There are no clear indications of higher debt levels impinging on growth, it depends on whether debt is used for financing investment

Kenneth Rogoff and Carmen Reinhart have become twice famous for different reasons. The first was for an amazing book called This Time Is Different, which was relevant in the context of the global financial crisis. The second is for a 2010 study that historically relates public debt to growth, which has gotten mired in controversy when certain data has been questioned. While the data problem can be addressed separately, their study showed that once the ratio of public debt to GDP of countries crosses the 90% threshold, then growth in GDP slows down. This broadly fits well with the generally accepted conventional wisdom that high government debt is not sustainable and is actually deleterious for the country.

This hypothesis can be tested for India since we went in for reforms in 1991-92. The period, admittedly, is too short to test such a hypothesis but the concept of fiscal discipline dominated economic thinking only after reforms were introduced. Therefore, this limitation has to be remembered when interpreting data.

Nevertheless, the study for this period is interesting as there were broadly four distinct phases that can be seen within the period up to FY13, where definite trends may be ascertained. The phases chosen have witnessed a unidirectional movement in the ratio of debt to GDP. Four aspects are captured in the accompanying table: average GDP growth, movement in the debt-to-GDP ratio (debt includes both central and state governments), combined fiscal deficit of the Centre and states and movement in gross capital formation in the public sector. The idea is to link debt levels with capital formation and GDP growth.

The table does show some interesting insights. To begin with, when the nation started on economic reforms, the focus was to lower the fiscal deficit, which also led to the debt levels being curbed. Growth did not pick up as the reforms were being put in place to create the right environment. Subsequently, in phase B, the country began to run higher deficits and debt was not associated with capital formation, as most of the borrowings were directed towards meeting revenue expenditure. It was probably only after FY03 that we started following the FRBM norms, which came into being in this year. While the fiscal deficit ratios came down, the debt levels remained high at over 90%. But this time the diversion was more towards capital formation, which reinforced growth?capital formation in public sector crossed 40% once again during this period. In the final phase, the government has gotten its act together and lowered the debt ratio to 72.5% with most states also reining in their debt and deficit levels. Growth has increased even while the fiscal deficit ratio has increased. Interestingly, when the deficit increased, capital formation also rose, while the converse happened when the deficit came down.

There are no clear indications as to whether higher debt levels impinge on growth, though some observations may make it tempting to draw such a conclusion. Declining debt levels in two phases have been associated with high growth while a phase of rising debt level (phase B) has witnessed lower growth. However, the third phase that had probably the highest debt levels, which exceeded the 90% benchmark, witnessed high growth too. Two sets of explanations may be examined here.

The first relates to the role of capital formation. When debt was high at over 90%, the public sector (which includes government and PSUs) also invested heavily, which helped in bringing about growth. However, in phase A and B, capital formation in public sector had declined, which also affected growth. In phase D, debt levels came down, but capital formation rose in the first three years and then declined. This was in line with the growth trends. Therefore, it can be stated that higher deficits and debt when aligned with higher capital formation can lead to better results.

The second explanation is that government debt levels come in the way of growth only in case it squeezes out private investment due to lack of funds. But in India this has not really happened as all government borrowings are in the market and the fact that banks do hold on to a higher quantum of SLR securities than what is mandated implies that there are other reasons for doing so in the realm of capital adequacy as well as provisioning for bad debts. Further, RBI has played a critical role in ensuring that funds are always made available to the banking system by actively indulging in open market operations to strike a balance between both the private sector borrowing and government requirements.

An argument put forward is that the interest rate regimes get affected by higher government borrowing. Here again, the reason for RBI increasing interest rates has historically been linked with inflation and not to ration out credit through higher rates.

While the numbers presented do not present a clear picture, there is reason to believe that government debt and growth cannot be really linked that easily. The quality of debt in terms of how the borrowed funds are being used is critical because if the funds are being used to create capital, then it benefits growth in an aggressive manner. Second, there have been few signs that such borrowing has come in the way of private sector borrowing. With growth in bank credit being generally steady over the years, there is no strong link here too. Even so growth is driven by other factors such as farm production, growth in service sector, economic environment, and inflow of foreign investment and so on.

Therefore, while such a linkage may be an attractive proposition, it is not really supported by data and the manner in which our system has functioned.

The author is chief economist, CARE Ratings. Views are personal