Here is why the government should not forget about the fiscal deficit

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010When it comes to ideas to revive an economy which is not doing well, economists are essentially two trick ponies,They will first suggest that the central bank should cut interest rates. At lower interest rates people will borrow and spend more, businesses will benefit and the economy will grow faster as a result. QED.
And if that is not happening they will suggest that the government should increase public expenditure. As the government spends more money, that money will land up as income in the hands of people who will in turn and spend that money. The money that they spend will land up as income in the hands of other people, who will also spend that money. And so the multiplier effect will work, first leading to spending, and in turn creating economic growth.
The second trick seems to be dominating the debate currently in India. The mainstream view now seems to be getting around to the idea that the government should forget about the fiscal deficit, during the next financial year and spend more money, in the hope of creating more economic growth. Fiscal deficit is the difference between what a government earns and what it spends. The difference is made up for through borrowing.
The finance minister
Arun Jaitley had said in his budget speech in July 2014: “My Road map for fiscal consolidation is a fiscal deficit of 3.6 per cent for 2015-16 and 3 per cent for 2016-17.” It’s now being suggested that the finance minister should abandon these targets for the time being.
The logic offered is very straightforward. The
combined fiscal deficit of the central government and the state governments has fallen dramatically over the last few years. In 2009-2010, the number was at 9.33% of the gross domestic product(GDP) of India.
By 2013-2014 this had fallen to 6.78% of the GDP. During this financial year(i.e. 2014-2015) it is expected to fall to 6.03% of the GDP. Along with this the total liabilities of the central government have also gone down over the years from 48.8% of the GDP in 2009-2010 to 46.3% in 2013-2014. This number is expected to fall further to 45.7% of the GDP in 2014-2015, as per the government debt status paper released by the ministry of finance in December 2014.
So, what this seems to suggest is that the finances of the Indian government(s) are well placed at this point of time and given that, the central government can easily spend more. But is that really the case? Rajiv Shastri makes a very interesting point in a column
he wrote for the Business Standard in December 2013:In reality, quantifying deficit and accumulated debt only as a percentage of GDP has the potential to misguide. In isolation it distorts both, the true scale of fiscal profligacy and the government’s debt-servicing ability.”
What Shastri is effectively saying here is that the government does not have access to the entire GDP to repay its debt. It repays its debt only out of the money that it makes every year through taxes and other sources of revenue.
How is the central government doing on that front? In 2007-2008, revenue receipts stood at 10.87% of the GDP. By 2013-2014, they had fallen to 9.06% of the GDP. As far as tax collections are concerned, they have fallen from 8.81% of the GDP to 7.36% of the GDP. This year tax collections are expected to be at 7.59% of the GDP. This number is unlikely to be achieved given that the shortfall in tax collections is expected to be around Rs 1,05,084 crore or around 0.84% of the GDP.
The non-tax revenues of the government have also fallen from 2.05% of the GDP to 1.70% of the GDP between 2007-2008 and 2013-2014. During this financial year the number is expected to be at 1.65% of the GDP. Interestingly, the interest that the government pays on its accumulated debt was at 3.43% of the GDP in 2007-2008. It has jumped to 3.79% of the GDP in 2013-2014.
An increase in interest payments means lesser money gets spent on other important things. As economists Taimur Baig and Kaushik Das of Deutsche Bank Research point out in a recent research note: “
India’s central government spends nearly a quarter of its total spending on servicing the large debt burden…Bringing this down would create valuable space for other far more important expenditures.”
What these numbers clearly tell us is that the ability of the government to service the debt that it has accumulated has been coming down over the years, which is clearly not a good sign. Also, when compared to other emerging market countries, India has one of the highest government debt levels in the world, as can be seen from the following table.
DebtTable

Further, it is also worth remembering that a lot of other emerging market countries have already tried increased public spending in the aftermath of the financial crisis (as I said at the very beginning, economists have basically got only two ideas) and the results haven’t been great.
As Ruchir Sharma of Morgan Stanley points out in a column in today’s edition(Feb 16, 2015) of The Times of India: “Many big emerging nations including China, Russia and Brazil just tried a full-throttle experiment in stimulus spending, and it failed. The average growth rate for emerging economies excluding China has fallen to 2.5% today, from more than 7% at the height of the spending campaign in 2010. That is the lowest growth rate in four decades, outside of a global recession.”
Any government looking at increasing its spending in order to boost growth should keep this in mind. Also, at the end of the day what matters is not the quantity of spending but the quality of spending.
As Baig and Das point out: “
Recent budgets have routinely allocated close to 5% of GDP in capital spending, a non-trivial amount by any measure. But these generous allocations have not materialized in a discernible pick up in the investment cycle…If the authorities aim at high quality, high multiplier projects worth 4-5% of GDP as opposed to simply ramping up the rate of spending, they will handily achieve the goal of providing a boost to the economy, in our view.”
Also, increasing public spending by the government takes away attention from economic reforms. Both can rarely be executed together. As Sharma points out: “A stimulus mindset is the opposite of a tough reform mindset, and governments can rarely do both as the contrasting experience of the 1990s showed. By the end of that decade, most emerging nations had no money to burn, no lenders they could turn to.”
Given these factors, increasing public spending by the government may not be the best way to go about reviving economic growth.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The article originally appeared on www.firstpost.com on Feb 16, 2015

