India’s government has an interesting position in the nation’s economy and society. On the one hand, the government seems to be a dominant presence in public discourse and daily lives. At the same time, it is curiously dysfunctional, and sometimes absent when needed most. These characteristics should be kept in mind when considering the country’s public finances, which have been very much in the news. Recent news triggers have been the report of the NK Singh’s The Fiscal Responsibility and Budget Management (FRBM) Committee, which reviewed India’s rules for fiscal responsibility, and RBI’s annual report on state government finances.
Numerous stories have appeared in the press, the topic even attracting the interest of The Economist magazine, presumably popular reading among foreign investors seeking signals of India’s economic health. In fact, the current RBI Governor Urjit Patel was a member of the NK Singh committee, and in January had raised alarm bells about India’s government debt-to-GDP ratio. Ratings agencies and investment banks have also had the same cautionary tone.
What are the issues? The NK Singh committee focused, as was its charge, on the fiscal consolidation path of the central government deficit, along with the overall government debt-to-GDP ratio. The chief economic adviser of the government, also a committee member, had some dissents, and there was a back-and-forth on the relative merits of targeting fiscal deficit versus the primary deficit (which excludes interest payments), the optimal path to follow in reducing the deficit, and what the optimal debt-to-GDP ratio should be. As laid out by Pronab Sen in Ideas for India (http://ideasforindia.in/article.aspx?article=When-windmills-tilt:-The-FRBM-debate), the Fiscal responsibility and budget management committee report did not provide neither theoretical nor policy clarity and completeness. Aside from which targets to choose and how to get there, issues of how to handle business cycles and unanticipated economic shocks remain muddy.
Unlike this debate’s focus on the central government, others have called attention to a deterioration in state government finances. Sub-national government deficits were a huge concern for India in the early years of the millennium, and the experience of countries such as Argentina and Brazil was a stark warning of the dangers of “soft budget constraints” for state governments. At that time, India successfully pushed fiscal responsibility rules for the states as well as the centre, although it is unclear how much the rules mattered relative to favourable economic conditions. In any case, focusing only on the central government’s finances while the states are increasing their deficits cannot be optimal.
How bad are state government finances? Certainly, nowhere near as bad as they were over a decade ago. The central bank report on state government finances notes an increase in the states’ debt burden, but concludes that “the overall fiscal position is found to be sustainable in the long run.” Others are less sanguine, including Toshi Jain and Sajjid Chinoy of JP Morgan Chase, whose report is a major driver of The Economist story. They worry about “monotonically rising” state debt-to-GDP, with the “risk of it turning explosive.” Interestingly, they are as careful as the reserve bank to strip out the impacts of the Ujwal Discom Assurance Yojana (UDAY) scheme, which brings state distcom debt on to the governments’ budgets, and they are clearer in recognising that this is just a one-time recognition of liabilities, and not an increase (since the state electricity distribution companies had implicit guarantees of their debts).
They also point out that the problem of increased state borrowing and deficits predates the demonetisation shock, although the latter made things much worse, hitting various revenue sources. The JP Morgan study provides a nice complement to the NK Singh committee report, by discussing fiscal consolidation road maps for the states.
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What is to be done? The justification for fiscal consolidation is to avoid unsustainable debt paths, and crowding-out of private investment, domestic as well as foreign. At the same time, the quality of government expenditure—the starting point of this column—matters, as many have recognised. Saugata Bhattacharya, chief economist at Axis Bank, recently said, “If borrowed funds aren’t being spent on productivity, then there’s a problem.” This issue is a perennial problem for governments everywhere. Surprisingly, we lack good models or estimates of trade-offs that could help shape fiscal consolidation rules for the centre and the states.
One policy reform that can be tackled more easily than that of improving government expenditure quality is highlighted in the JP Morgan report—the states can now borrow on the market, but the nature of implicit guarantees means that the interest rates they pay have little relation to default risk. Changing this requires better-functioning bond markets and harder budget constraints. The latter requires extending the approach of the fourteenth finance commission, further moving away from discretionary centre-state transfers.
The big unknown in all this is the impact of the introduction of GST. If that is as successful as is hoped, and if the demonetisation shock also wears off quickly, it is possible that the relative optimism of the RBI report on state government finances (though not quite in line with the Governor’s concerns) will be borne out. Meanwhile, we can worry a little bit about fiscal deficits, but maybe we should worry more about the quality of government spending, and our lack of understanding of the processes that truly drive Indian economic growth.
Authore is the Professor of economics, University of California, Santa Cruz. Views are personal.