The Indian economic recovery has gathered strength in recent months. Annual output will likely cross pre-pandemic levels by the end of this fiscal year. However, there are some long shadows over the economic outlook—consumer confidence is still low, corporate investment has not yet recovered, smaller enterprises have been hit hard, inflation is likely to rise in the first half of the next calendar year, global interest rates could rise, and the threat from the new variant of the covid virus needs to be watched carefully. Some of these economic concerns should ease over the coming quarters if the growth momentum is maintained.
One of the more persistent economic burdens that the pandemic leaves behind is the high level of public debt. It is a burden that has to be reduced over a decade rather than a few quarters. The collapse in economic activity during the worst months of the pandemic forced the government to borrow more to run its essential services, provide some support to the poor, and build infrastructure in the absence of robust private-sector investment. Public debt as a proportion of India’s gross domestic product (GDP) shot up by 15 percentage points in a year, to levels never seen before. It is expected to decline only gradually, from the current 89.8% to 85.7% at the end of 2025-26, according to estimates of the 15th Finance Commission. That will still be 25 percentage points higher than what the committee to review the Fiscal Responsibility and Budget Management Act had recommended in 2017.
Most countries have seen their public debt shoot up because of a decline in revenues as well as an increase in spending after the pandemic struck, so India is not an exception. Yet, it is important to remember that the combined debt of the Union government and states is a massive 26 percentage points higher than the average of emerging-market and middle-income countries, which was 64.3%. It is also 20 percentage points higher than its Asian peers. Much of this gap is not just because of what happened in the first two years of the pandemic, but also because India entered the crisis with weaker public finances than most comparable economies.
How do countries bring down their public debt as a proportion of their economy? Economists look at three main drivers of change—nominal economic growth, the interest rate that the government pays on its debt, and the primary balance in the government budget. A useful thumb rule is that the burden of public debt will automatically get lighter when the rate of nominal economic growth is much higher than the rate of interest that the government pays on its debt; the need for a sharp reduction in its primary deficit is relatively small. On the other hand, the government will have to aggressively bring down its primary deficit, or even aim for a primary surplus, in case nominal economic growth is weak and/or there is a jump in interest rates. Another way to say the same thing is that the need to go for fiscal austerity is lower when the economy is growing rapidly and the government is paying low rates of interest on its public debt.
The charts here show the India story since the turn of the century in terms of the rate of interest on government borrowings (r), the rate of nominal economic growth (g) , and the difference between the two (r-g).
India managed to bring down its ratio of public debt to GDP by 18 percentage points between 2002-03 to 2010-2011 because of its splendid growth acceleration; the Union government reported a primary surplus in only two of those nine years. The gap between interest rates and nominal GDP growth narrowed after that, as nominal economic growth came down sharply because of a combination of slower real growth as well as lower inflation. The public debt dynamics in the first decade of the century were very different from those in the second decade.
What about the third decade? Most estimates suggest that the burden of public debt—and hence the interest costs of the government—will continue to be high by historical standards till at least the middle of this decade. However, there is no reason to be worried about the sustainability of Indian public debt as long as economic growth is on track. The International Monetary Fund says that the debt-stabilizing primary deficit for India is 2.9% of GDP, which is lower than the current elevated level because of the pandemic but in line with the average level over the medium term.
This has important implications for Indian macroeconomic policy. As the monetary policy of the Reserve Bank of India pivots back towards inflation control, and thus gives less importance to supporting the fiscal operations of the government, interest rates will begin to inch up. The primary deficit will only gradually come down to sustainable levels in the next three years. A lot will then depend on the Indian growth trajectory in terms of bringing down the ratio of public debt to GDP, without imposing premature austerity or hindering inflation control via fiscal dominance over monetary policy.
Every Union budget has a central theme. There is now good reason for finance minister Nirmala Sitharaman to make economic growth the focal point of the new budget she is scheduled to announce early next year.
This article was originally publish in The Mint on 15 December 2021.
The opinions expressed in this essay are those of the authors. They do not purport to reflect the opinions or views of CCS.