India’s Struggle with the FRBM Act, Rising Debt and the COVID-19 Scenario
Developments in the FRBM Act
The Fiscal Responsibility and Budget Management Act (2003 was introduced by former Finance Minister Yashwant Sinha to promote fiscal prudence in Indian governance. The FRBM Act in some of its initial versions mandated the following points, but not exhaustively:
- Bringing the gross fiscal deficit (the difference in between the government receipts and the government expenditures) down to 3% of the GDP by March 2008, with a targeted reduction in the same by 0.3% per annum.
- Complete elimination of the revenue deficit (the difference in between the revenue receipts and the revenue expenditures of the government), with a targeted reduction in the same by 0.5% per annum.
- Reduction of liabilities to 50% of the estimated GDP by the year 2011.
- Barring the government from directly borrowing from RBI to monetize the deficit for the independence of monetary and fiscal policy, including the purchase of primary issues of the Central Government securities by the RBI after 2006.
Over time, the Act developed in many respects, such as the introduction of Fiscal Responsibility Legislations (FRLs) for states by the 12th Finance Commission, and setting of the fiscal deficit threshold limit of 3% of Gross State Domestic Product (GSDP) for the states with some year-to-year flexibility and an additional headroom to a maximum of 0.5%. Also, the concept of effective revenue deficit (difference in between the revenue deficit and grants by the central government for the creation of capital assets) was introduced, among other changes to the targets (mildly criticized to be too strict to be followed) by the government. Looking at the gross fiscal deficit and revenue deficit numbers of the Indian government over the years, it is clear the government indeed failed to stick to the requirements of the FRBM, achieving them only once in 2007–08 with a 2.5% gross fiscal deficit, which was immediately followed by the global subprime crisis.
Currently, the FRBM Act requires the government to limit fiscal deficit to 3% of the GDP by 31st March 2021, and the debt of the central government to 40% of the GDP by 2024–25.
Why is Fiscal Deficit or Debt a Problem?
While fiscal deficit can be considered a flow variable, the accumulation of the deficit over time gives us the debt of the economy, a stock variable. A large debt and persistently high fiscal deficit indicate negatively towards the financial health of an economy. It may not necessarily mean that the economy is at the brink of a crisis or a collapse, but it might hint towards it; Greece had a debt to GDP ratio of 126.7%, highest in the European Union, when it slipped into a financial crisis. As of the third quarter of 2019, it struggles with the vestiges of the same, at a 178.2% debt to GDP ratio. Just as a firm with a high amount of debt has a weak credit profile due to uncertainty about whether it can make its repayments or not, the credit profile of a country can weaken due to mounting national debt and doubts about the nation’s ability to pay them back.
If we make a comparison of 2019 figures of the debt to GDP ratios of a few emerging market countries, we see that India is second to only Brazil and Pakistan. Moreover, various credit rating agencies have indicated that the situation may worsen further; while Fitch forecasted an increase in the debt to GDP ratio from 70% to 76% due to a wider fiscal deficit and low economic growth, Moody’s has proposed an even higher increase to 81%.
It may be argued that at times, a higher debt to GDP ratio may not necessarily indicate towards a weak economy, such as in the case of Japan, the USA and China, which have a debt to GDP ratio of around 200%, 110% and 303% respectively. Here, the question arises as to whether India can fit in with these countries. It is an important thing to note that India, as of now, doesn’t have the infrastructure that these countries have, or the robust capital market that is the lifeblood of the US economy, which enables it to come up with novel debt instruments to take care of its existing debts. To reach the league wherein the world perceives India as a strong and developed economy, which is able to sustain itself even with a high level of debt due to high productivity, it’ll take a number of reforms and developmental activities. This has been addressed (at least superficially) in the Finance Minister’s multiple addresses to the nation last week. If everything goes as stipulated, the Indian economy will be able to perform more efficiently, with vigorous supply chains and better employment of factors of production. These reforms, however, are going to take a long time to bring visible impact to the economy.
