Ashima Goyal

How to spend, yet reduce government debt

Ashima Goyal | Updated on May 16, 2021

Deficit matters India must never lose sight of fiscal consolidation   -  /iStockphoto

A short-term rise in deficit to combat the pandemic is necessary. But in the medium term it is vital to reduce debt

Covid19 has seen a jump in public debt as a result of governments’ protection and stimulus expenditure. The largest rise by far is in advanced economies (AEs) who account for 80 per cent of the rise in borrowing. But their interest costs remain low. G-7 AEs debt rose from 85 per cent of GDP in 2005 to 140 per cent in 2021, but average debt servicing fell from 2 per cent of GDP to 1.5 per cent now. The reason is very low interest rates.

One school of thought argues real interest rates are likely to remain below growth rates because of secular stagnation — an excess of savings over investment, so that governments should borrow and spend more to raise growth. The real debt ratio falls if the rate of growth (g) exceeds the real interest rate (r), but rises with the primary deficit ratio (PD). PD is the excess of real government expenditure over taxation as a ratio to output. When ‘r’ is less than ‘g’ public debt ratios can reduce over time even if the PD is positive. The first component is the snowball effect.

Others fear real interest rates can rise enough to make debt unsustainable. There was a warning jump in benchmark US government 10-year bond yields after the large US stimulus announcement as well as inflation that exceeded the April forecast. They have risen from 1 per cent in end January to 1.68 per cent now.

In many emerging markets (EMs) also ‘g’ is expected to exceed ‘r’ because of good growth prospects. But borrowing costs are high and unstable. Indian government’s interest payments are the largest component of expenditure at above 3 per cent. Bond markets are more willing to lend to AEs. Volatility and uncertainty can raise risk premiums and interest rates. Sources of risk are domestic and international. Therefore it is necessary to reduce both, thus lowering the probability of interest rate volatility.

After the global financial crisis (GFC) not enough was done to moderate spillovers from AE quantitative easing (QE) and exit on EMs. They faced larger shocks in 2011, 2013, 2015, 2018 than they did during the GFC itself. In 10 major EMs pre-GFC IIP growth was 4.3 (2000-08); post-GFC (2009-17) it was 1.3. Since 2005 EMs account for more than 50 per cent of global growth — therefore a slowdown in EMs hurts the growth of all countries.

Countercyclical macroprudential regulation in the major source countries can reduce capital flow volatility. At present, such regulation is more in EMs than in AEs and applied more on debtors than on creditors, although research shows regulating the latter creates better incentives. For example, two major source countries, US and UK, have no prudential regulation of the non-bank financial sector.

Excessive focus on banks led to arbitrage towards non-bank sectors. Zero policy rates induced large cross border flows in a search for yield that reversed during global risk-off episodes. Careful Fed communication will be required when the Fed exits from QE to avoid a repeat of the 2013 taper tantrum-induced rise in EM interest rates. EMs need to ensure foreign flows remain a low percentage of domestic markets.

Important among domestic policies that reduce volatility are reforms and shift in government expenditures towards those that raise productivity. Spikes in domestic interest rates, excessive volatility of exchange rates and real over- or under-valuation and should be avoided. Reforms must avoid shocking the system, even as they remove supply-side bottlenecks that create volatility. That is one reason, at this stage of the pandemic, local containment is better than a national lockdown. It gives more degrees of freedom aligned to local conditions, while reducing infections.

A short run rise in deficits to protect incomes and prevent scarring from Covid-19 is essential, but a persistent rise in debt can raise risk premiums. A sustainable fiscal stance requires debt to fall in the medium term.

Despite a measured fiscal response to Covid-19, combined Indian government debt levels have risen towards 90 per cent of GDP in 2021. A high-powered inter-governmental Group is to redraft the FRBM that currently mandates a reduction to 60 per cent by 2025-26. Some relevant issues are outlined below.

Reducing public debt ratios

For the last 40 years Indian ‘g’ substantially exceeded ‘r’ paid on government debt.

Since ‘g-r’ much exceeded the positive PD, according to the formula, debt should have fallen 46.8 per cent over 2000-20, but the actual fall was only 6.8 per cent. The differences approximate off Budget items and contingent liabilities that added to debt. In successive 5-year periods over 2000-2020 estimates for these are 12.7, 14.2, 7, and 6.1. So after peaking over 2005-2010, these additions to debt fell, pointing to more transparency and better budgetary processes setting in slowly after the FRBM legislation.

Since all borrowings to further government objectives are now brought into the Budget, they should also decrease steadily on the specified FRBM adjustment path, barring further global shocks. Moreover, there is progress on attempts to monetise large poorly performing government assets accumulated in the planning period, to retire government debt or transform expenditure in more productive directions. A distinction between a temporary and a permanent rise in government expenditure is important. While deficits can finance the former, the latter requires a rise in taxation. Indian tax GDP ratios remain on the lower side given the large expenditure on physical and social infrastructure required. But the past decade has seen extensive tax reform as well as more comprehensive databases that should reduce informality and tax evasion.

Fiscal consolidation suffered from a poor appreciation of the snowball effect. Excess liberality in the 2000s wasted and excess consolidation in the 2010s reduced ‘g-r’ and the snowball effect. Policy was pro-cyclical since real interest rates were low when inflation rates were high in the 2000s and high when inflation was low after 2014.

The lessons for post-Covid-19 adjustment are to avoid pro-cyclicality as well persistent non-tax financed rise in spending, while maximising the snowball effect. To do this countercyclical policy must smooth shocks, prevent spikes in real interest rates and sustain growth. Nominal rates can vary with inflation. Smooth reduction in debt will help prevent a rise in risk premiums that can raise nominal and real interest rates.

Simulations show a countercyclical deficit path, that supports Covid-19 spending, does better over 10 years compared to a path that maintains a uniform PD of 1. Keeping ‘g-r’ at 5, reducing the PD to a mild surplus in 5 years, and avoiding off Budget liabilities, will reduce the debt ratio as much in six as was earlier accomplished in 25 years and reach FRBM target by 2030-31, 5 years behind the 2018 FRBM path. Once debt is steady at the FRBM target the PD can be positive at 2 per cent.

 

The writer is Emeritus professor, IGIDR. Views are personal

Published on May 16, 2021

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