 "finance, debt, bridge, gap, dividend")
The combined stock of debt owed by Indian states is about 21 per cent of gross domestic product (GDP) — excluding UDAY bonds — today and is proliferating unsustainably. Higher borrowing (fiscal deficit) by states, even though it remains within the annual target of three per cent of GDP, threatens the sustainability of sub-national debt at present levels.
India’s fiscal rule framework imposes legal limits of three per cent of GDP on the fiscal deficits of central and state governments. Adhering to these borrowing limits, though prudent economics, makes for difficult politics as expenditure is curtailed. It is, therefore, a significant achievement that Indian states have largely operated within their three per cent fiscal deficit limits in the past decade.
This raises a paradox: Why is the states’ debt unsustainable today despite their commendable adherence to hard borrowing limits? Though high primary deficit of the states is one reason, there is also a deeper, conceptual reason for their deteriorating debt levels.
Internally inconsistent fiscal rules
Illustration: Binay Sinha
The fault lies not in the inadequate implementation of fiscal rules by the states but in the design of these rules themselves. A three per cent cap on fiscal deficit is too high to stabilise the states’ debt around the desired level of 20 per cent. Why then was the states’ fiscal deficit target set at this level?
Though an insubstantial, post-facto justification, based on simplistic fiscal arithmetic, came from the 12th Finance Commission, the level of the states’ fiscal deficit target was probably kept at three per cent to make it politically palatable by maintain equality with the Centre’s deficit target.
But the symmetry in the deficit targets for the states and the Centre was, and remains, inconsistent with the widely divergent debt levels of the two tiers of the government. While the annual fiscal deficit targets of three per cent of GDP are equal for both the Centre and the states, experts within the government and outside have long argued for an unequal division of general government (states plus the central government) debt, with 40 per cent apportioned to the Centre and the residual 20 per cent to the states. Thus, by design, India’s fiscal framework creates a tension between the equal targets for annual flows of borrowing (that is, fiscal deficit) on one hand and the unequal levels of the desired stock of accumulated borrowing (that is, debt) on the other.
The importance of the level of debt
What matters for macroeconomic stability is not the value of debt in rupees but the magnitude of debt relative to the magnitude of GDP, that is, the debt-GDP ratio. In a country with high nominal GDP growth like India, this has key implications on how fiscal data are interpreted. As GDP grows rapidly, it partially erodes the debt-GDP ratio each year because even if debt rises in magnitude (due to fresh borrowing), it shrinks in proportion to GDP.
For example, at present levels of nominal GDP growth of 11-12 per cent, about 11 per cent of the debt-GDP ratio is eroded each year merely on account of GDP growth. In the previous fiscal year (FY17), this was over five percentage points of the central government’s debt ratio of 49.4 per cent of GDP. Therefore, despite fresh borrowing of 3.5 per cent of GDP last year, which added to the magnitude of debt, the Centre’s debt-GDP ratio decreased from 49.4 per cent in FY17 to 47.4 per cent of GDP in FY18. How? Because between FY17 and FY18, GDP growth eroded as much as 5.5 percentage points from the central government’s debt-GDP ratio.
States, however, are not so lucky. GDP growth erodes their debt-GDP ratio by only 2.1 percentage points, less than half as compared to the Centre. Like in the case of the central government, this is about 11 per cent of their present debt-GDP ratio of just over 20 per cent of GDP. The rate of erosion (that is, 11 per cent) is the same for both tiers of the government. However, in the case of states, this erosion rate works on a much lower debt-GDP ratio of 20 per cent of GDP, yielding a smaller annual growth-erosion as compared to that of the central government.
Though counter-intuitive, it follows therefore that the Centre can afford larger deficits because of its larger stock of debt alone. A symmetry cannot be forced on the targets for fiscal deficits of central and sub-national borrowing given the significant difference in their present and desired stocks of debt. Any such attempt will simultaneously induce the debt-GDP ratios of the two tiers of the government to converge. Currently, at around three per cent of GDP, states are borrowing more than their annual erosion of debt due to nominal GDP growth. If this trend continues, their debt-GDP ratio will continue to rise, eventually stabilising at around 30 per cent, far above the desired level.
To the extent that debt is taken as an anchor around which fiscal policy is planned, it may provide for a rare infusion of logic in the otherwise dismal science of setting the levels of fiscal targets. An upper bound for fiscal deficit can easily be derived from the desired level of debt. At 11-12 per cent of economic growth, converging to the desired debt-GDP ratio of 40 and 20 per cent for central and state governments respectively requires that the states run deficits of no more than two per cent of GDP, significantly lower than their present deficit targets. The Centre, on the other hand, can afford deficits of up to four per cent of GDP. It is no surprise, therefore, that sub-national debt is projected to rise even though states have largely adhered to their present fiscal deficit limits. The 15th Finance Commission, which is likely to be set up later this year, must amend fiscal rules to maintain consistency between the stock and flow variables.
The author is a Delhi-based economist
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