In these trying times when the importance and urgency of a fiscal stimulus has increased manifold, the only things that remain to be done are to understand the state of India’s debt and to consider ways of financing the debt. In order to judge what implications a high debt to GDP ratio has in the case of India, it is important to look at the sustainability of India’s debt. An interesting perspective in this regard is given to by a study by Paolo Mauro and Jing Zhou, who say that the interest growth differential is the prime factor in describing the sustainability of debt of a nation and the downgrade of its credit ratings, with a negative differential indicating that the debts are coverable by the growth of the economy. There has been a significant drop in India’s growth projections by the World Bank and IMF, the numbers being 1.5–2.8% and 1.5–5.8% respectively, while the ADB projection is at 4%. The State Bank of India’s research suggests that the aforementioned differential is likely to turn positive for India towards the end of 2020 if the growth numbers do not show an improvement from the current estimates. The gross fiscal deficit for FY21 has been estimated to be 7.9% of the revised GDP.
India’s Response to COVID-19
As of now, India has announced a fiscal stimulus of nearly 10% of the GDP, in line with measures taken by many other countries. The total announced borrowing of the centre and states is estimated to be standing an excess of ₹10 lakh crores. There are three noteworthy causes of concern here. The first one is the fact that the government relies excessively on small savings of India for financing its deficit, including the financing of the Food Corporation of India, which makes food security heavily reliant on small savings. The other point to be noted is that there has been little clarity regarding how the government actually plans on financing its debt. Given the exceptional situation that the pandemic has brought with it, it is not unlikely that the government might resort to monetisation of its debt. The RBI, in April, engaged in the purchase of various government securities in the secondary market in order to soften bond yields, a measure taken by many central banks around the world. However, some say that this might signal towards future prospects of monetisation as well.
Thirdly, loan guarantees, concessions for MSMEs and other sector-wise measures that have been taken by the government seem like sensible measures, but there have been no announcements of plans regarding how banks and NBFCs crumbling under 6-month moratoriums are to be handled. Banks could probably become wary of credit creation in such a scenario, expecting low profitability and high risks. It is also important to note that a major chunk of the 20 lakh crore “Atmanirbhar Bharat" package announced by the government consists of liquidity measures, and includes the measures announced earlier under the PMGKP and by the RBI, and these liquidity measures might do little to promote credit creation.
The administration’s (more than welcome) policies target long term scenarios, whereas the relief warranted for a short to medium term occurence, such as a recession, is missing. Demand might start seeing a slow revival after the opening of lockdowns, but tax cuts or other incentives might have supported this further. Of course, this only works if tax cuts are actually and immediately translated into expenditure, which could be hindered due to apprehensions. In any case, it may prove to be an effective medium term tool for the government to stimulate demand. The lack of an efficient supply chain has also affected farmers adversely, and it is important that their produce is bought by the administration. At the same time, food security of the nation needs to be ensured. The government should also promote energy efficiency in homes and population control among the people of the country; it is important to understand that the population of a country can debilitate the infrastructure and the efficacy of public schemes and expenditures.
All in all, it is perhaps a general consensus that the FRBM targets are to be further postponed in these exceptional times. The inevitability of debt calls for more ways to raise it from the domestic sector of the economy, such as the issuance of a COVID bond. This shall prove to be a more effective and a more concrete way of providing COVID relief than schemes such as CM and PM funds, which rely on the altruistic behaviour of people and provide them with no tangible returns.
References
1. “India has less fiscal room to support economy; rise in debt-GDP ratio to weaken credit profile : Fitch”, Economic Times, 12th April 2020
2. “India’s government debt could mount to 81% of GDP by 2024 even at the pre-COVID rate of growth, warns Moody’s”, Business Insider, 8th May 2020
3. Mauro, & Zhou (2020), R Minus G Negative: Can We Sleep More Soundly?, IMF Working Paper №20/52
4. Government Borrowing and Redemption Matched till May: RBI Monetisation of Fiscal Deficit a Must, SBI Econowrap Issue №01, FY21
5. New Package and Fiscal Dynamics, SBI Econowrap Issue №10, FY21
