Advice and dissent on India’s fiscal path
Source: By Indira Rajaraman: Mint
The report of the Fiscal Responsibility and Budget Management (FRBM) review committee (chaired by N.K. Singh) was made public in mid-April 2017, three months after submission to the government at the Centre. The report prescribes a fiscal path over a six-year period of fairly severe fiscal tightening going up to the year 2023. What it prescribes for the period beyond is a bit unclear, and is one of the issues raised in a detailed note of dissent by a key member of the committee, the chief economic adviser (CEA). The rejoinder to the dissent note by the committee does not clarify matters. The other members of the committee included important functionaries like the serving governor of the Reserve Bank of India.
The report carries a draft Bill in an annexed. In a section of the Bill headed “Debt target”, there is a commitment that the outstanding debt of general government in India, summing across Centre and states, will not exceed 60% of gross domestic product (GDP) by 2023, and that the Central component of this will not cross 40% of GDP. It then commits to maintaining these targets thereafter, which presumably means that the ceilings will continue to hold. The steady state level of public debt towards which the Indian economy will converge is left unspecified, other than that it will, by implication, lie below the ceiling. The steady state level will be a function of the operating target for the general government fiscal deficit (FD). But since the Bill prescribes the FD path only for the Centre, and only up to 2022-23, it does not in fact carry a fiscal vision going beyond six years.
The major point (of several) in the CEA’s dissent note, which is totally valid, is that the medium-term debt and FD targets have to be specified, and the consistency requirement between the two formally upheld, since debt is the accumulation of fiscal deficits over time, mediated by the nominal rate of GDP growth. For example, the Maastricht treaty operating target for the FD at 3% of GDP was consistent with an eventual debt target of 60% of GDP in an economy growing at a nominal rate of 5.26%, which was judged feasible for the European Union member states. Exactly like a slide in a children’s park, the fixed FD moves the economy asymptotically towards the steady state debt level targeted. The assumed growth rate can also be worked backwards from the ratio of the targets for debt and FD, which was 20 in the Maastricht case (but is not a simple reciprocal).
The FRBM committee’s target for the general government FD, not stated in the Bill but specified in chapter 4, is set at 5% of GDP (there is some confusion about how the FD target will be split between the Centre and states, with chapter 4 saying 2.5% each, but chapter 5 showing states going down to 2% by 2023, and further down to 1.7% by 2025). The nominal GDP growth rate assumed is 11.5%. Staying with general government for the moment, an FD held steady at 5% will move the economy at that nominal GDP growth rate towards a resting debt level of 48.5% of GDP. So is 48.5% of GDP the eventual debt target visualized by the committee? If so, that is at odds with chapter 4, which strenuously strives to establish 60% as the prudent level for debt—as a target, not just as a ceiling.
Another issue correctly flagged by the CEA is that the FD target of 5%, through a back-of-the-envelope calculation first used by the 12th Finance Commission, is based on very uncertain estimates of the household financial savings rate. Most of all, there was no need whatever for this independent path towards defining an FD target. The report claims that the entire exercise was anchored on debt. With a debt anchor, and an assumed nominal GDP growth rate, the required FD would have emerged automatically out of the relevant equation.
The CEA then goes on to recommend the primary deficit (PD, obtained by subtracting interest on the public debt from the FD), as the appropriate operating target towards any prescribed debt destination, but here I disagree. Fiscal rules in terms of the primary deficit call for projection not merely of GDP growth, but also the rate of interest on public debt. To invoke the growth theory expectation that these two rates will be equal in the long run is to ignore medium-term realities and the frequent experience in many countries of cross-over between the two. The FD is the best operating target, since it in effect folds in the required adjustment in the primary deficit when unanticipated changes happen in the relative positioning of growth and interest rates.
