Dealing with the high government debt

GS Paper III

News Excerpt:

The pandemic’s aftermath has led to the Centre and states accumulating a high level of debt. Bringing it down will be a challenge for the next government.

More details on the news:

  • The government will end its term with overall public debt in excess of 80% of India’s gross domestic product (GDP) at current market prices.
  •  According to International Monetary Fund (IMF) data, general government debt – the combined domestic and external liabilities of both the Centre and the states – touched 84.4% of GDP in 2003-04. That ratio fell to a low of 66.4% in 2010-11. It rose gradually to 67.7% in 2013-14 and 70.4% in 2018-19.
  •  The debt-GDP ratio increased to 75% in 2019-20 and peak at 88.5% in 2020-21, before easing to 83.8% and 81% in the following two fiscal years (April-March).
  • The IMF has projected the ratio at 82% in the current fiscal and 82.4% for 2024-25, which is still close to the high levels of the early 2000s. 

Government debt 

  •  Government debt is basically the outstanding domestic and foreign loans raised by the Centre and states – plus other liabilities, including against small savings schemes, provident funds and special securities issued to the Food Corporation of India, fertiliser firms and oil marketing companies – on which they have to pay interest and the principal amounts borrowed.
  •  As per the Fiscal Responsibility and Budget Management (FRBM) law, the general government debt was supposed to be brought down to 60% of GDP by 2024-25. The Centre’s own total outstanding liabilities were not to exceed 40% within that time schedule.
  •   In absolute terms, the Centre’s total liabilities have more than doubled from Rs 90.84 lakh crore to Rs 183.67 lakh crore between 2018-19 and 2024-25.
  • India faces challenges in enhancing its credit ratings due to elevated debt levels and the substantial cost associated with servicing that debt.

Fiscal Responsibility and Budget Management Act, 2003 (FRBM Act)

  •  The FRBM Act aims to introduce transparency in India's fiscal management, fostering fiscal stability and providing the Reserve Bank of India (RBI) flexibility to address inflation. Equitable distribution of India's debt over the years is another long-term goal.
  •  The FRBM Act mandates the government to annually present the following documents in Parliament alongside the Union Budget:
    •   Medium-Term Fiscal Policy Statement
    •  Macroeconomic Framework Statement
    •  Fiscal Policy Strategy Statement
    • The Act also requires projections of revenue deficit, fiscal deficit, tax revenue, and total outstanding liabilities as a percentage of GDP in the medium-term fiscal policy statement.


Debt-to-GDP ratio

  • The debt-to-GDP ratio is the ratio of a country's public debt to its gross domestic product.
  • The debt-to-GDP ratio can also be interpreted as the number of years it would take to pay back debt if GDP was used for repayment.
  • The higher the debt-to-GDP ratio, the less likely the country will pay back its debt and the higher its risk of default, which could cause a financial panic in the domestic and international markets.

Reasons for high level of debt

  • Covid-Induced Disruptions and Increased Borrowing: The most obvious reason is the Covid-induced disruptions that forced governments to borrow more – to fund additional public health and social safety net expenditure requirements – amid a drying up of revenues.
    • The combined gross fiscal deficit of the Centre and the states – the gap between their total spending and revenue receipts – went up from 5.8% and 7.2% of GDP in 2018-19 and 2019-20 respectively, to 13.1% and 10.4% in the next two fiscals.
    • The Centre’s fiscal deficit alone increased from 3.4% of GDP in 2018-19 to 4.6% in 2019-20, 9.2% in 2020-21 and 6.8% in 2021-22.
  •  Debt in other countries: India was no exception though. Most countries sought to mitigate the impact of the pandemic through fiscal stimulus and relief programmes.
    •  General government debt climbed from 108.7% of GDP in 2019 to 133.5% in 2020 and 121.4% in 2022 for the US; from 97.4% to 115.1% and 111.7% for France; from 85.5% to 105.6% and 101.4% for the United Kingdom.
  •     Increased Public Investments: The government, apart from spending more on income and consumption support schemes, also stepped up public investments in roads, railways and other infrastructure.
    • The Centre’s capital expenditure, as seen from chart 2, dropped from 3.9% to 1.5% of GDP between 2003-04 and 2017-18. It revived significantly thereafter to reach 3.2% in 2023-24 and 3.4% in the Interim Budget for 2024-25.