India does not need a fiscal stimulus

indian rupeesIn the recent past there has been talk of the government launching a fiscal stimulus in the next budget. Fiscal stimulus essentially refers to the government increasing public spending. The idea is that with the government spending more money, economic growth will be faster.
If the new gross domestic product (GDP) numbers are to be believed, India is likely to grow at 7.4% in this financial year (2014-2015). And at that rate of economic growth a fiscal stimulus may clearly not be required.
Nevertheless, high frequency data suggests otherwise. Exports fell in December 2014. The number of stalled projects continues to be huge. The car sales remain muted. Bank loan growth continues to remain slow. The bad loans of banks, especially public sector banks, continue to remain high. And corporate profitability continues to remain dull.
With these factors in the background, there might be pressure on the government to launch a fiscal stimulus. The question is would a fiscal stimulus be appropriate at this point of time?
One reason offered in favour of a fiscal stimulus is that the
combined fiscal deficit of the central government plus the state governments has been falling over the years. It had reached 9.33% of the GDP in 2009-2010(GDP at current market prices as per the old GDP series). Since then the combined fiscal deficit has come down to 6.78% of the GDP in 2013-2014. It is expected to fall further to 6.03% of the GDP in 2014-2015. Fiscal deficit is the difference between what a government earns and what it spends.
Since the combined fiscal deficit has fallen over the years, the government might as well spend some more money in the next financial year, is one logic being offered. There are a number of reasons why this does not make much sense.
First and foremost, the fiscal deficit as a proportion of GDP has fallen primarily because the GDP at current market prices has gone up dramatically between 2007-2008 and 2013-2014, at the rate of 14.7% per year. Much of this increase was due to the high inflation(at times greater than 10%) that had prevailed during this period.
Hence, the fiscal deficit to GDP ratio has come down primarily because the denominator (i.e. the GDP) has gone up at a very fast rate due to inflation. Along similar lines the general government liabilities which includes total debt of the central as well as state governments, loans from the central government to state governments and other liabilities, has fallen over the years. In 2008-2009, the general government liabilities were at 70.6% of the GDP. By 2013-2014, they had fallen to 65.3% of the GDP.
As economist Tushar Poddar
of Goldman Sachs wrote in The Economic Times recently: India’s stock of government debt has been eroded by high inflation in recent years.”
Hence, just looking at the fiscal deficit to GDP ratio or the general government liabilities to GDP ratio is not enough. What we also need to take a look at is whether the ability of the government to service the absolute debt that it has accumulated over the years has gone up. And this is where things get interesting.
One of the ways through which the government repays debt is through the tax revenue that it earns. Chetan Ahya and Upasana Chachra of Morgan Stanley in a recent note point out that the tax revenue earned by the central government as a percentage of the GDP has been falling over the years.
In 2007-2008, this had stood at 11.9% of the GDP. By 2013-2014, it had fallen to 10% of GDP. And in 2014-2015 it is expected to fall further to 9.6% of the GDP. What this means is that the ability of the government to service the debt that it has already accumulated has come down over the years.
Further, interest payments as a portion of the total expenditure in the annual budget of the central government have started to shoot up again. As e
conomists Taimur Baig and Kaushik Das of Deutsche Bank Research point out in a recent research note: “India’s central government spends nearly a quarter of its total spending on servicing the large debt burden. Despite the decline in the debt/GDP ratio in recent years, interest spending has begun to rise again, both as a share of GDP and a share of total spending.”
In fact, the interest that the government pays on its outstanding debt is the biggest line item in the budget. As Baig and Das point out: “Indeed, interest spending is bigger than any other line item in India’s current expenditure (e.g. defence, subsidies, health, and education) budget. Bringing this down would create valuable space for other far more important expenditures.”

Interest spending taking up a large chunk of the budget

Source: CEIC, Deutsche Bank

Also, it is worth remembering that countries do not operate in isolation. While the fiscal deficit and the overall liabilities of the government may have come out as a proportion of the GDP, they still remain high in comparison to other countries. As Poddar points out: “At 6.7% of GDP in 2013-14, the general government fiscal deficit[combined fiscal deficit of centre and states] is significantly higher than the Asian average of under 2% of GDP.”
Further, government borrowing tends to crowd out private sector borrowing and ensures that interest rates remain high. As Ahya and Chachra of Morgan Stanley point out: “
We believe that national fiscal (central plus state government) deficit below 5% of GDP will be ideal to allow real borrowing cost for the private sector to reduce meaningfully and encourage private investment.”
To conclude it is worth pointing out what economists Baig and Das of Deutsche Bank Research point out: “A
1% of GDP reduction in deficit leads to growth rising by 0.4% within 2 years subsequent to the effort. Most interestingly, the effect is persistent…suggesting a lasting impact on growth from fiscal consolidation.”
What all this clearly tells us is that the government should continue on the path of fiscal consolidation that it had laid out in the last budget. The finance minister Arun Jaitley had said in his budget speech that the government wants to achieve a fiscal deficit of 3.6% of the GDP in 2015-2016 and 3% of GDP in 2016-2017. He should continue working towards these goals.


The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning, on February 12, 2015