Debt-to-GDP over fiscal deficit: Will FM Sitharaman's strategy pay off?

Since the finance minister announced a glide path based on debt-to-GDP ratio to measure fiscal deficit, opinion has been divided on the move since it would also reflect on government borrowings

In 2018, the central government amended the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, in an effort to reduce debt-to-gross domestic product (GDP) ratio to 40 per cent by FY25 and the fiscal deficit to 3 per cent by FY21. However, the Covid-19 pandemic played spoilsport, with India’s fiscal deficit rising from 4.6 per cent of GDP in FY20 to 9.2 per cent in FY21. 

 

The FRBM amendment in 2018 was preceded by the recommendations of the NK Singh-led committee set up in 2016 to chart a new fiscal consolidation roadmap. 

 

Fast forward to 2025, and Finance Minister Nirmala Sitharaman in her FY26 Budget announced a new glide path with debt to GDP ratio as the fiscal anchor, moving away from the current practice of targeting fiscal deficit.  

 

“Our endeavour will be to keep the fiscal deficit each year such that the central government debt remains on a declining path as a percentage of the GDP,” she said 

 

The government now targets to bring down the debt-to-GDP ratio to 50 per cent by FY31 with one percentage point deviation from either side.   

 

Economic Affairs secretary Ajay Seth in a post-Budget interview told Business Standard that though every budget hereon will have a precise fiscal deficit number, it will be a “derived number” from the debt-to-GDP target.   

 

However, this is in contrast to the 2018 amendment of the FRBM Act which maintained that “government will simultaneously target debt and fiscal deficit, with fiscal deficit as an operational target.”  

 

What the proposal entails 

 

The debt-to-GDP ratio for the period FY27-FY31 is based on three nominal GDP growth scenarios of 10 per cent, 10.5 per cent, and 11 per cent. For each, there are three debt-to-GDP targets such as mild, moderate, and high, depending on the degrees of fiscal consolidation the government wants to target. 

 

The six-year road map aims to bring down the debt-to-GDP ratio to a range of 47.5-52 per cent from 57.1 per cent in FY25. For FY26, the Budget pegs debt-to-GDP ratio at 56.1 per cent — assuming nominal GDP growth of 10.1 per cent — effectively aiming to bring it down by one percentage point in a year. 

 

“This approach would provide requisite operational flexibility to the government to respond to unforeseen developments. At the same time, it is expected to put the central government debt on a sustainable trajectory in a transparent manner,” said the 'Medium Term Fiscal Policy cum Fiscal Policy Strategy Statement' presented along with the Budget. 

 

The government now targets to bring down the fiscal deficit to 4.4 per cent of GDP in FY26 from the revised 4.8 per cent of GDP in FY25. In FY22, the Budget had set a glide path to bring down the fiscal deficit to below 4.5 per cent of GDP by FY25. 

 

“Sans any major macroeconomic disruptive exogenous shock(s), and while keeping in mind potential growth trends and emergent development needs, the government would endeavour to keep fiscal deficit in each year (from FY27 till FY31) such that the central government debt is on declining path to attain a debt to GDP level of about 50±1 per cent by 31st March 2031 (the last year of the 16th Finance Commission cycle),” the statement said. 

 

It added that the choice of fiscal anchor aligns well in the context of sustained efforts of the government to promote fiscal transparency through proper disclosure of off-budget borrowings. 

 

“The choice of debt-to-GDP ratio as the fiscal anchor is in line with current global thinking. It encourages shift from rigid annual fiscal targets towards more transparent and operationally flexible fiscal standards. It is also recognised as a more reliable measure of fiscal performance as it captures the cumulative effects of past and current fiscal decisions. It is expected that the debt to GDP-based fiscal consolidation strategy would help rebuild buffers and provide requisite space for growth-enhancing expenditures,” the statement explained. 

 

What the experts say 

 

DK Srivastava, chief policy advisor at EY India, said discontinuing the practice of giving a glide path for fiscal deficit amounts to moving away from a transparent indicator to a less transparent indicator of debt-to-GDP ratio. “Fiscal deficit comes first. One decides what is going to be the annual borrowing. From the annual borrowing, the annual debt is determined. It is not the other way round,” he added. 