Way forward

  • Fiscal Consolidation for Debt Control: While fiscal consolidation can ensure a check on borrowings and not too much being added to the stock of government debt relative to GDP – the IMF has warned against it crossing the 100% mark – there are two other routes as well for bringing the latter down. That would involve what one may call the denominator effect.
  •    Leveraging Nominal GDP Growth: Government debt and fiscal deficits are usually quoted as ratios to GDP at current market prices. That being so, high nominal GDP growth – the denominator rising faster than the numerator – can go some way in solving the government’s debt problem. GDP growth, in turn, can come from both real output increases and inflation.
  • Growing" or "Inflating" Away Debt: The second and third way to drive down the government debt-to-GDP ratio is, then, to “grow” or “inflate” it away. This actually happened during 2003-04 to 2010-11 when general government debt, as already noted, plunged from 84.4% to 66.4% of GDP. That period, incidentally, also witnessed an average annual GDP growth of 7.4% in real and 15%-plus in nominal terms after adding inflation.
  •   Balanced Approach for Current Debt problem: India probably needs a combination of both fiscal consolidation and growth (from output more than inflation) to deal with its current debt woes, which are no less a legacy of Covid.


Supplementary information

Debt-to-GDP ratio of Indian states:

  • More than 33 % of India’s constituent units, the states and Union Territories with legislature, have projected their debt to cross 35 % of their respective gross state domestic product (GSDP) at the end of 2023-24.

Why do states see an increase in the debt-to-GDP ratio?

  •  Spending on infrastructure development, social welfare programs, and public services.
  • Budget deficits when revenue generation is less than expenditure.
  •   Economic shocks and unforeseen circumstances such as Pandemic.
  •  Political pressures lead to populist spending.
  •  Limited revenue-raising powers of the state government.

Factors affecting variation in debt-to-GDP ratios of Indian states:

Overall, the state-wise debt in India varies due to the following reasons-

  •  Economic Disparities: States with higher GDPs tend to have lower debt-to-GDP ratios.
  •  Fiscal Policies: Prudent fiscal practices can lead to lower debt burdens.
  • Demographic Factors: Population size and growth influence revenue generation and social spending, affecting the ratio.
  •  External Shocks: Natural disasters and economic shocks may lead to increased borrowing.
  •  Political Decisions: Governance quality impacts responsible debt management.
  •   Regional Disparities: Variations in regional economic conditions and historical debt burdens add complexity to these ratios

Implications of High Debt-to-GDP Ratios of Indian States:

A high debt-to-GDP ratio signifies a state's debt burden is substantial compared to its economic output. This indicates financial vulnerability and reduced fiscal flexibility. High debt levels can increase interest payments, crowding out other critical expenditures like healthcare and education. It may also raise concerns among investors and credit rating agencies, resulting in higher borrowing costs.

States with elevated debt levels face several challenges:

  •  Budget constraints: High-interest payments on debt reduce funds for critical services like education and healthcare.
  •  Reduced fiscal flexibility: Elevated debt levels hinder the ability to respond to economic downturns or emergencies.
  •   Investor confidence: High debt erodes investor confidence, raising borrowing costs and hindering economic growth.
  • Credit rating impact: It leads to credit rating downgrades, indicating higher credit risk and intensifying financial pressures.

Strategies to improve the high debt-to-GDP ratio of Indian states include:

  •  Fiscal Discipline: Reduce budget deficits to curtail debt accumulation.
  • Revenue Enhancement: Boost revenue through effective taxation policies.
  •  Prudent Borrowing: Implement responsible borrowing practices.
  • Debt Restructuring: Refinance existing debt to secure lower interest rates.
  •  Economic Growth: Invest in productive sectors to stimulate GDP growth.
  •  Enhanced Creditworthiness: These strategies can improve credit ratings.
  •  Lower Borrowing Costs: Resulting in reduced interest payments.
  • Sustainable Finances: Ensuring long-term fiscal stability.

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