As India targets debt reduction, lack of clarity could risk hard-won gains

The government has done really well on the fiscal front, but any ambiguity about the future path could put the hard-won gains at risk

The impact of the rationalisation and reduction in goods and services tax rates on growth and tax collections will be carefully studied by the Ministry of Finance, which has likely started preparation for the next Union Budget. However, this will not be the only aspect that financial markets and other stakeholders will watch closely. From the next financial year, the government will shift to a different fiscal anchor. Since this may require adjustments in financial market expectations, a few broad issues will need to be debated over the coming months.

 

In the 2024-25 (July) Budget, Union Finance Minister Nirmala Sitharaman announced that from 2026-27 onwards, the government will aim to keep the annual fiscal deficit such that the Union government’s debt will be on a declining path as a percentage of gross domestic product (GDP). Thus, the government’s focus will be on debt. Notably, the Fiscal Responsibility and Budget Management (FRBM) Act was amended in 2018 to include both debt and deficit targets. Fiscal deficit was targeted to decline to 3 per cent of GDP by 2020-21, while central government debt was targeted to be reduced to 40 per cent of GDP by 2024-25. The path was severely disrupted by the Covid-19 pandemic, which increased both the fiscal deficit and public debt significantly. However, to its credit, the government has made a remarkable recovery since.

 

In the 2021-22 Budget speech, the finance minister had announced that the government intends to reduce the fiscal deficit to below 4.5 per cent of GDP by 2025-26. The government is on track to achieve the target this year. This was not easy as the fiscal deficit had increased to 9.2 per cent of GDP in 2020-21, with an extremely uncertain economic outlook. It is also worth noting that the consolidation has been achieved with an increased level of capital expenditure. The Union government’s capital expenditure has increased to 3.14 per cent of GDP in 2025-26 from 1.67 per cent in 2019-20. The government, therefore, has done very well in managing its finances.

 

Nevertheless, the shift from next financial year will need more clarity. For the fiscal anchor to be effective, it should be easy to communicate. While debt was embedded in the fiscal law, the annual operating target was fiscal deficit, which was to be reduced systematically to a certain level. Financial markets and other stakeholders understood this well. The idea of keeping debt on a declining path may not be that easy to communicate, with implications for the pricing of government bonds. The fiscal policy statement presented with the Budget in February noted that the fiscal deficit would be kept such that the debt is on a declining path to attain the level of 50±1 per cent of GDP by March 2031.

 

The document also presented scenarios with different levels of nominal GDP growth and various degrees of fiscal consolidation. For instance, with nominal growth of 11 per cent and mild fiscal consolidation, central government debt is projected to decline to 50.1 per cent of GDP by March 2031 from the current year’s projected level of 56.1 per cent. However, with 10 per cent nominal growth and mild consolidation, debt will decline to 52 per cent. Obviously, a lower level of nominal growth will complicate the issue. The economy grew only 8.8 per cent in nominal terms in the first quarter of the ongoing year, and full-year growth is likely to be at a similar level. If such growth (under 10 per cent)  continues for a few years, attaining the 50 per cent debt target could demand aggressive tightening.

 

This implies that there would be several moving parts, which could make communication difficult. Besides, several other issues require clarity and debate. Compared to the earlier target of reducing central government debt to 40 per cent of GDP, it is now targeted to be around 50 per cent by March 2031. So, will the higher level of debt curtail the government’s ability to respond to a potential shock? Alternatively, would continuing on the existing path and reducing the fiscal deficit to 3 per cent of GDP or below not help create more policy space?

 

Further, financial markets look at the general government debt. Thus, in this context, will states be expected to follow a similar framework, targeting a debt level over the medium term? This may require different targets for different states to ensure that the general government debt remains on a declining path over the medium term.

 

Finally, clarity on the level at which the fiscal deficit is expected to stabilise over the medium term will help. This is important, particularly in the context of the financing capacity of the economy. The net household financial savings have declined in recent years. If most of the savings are used to finance the general government deficit, it would affect the cost of capital in the economy and increase dependence on foreign savings, if private investment revives sustainably, a necessary condition for growing at a higher rate in the long run. Thus, there are several issues that need policy attention. The government has done really well on the fiscal front over the past several years, and any ambiguity about the future path could put the hard-won gains at risk.