 

Pronab Sen, former chief statistician of India, said the two indicators are used for different purposes, depending upon the macro condition one is trying to address. 

 

“When you focus on the debt-GDP ratio, you are trying to hold down the level of interest that comes in every year's budget. The fiscal deficit becomes important because it is government borrowing. It's a flow, not a stock. When you're looking at flows, the important thing about the fiscal deficit is whether it is crowding in or crowding out private investment. In the current situation, where private investment is doing nothing, a high fiscal deficit is actually a good thing. As private investment starts picking up, you should start reducing the fiscal deficit to make space,” he added. 

 

Srivastava also contends that the government should have revealed a plan to achieve the 40 per cent debt to GDP ratio and 3 per cent fiscal deficit as envisaged in the FRBM Act. 

 

“When you have an annual reduction of debt-to-GDP ratio as a target, then even with a fiscal deficit level of 4.4 per cent or 4.3 per cent, very marginal decreases would be consistent with an annual reduction in the debt to GDP target. Therefore, for many years, we can be considerably removed from the FRBM targets and the government finances will remain well above sustainability levels, even while showing a reducing path for the debt to GDP ratio. So, it is not enough to say that we will focus on annual reduction,” he said. 

 

Srivastava believes that in initial years, the government will opt for mild fiscal consolidation due to impending pressure from the 8th Pay Commission awards that are set to begin in FY27. 

 

Sen said the government should reveal annually what kind of consolidation it is carrying out: mild, moderate or high. 

 

When it comes to states, Seth said the government is not going to push them to adopt debt-to-GDP ratio as the fiscal anchor. “It is not for us to push them in a direction, but our guidance to them has been that they don't exceed 3 per cent of GSDP (gross state domestic product). Conversation is to guide them towards a more capital orientation rather than a revenue one. The correction will take time.” 

 

Sen said it would be sensible for states to shift to debt as the fiscal anchor. “You've too many states which run very high debt to GSDP ratios. So, it may not be a bad idea to focus on it,” he added. 

 

However, Srivastava said the Centre cannot make the transition mandatory for states. “All states have their own fiscal responsibility legislations. Most of them have a 3 per cent target fiscal deficit. Even if the finance commission recommends shifting towards debt-to-GDP ratio, it will only be advisory in nature. It doesn’t translate into a change in legislation,” he added.   

Sovereign rating woes 

 

While most rating agencies were positive about the shift in India’s fiscal anchor, their assessments on its impact on the country’s sovereign rating varied. 

 

Fitch Ratings said increased confidence that the government can adhere to its medium-term fiscal framework and keep debt firmly on a downward path could eventually lead to upward pressure on India’s rating. “However, plans for a gradual pace of debt reduction could leave the authorities with little room to respond to shocks without putting debt reduction targets at risk,” it added. 

 

 However, Moody’s Ratings said while adherence to the downward trajectory in debt would support a view of enhanced policy credibility, the projected improvements may not be sufficiently material to change its broader assessment that India’s fiscal strength will remain weaker than most of its Baa-rated peers.  

 

“Over the next two years, we continue to expect India’s general government deficit, which combines the fiscal position of the central and state governments, to remain among the widest when compared to Baa-rated emerging market peers, rendering India’s debt burden higher and debt affordability weaker,” it maintained. 

 

S&P Global Ratings said the upgrade trigger for its sovereign ratings rests on a meaningful narrowing of India's fiscal deficits, such that the net change in its general government debt falls below 7 per cent of GDP on a structural basis. “This may improve the fiscal flexibility and performance score. But a lower debt-to-GDP ratio for India would not necessarily lead to an improved debt burden score. This is due to the country's very high ratio of government interest servicing to revenue,” it cautioned. 

 

For rating agencies, it seems the proof of the pudding will lie in a tangible reduction in both debt-to-GDP ratio as well as the fiscal deficit.