Debt, deficits, growth: Why state discipline matters for fiscal health

While markets focus on the Centre's consolidation, state fiscal discipline and strong growth will be crucial to medium-term fiscal sustainability

Until 2017, India’s fiscal architecture was centred around a path of fiscal deficits. That changed when public debt became the anchor in 2018, underpinned by the recommendations of the N K Singh Committee report. This was both necessary and desirable because debt dynamics are the ultimate measure of medium-term fiscal sustainability — or lack thereof. Also, a focus on medium-term debt dynamics to gauge inter-temporal fiscal sustainability frees up annual fiscal deficits to play a short-term counter-cyclical role.   

Focusing on public debt dynamics has assumed a new-found urgency post pandemic, because the fiscal response to the pandemic, alongside the hit to GDP growth, in those years worked jointly to dramatically push up debt ratios in many parts of the world.   

In India’s case, public debt/GDP gapped up from 70 per cent in 2018 to 89 per cent in 2021, before re-tracing to about 82 per cent in 2024-25. To be sure, there is no sacrosanct level of debt in a post-pandemic world. Instead, what matters is how debt dynamics evolve over time. A monotonic increase in debt ratios is a tell-tale sign of fiscal unsustainability. Conversely, making fiscal space for future shocks necessitates putting debt/GDP on a firmly declining path. 

That is exactly the path the Central government has chosen. Recall, until this year, the Centre was committed to reducing its fiscal deficit to below 4.5 per cent of GDP in FY26 and it is on course to achieving that target. Going forward, however, the Centre has indicated fiscal policy will be governed by reducing Central debt — from 57 per cent of GDP in FY25 to 50 per cent (+/-1 per cent) of GDP by March 2031. 

The importance of growth 

What will this imply for the fiscal path going forward? Recall, debt dynamics depend on the interplay of three variables: The primary deficit (pd), the weighted-average cost of borrowing (r) and nominal GDP growth (g). In particular, “r-g” — the relationship between borrowing costs and nominal GDP — is crucial to debt dynamics. For any given primary deficit and cost of borrowing, the higher the nominal GDP growth, the more favourable debt dynamics. The corollary: The lower the nominal GDP, the more the primary deficit (and hence fiscal deficit) needs to be reduced to achieve a given debt target.  

Now consider this: If nominal GDP growth averages 10 per cent over the next 5 years — as the Centre may assume in its baseline assumptions — the Centre will have to reduce its fiscal deficit from 4.4 per cent of GDP in FY26 to 3.6 per cent of GDP in FY31 to reach the central debt target of around 50 per cent of GDP by FY31. A 0.8 per cent of GDP consolidation across five years is not a particularly onerous task, especially given that a declining interest payments/GDP ratio will mechanically do most of the work in the coming years.  Instead, the primary deficit (what the Centre controls) will have to come down by only 0.4 per cent of GDP over the next five years — which is unlikely to put pressure on the system. 

But small changes in nominal GDP can have large implications for the fiscal ask. Nominal GDP is on course to printing at just 8 per cent in FY26. While this may be an overshoot, China’s excess capacity is creating disinflationary pressures around Asia and is likely to keep inflation and, with it, nominal GDP, capped.  

What if nominal GDP growth settles at 9 per cent in the coming years, which is increasingly plausible? Then the Central fiscal deficit would need to be reduced all the way to 3 per cent of GDP by FY31, necessitating a large 1.4 per cent of GDP consolidation because “r-g” is less favourable under this scenario. The primary deficit will have to do the heavy lifting and be reduced by 1 per cent of GDP in five years. So, how growth pans out from here will have a crucial bearing on fiscal pressures in the coming years.  

Enter state debt 

But even as the focus in the upcoming Budget is likely to be on how central finances evolve, what matters for the economy — debt sustainability, borrowing costs and ratings — is how combined public debt evolves, which brings into play (often-ignored) state debt dynamics. 

While state debt — currently at around 28 per cent of GDP — is half that of the Centre, its dynamics in the coming years are far more precarious because (i) states have a much higher primary deficit (1.3 per cent of GDP), (ii) states have higher borrowing costs, because they pay a premium over the Centre and; (iii) paradoxically, the favourable effects of a negative (r-g)  are less beneficial for states because of the lower stock of initial debt that it can work on, such that the adverse impact of a larger primary deficit tends to dominate. 

The implication: If state deficits remain at current levels (3.3 per cent of GDP), state debt will continue to monotonically rise — whether nominal GDP is 9 per cent, 10 per cent or even 11 per cent. 

More importantly, what this does is to undo some of the effects of the Centre’s consolidation. Consider this — if nominal GDP averages 10 per cent, and the Centre reduces its deficit to 3.6 per cent of GDP, central debt/GDP would fall from 56 per cent to 50 per cent of GDP by FY31 — with the Centre thereby meeting its debt target. But combined debt would barely move, edging down from 81.5 per cent currently to 79 per cent of GDP in FY31, because half the central consolidation would be undone by the states. 

Things get more hairy if nominal GDP settles at 9 per cent. Now the Centre would have to reduce its deficit all the way to 3 per cent of GDP to bring central debt down to 50 per cent. But despite that large consolidation by the Centre, combined debt would barely move — from 81.5 per cent to 80 per cent of GDP by FY31 — because state debt undoes the bulk of central reduction.

  What are the lessons from all this?   

First, growth is crucial for debt sustainability. The lower the nominal growth, the more the fiscal consolidation needed for debt sustainability, and this can create a vicious cycle of austerity and lower growth that Europe experienced in the last decade. So strong growth is a necessary, if not sufficient, condition for debt sustainability. 

Second, to bring combined public debt/GDP down decisively in the coming years — and thereby create fiscal space in a shock-prone world — central fiscal consolidation will not be enough. State debt is on a monotonically rising path, and fiscal consolidation at the state level is crucial to stabilising state debt dynamics and helping bring combined public debt down. Burden sharing — how much of the deficit reduction is done by the Centre and states given that state debt is half of the Centre’s — is something the Centre and states will need to reach a grand bargain on. On this front, the report of the 16th Finance Commission is eagerly awaited. 

Third, sustained deficit reduction at a time when the economy needs much more investment in human and physical capital along with managing the green transition will require improving the quality of expenditures (especially at the state level) and being bold and creative on revenue mobilisation through disinvestment and asset monetisation.

Over the next few days, markets will obsess about the Centre’s deficit, borrowing and the impact on bond yields. But while this will generate a lot of noise, it will not throw much light. Instead, true fiscal sustainability will depend on how combined public debt evolves in the coming years. 

 

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The writers are in the economics team at J P Morgan Chase India