In his maiden budget speech finance minister Arun Jaitley had talked about the government working towards lower fiscal deficits in the years to come. “ 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,” Jaitley had said in July 2014, when he presented the first annual budget of the Narendra Modi government. Fiscal deficit is the difference between what a government earns and what it spends.
A lot has changed since then. The mainstream view that now seems to be emerging is that the government needs to spend more in the days to come, given that the private sector is not spending as much as it should.
One of the first to advocate this view was Arvind Subramanian, the Chief Economic Adviser to the ministry of finance. In the Mid Year Economic Analysis Subramanian wrote: “Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world. The ripples from the corporate sector have extended to the banking sector where restructured assets are estimated at about 11-12 percent of total assets. Displaying risk aversion, the banking sector is increasingly unable and unwilling to lend to the real sector.”
This has led to a situation where banks aren’t interested in lending and corporates aren’t interesting in investing. In order to get around this problem Subramanian suggested that: “it seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward, not to replace private investment but to revive and complement it.”
On the face of it, this make perfect sense. It is being suggested that finance minister Jaitley should give up on the fiscal deficit target of 3.6% of the GDP for 2015-2016 and look to work with a higher fiscal deficit number. The logic offered is straightforward. The public liabilities of the central government(which includes the public debt and other liabilities like external debt reported at current exchange rates and liabilities of the national small savings fund) have been falling over the years.
The public liability in 2008-2009 stood at 48.9% of the GDP. Since then the number has fallen to 45.7% of the GDP in 2014-2015 (estimated). The biggest fall has come under other liabilities which include national small savings fund and the state provident funds. These liabilities have fallen from 9.7% of the GDP to 5.8% of the GDP. The public debt has risen marginally from 39.1% of the GDP in 2008-2009 of the GDP to 39.9% of the GDP in 2014-2015.
On the face of it, the public debt and liability numbers of the central government are in a comfortable range. All in all the simple point is that the government can spend more, run a higher fiscal deficit and look to finance that through higher borrowing.
But these numbers do not take into account the public liabilities and debt of the state governments. How do there numbers look? Article 293(1) of the Indian Constitution empowers the state governments to borrow domestically. The public liabilities of the state governments stood at 26.1% of the GDP in 2008-2009. This has since fallen to 21.4% in 2013-2014. The public debt of the state governments has also fallen from 19.1% of the GDP to 16.1% of the GDP.
The number that one needs to look at is the general government liabilities and not just the central government liabilities. As the latest Government Debt Status Paper points out: “General government [liabilities] represents the indebtedness of the Government sector (Central and State Governments). This is arrived at by consolidating the debt of the Central Government and the State governments, netting out intergovernmental transactions viz., (i) investment in Treasury Bills by States which represent lending by states to the Centre; and (ii) Centre’s loans to States.”
As can be seen from the accompanying table the general government liabilities were at 70.6% of the GDP in 2008-2009 and have fallen to 65.3% of the GDP in 2013-2014. This fall has primarily come about due to a fall in liabilities of the state governments.
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So does this mean that the government can borrow and spend more and in the process run a higher fiscal deficit? The answer is not so straightforward. The latest government debt status paper provides several reasons in favour of India’s debt being sustainable. As it points out: “Government debt portfolio is characterized by favourable sustainability indicators and right profile. Share of short-term debt is within safe limits, although it has risen in recent years. Most of the debt is at fixed interest rates which minimizes volatility on the budget.”
Over and above this most of government debt is domestic in nature and hence, there is no currency risk. “Conventional indicators of debt sustainability, level and cost of debt, indicate that debt profile of government is within sustainable limits, and consistently improving,” the status paper points out.
But does this mean that the government can borrow and spend more without attracting the ire of the international rating agencies which have been following India’s fiscal deficit levels rather closely over the last few years? The thing is that India’s public liabilities and debt cannot be looked at in isolation.
We live in a highly globalized world where economic numbers are constantly being compared. As economist Sajjad Chinoy wrote in a recent column in the Business Standard: “India’s consolidated fiscal deficit is currently close to 6.5 per cent of GDP, while countries with the same sovereign rating as us have a median and mean deficit of 2.5 per cent of GDP – 400 bps lower! The inflation tax has been chipping away at India’s debt/GDP ratio, but at 65 per cent – it is substantially higher than the 40 per cent debt/GDP ratio of the median country amongst our sovereign ratings peers.”
This is a very important point which most mainstream views on the subject seem to be ignoring. Jaitley in his maiden budget speech had promised a path of fiscal consolidation. If he chooses to abandon it midway this is not likely to go down well with foreign investors as well rating agencies.
Further, it is worth remembering that the Federal Reserve of the United States plans to start raising interest rates sometime this year. This means that a lot of easy money that has come into India and other emerging markets might leave the country.
The last time this happened in May 2013 was when Ben Bernanke, the then Chairman of the Federal Reserve merely hinted at interest rates going up in the future. Back then, a lot of easy money left India (particularly the debt market) and the rupee fell to 69 to a dollar in the process. I am sure the finance minister does not want anything of that sort to happen all over again.
Given this, he should be very careful about how he goes about financing any big public investment programme. In tomorrow’s column I will discuss how Jaitley can look to finance a public investment programme.
The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 28, 2015