully with the state finance ministries and with the Finance Commission of India.

Contingent liabilities of the sovereign in key areas

We discuss key issues and propose the way forward in the case of liabilities in three key areas. These proposals have already been put forward and discussed at length in the FRBM report. There are other contingent liabilities, e.g., in pensions, which are not discussed here.

In power

· Address the flow problem: There should be no further bank financing of the operating losses of state power utilities. Instead, state governments should make a firm commitment to underwrite the shortfall in the revenue of distribution companies as equity or an interest-free loan on an annual basis.

· Increase state utilities’ revenue: Distribution companies and state governments must achieve time-bound targets to earn positive revenue. Compulsory metering, technological upgradation and periodic tariff revision and implementation should be adhered to.

· Notably, raising tariffs is bound to increase the incentives for theft, which will show up as an increase in ‘aggregate technical and commercial’ losses. Therefore, separate measures to address such losses should be taken by all states. Lessons from the Gujarat experience can be used, for example, crackdown on thefts and unmetered power supply and introduce separate feeder lines for different segments.⁴

· Cut down the role of intermediaries: A framework should be developed to facilitate electricity generation companies to directly sell their surplus power to consumers at a negotiated price.

In food

· State governments maintain food credit accounts with commercial banks. The credit is used by certain states for centralized procurement of cereals on behalf of the Food Corporation of India. There are long delays in servicing these accounts, particularly in some states. These arise mainly due to disputes between those state governments and the FCI that delay the reimbursement of procurement expenses to the state concerned. These accounts should have long ago been classified as NPAs.

· Food credit to centralized procurement states should be routed only through the FCI, duly guaranteed by the Government of India. This would streamline the process, improve its efficiency and minimize the disputes between procuring states and the FCI that lead to persistent irregularities in the food credit account of the concerned states. A comprehensive special audit of grain stocks should be conducted to accurately determine the level of irregularities that have already built up, and these should be settled by the Central government and the FCI as soon as possible.

In government-sponsored credit guarantee schemes

· The Government of India has launched many credit guarantee schemes – the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), Credit Risk Guarantee Fund Scheme for Low Income Housing, and so on – to increase the flow of formal credit to various targeted beneficiaries. These credit guarantee schemes may have helped the intended beneficiaries to get credit at more favourable terms, but it is important that these schemes are run in a prudent and transparent manner.

· While the Government of India has made an explicit assurance that it will fund these schemes if their corpus runs short, it is important to make sure that the schemes are run well so that loan losses are minimized, and that they are kept adequately funded on an ongoing basis, based on certain prudential norms.

References

FRBM Review Committee Report, 2017, https://dea.gov.in/sites/default/files/Volume 1 FRBM Review Committee Report.pdf

Amandeep Kaur and Lekha Chakraborty, 2018, ‘UDAY Power Debt in Retrospect and Prospects: Analyzing the Efficiency Parameters’, NIPFP Working Paper No. 244.

Prachi Mishra, Vishal Vaibhaw, and Andrew Tilton, 2018, ‘Fiscal Prudence: Pain or Gain for India?’, Asia in Focus, Goldman Sachs Economic Research.

The Solutions

1. By 2022–23, the Union government’s fiscal deficit should be brought down to 2.5 per cent of GDP, as should the states’ combined fiscal deficit. This will help private borrowing take off. India’s overall debt-to-GDP ratio should come down to 60 per cent.

2. An independent fiscal council should be set up that can monitor the fiscal deficit, project the future path of key macroeconomic indicators and manage the response to emergencies that require more spending.

3. State government deficits will need to be reined in and state finance commissions given more resources. State-level fiscal responsibility legislation will have to be updated.

4. The government should work on clarifying the scope of its ‘contingent liabilities’, which emerge out of its various promises and guarantees. Action will be needed to clean up pensions, power, food and credit guarantee schemes – any and all of which could cause a major fiscal pile-up in the future.

¹See the note by Sajjid Chinoy on external imbalances in this volume.

²Defined as two successive years of at least a percentage point of GDP’s worth of fiscal expansion.

³See Pranjul Bhandari’s note in this volume, ‘The Slow Pace of Infrastructure Buildout’, for suggestions on how the composition of the fiscal deficit can be adjusted in a growth-enhancing manner.

⁴Kaur and Chakraborty (2018) show how the financial and operational efficiency parameters envisaged in the Ujwal DISCOM Assurance Yojana have not yet been met by many participating states.

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