The national debt target of 60% is split into 40% for the Centre, 20% for states. The states’ debt target has been set (roughly) at where their debt level currently stands. State borrowing through securities is under the operational control of the Centre, but the report alleges instances of off-budget borrowing beyond approved limits through parastatals, not adding to outstanding state debt, but serviced through the budget. These points to shocking failure on the part of state-level auditors. States were also, with full official sanction, permitted (even pressured) to borrow beyond routine limits so as to enable them to take over the debt of power utilities over a two-year window, 2015-17, under the Ujwal DISCOM Assurance Yojana (Uday) scheme. The report has disappointingly little to say about the response to Uday, which was an optional scheme—an important issue, since Uday provides a template for resolving all parastatal debt in ways similar to that attempted for power utilities. The FRBM committee is to be commended for having unearthed state-level malpractices, but without taking on board the impact of resolution of all parastatal debt, the stable debt path projected for states seems more a hope than a realistic vision.
The debt target of 40% for the Centre is arrived at through an econometric exercise, unfortunately modelled on a long-discredited 2010 paper by Carmen Reinhart and Kenneth Rogoff. The damage done by that paper went beyond its computational problems. It assigned causality running from debt levels (beyond an estimated threshold) to growth, when in fact reverse causality running from slowing growth to a rise in debt is more plausible, both as a mechanical outcome and as a result of rising expenditure on social safety nets at times of distress.
The report’s final defence of its general government 60% debt target (yes, as a target, not a ceiling) is that a fan around it based on risk under various stress scenarios keeps the upper band just within a danger mark of 85%. Quantifying that danger point poses the same problem as that which afflicts target setting with respect to the PD instead of the FD. It requires projections of the relative values of interest rates on public debt and growth, which is virtually impossible at the best of times.
But I don’t need the danger mark. I have no problem whatever with the debt target of 60% (unlike the CEA, who finds it not just arbitrary but too low), provided the general government FD target is consistent with it at the assumed nominal growth rate. But I don’t see the need to rush pell-mell towards 60% by 2023. A slide towards a steady state 60% at an FD target consistent with it (6.2%), will serve us fine. Financial markets reward steadiness in fiscal targets, not necessarily a rush to correction which may well prove unsustainable.
On the revenue deficit (RD), the committee prescribes a target of 0.8% of GDP for the Centre, but the CEA’s dissent note sees no need for a separate RD limit. Dual limits on the FD and RD were adopted in India so as to protect capital expenditure, given by the difference between the FD and the RD. But unless the maintenance (revenue) implications of capital expenditure are fully worked into the projections, the capital structures themselves will become in fructuous over time. Unless formal budgetary procedures develop an organic relationship between budgeted capital expenditure, and its incremental maintenance impact on revenue expenditure, there exists an information vacuum in which it becomes difficult to either justify, or find fault with, an RD target.
The key element in the terms of reference given to the committee was counter-cyclicality in fiscal targeting, which is particularly difficult in India, given the timing of release of growth estimates. In the just concluded year 2016-17, for instance, the extent of the growth slowdown became known only when, along with the revised advance estimates for 2016-17 issued at the end of February, the growth figures for the previous year 2015-16 were also revised sharply upwards. This will be the problem every year, since the budget exercise will not have at hand revised estimates for the year just concluding, nor a reliable growth forecast for the forthcoming year. The committee, in all fairness, did not know the growth slowdown in its fullness either. But their front-loaded sharp reduction of the FD for 2017-18 from 3.5% to 3.0%, even as a blind correction, sits uncomfortably beside their prescribed incremental growth trigger of 3% for so high a correction of the FD in a single year (in the event, the budgeted deficit for 2017-18 was set a bit higher, at 3.2%).
But why not shift calibration from growth to rainfall? Rainfall deficiency has so far been treated fiscally in the disaster relief category. It is that too, but calls for much more. Unless the frequency of rainfall deficiency in the south of India is addressed through capital enhancement for preservation of precipitation and recovery from wastewater, the human (and growth) consequences in an otherwise dynamic region will be unimaginable. The drought this year in Tamil Nadu and neighbouring states has to be addressed through a national war effort—which necessarily calls for fiscal accommodation.
