Some Policy Issues Connected to Fiscal Deficit and Debt Management

FISCAL DEFICIT, DEBT AND LIABILITIES OF THE GOVERNMENT OF INDIA

SOME POLICY ISSUES

Why should Government run fiscal deficits at all?

Investments require capital- both equity and debt. Poor countries lack capital. Low capital is the result of low gross domestic product and low savings. Low domestic savings leads to low capital formation. And, the vicious cycle of low GDP, low savings, low investments, low GDP, low savings can continue for decades unless broken.

The Governments and central banks are assigned the responsibility by the society to break this vicious cycle. To break this vicious cycle, investments must be made in physical capital- in manufacturing and infrastructure, in human capital – in education, health and skills, and in creating institutions of governance, regulation and administration of justice.

The Governments have used different means to raise the capital required. They have went about simply printing money.  They have the used/ directed the financial system (central bank and banks) to create money and credit. They have also commandeered the system to direct savings to themselves. Inability to keep printing of currencies, within limits which system could absorb, led to run away inflation in seventies and eighties and was generally abandoned. Too much money creation by excessive borrowings from the central banks also had the same results.

Like most of the other countries, Indian Government used printing of currencies and creation of money for financing its expenditure and investment needs with predictable bad consequences. System of issuances of ad-hoc treasury bills to RBI was abandoned in 1990s. The system of automatic monetisation of deficits got completely stopped in the first decade. This had good impact on inflation.

Savings of the people and expansion in money supply by the financial system constitute the pool of capital available. Normally speaking, this pool of capital is best used by the private sector to make investment. However, there are market failures leading to private sector not making investment in several desirable economic sectors. Investment in human capital is one such area, where private sector has not been able to take care of such investment needs, especially for the poor and disadvantaged segments of society. Need for such investments is larger in the earlier phase of development whereas investment in such merit goods is not made by the private sector. Likewise, large infrastructure needs, which mostly represent public goods, can also be made by the Governments and public sector.

Normal resources of the Government- tax revenues- are insufficient to meet these investment needs. That justifies the borrowing by the Governments or running fiscal deficits.  

Should fiscal deficit limits not be loosened for Capital expenditure?

Government’s primary task is to deliver governance services, which are public goods, to people paid for by revenues collected from taxes. This includes services to redistribute incomes to poor, marginal and disadvantaged sections of Indian society. All these services are of consumption nature and don’t lead to capital formation for raising productive capacities of the economy. Therefore, government should normally not run any fiscal deficit. In India, we have raised a large public sector which is engaged in productive parts of the economy. Equity infusion in such public sector companies was made by the Government. Government also support creation of public infrastructure through its agencies. Such capital expenditure also aids to the productive capacities of the country. Therefore, capital expenditure to support investment in public enterprises and to fund infrastructure creation through Government agencies seems quite justified for being made from the public exchequer. This justifies raising of debt by Government for incurring such expenditures.

Unfortunately, over the years, Government’s borrowings have been increasingly used to fund consumption expenditure and a considerable part of capital expenditure incurred is actually no on creation of productive capital assets. In the year 2019-20, the Government has budgeted a fiscal deficit of Rs. 703760 crore. Expenditure budgeted as Capital Expenditure is only Rs. 338569 crore. It is only about 48% of the fiscal deficit. As fiscal deficit represents borrowing, more than half of the borrowings, even in terms of budgeting, is meant to be spent on consumption expenditure. Almost similar was the situation in the year 2018-19 RE. Less than half of the borrowings only are meant to be used for capital expenditure. Actual position usually turns out to be still worse. In 2017-18, actual amount spent on capital expenditure was Rs. 263140 crore out of the fiscal deficit of Rs. 591062 crore which was only 44.5%.

What exactly constitutes the capital expenditure of the Government of India? The largest item of capital expenditure is a provision of Rs. 1.03 lakh crore for Defence Expenditure. Buying of weapons and other means of warfare are extremely important for national security but these don’t raise productive capacity of the economy. This expenditure is a little less than 1/3^rd of entire capital expenditure. There are funds budgeted for supporting infrastructure construction by Government agencies. Equity contribution for Metro Projects (Rs.17.7 thousand crore), Capital Contribution to Railways (Rs. 65.8 thousand crore), Capital Works of National Highways (Rs. 36.7 thousand crore) and other Road works of Ministry of Road Transport (Rs. 35.4thousand crore) fall in this class and certainly appears quite justified. Capital outlay of Rs. 21.01 lakh crore is budgeted for Nuclear Corporation (Rs.3000 crore), Food Corporation of India (Rs. 1000 crore), for investments in multilateral financial institutions (Rs. 5500 crore), for other financial institutions like NIIF (Rs. 4000 crore), for construction of police housing (Rs. 1900 crore under Police Research) and for other contribution of Rs. 1260 crore to CPSUs) seem partly for creation of productive economic capacity and partly for supporting current operations. Capital expenditure under two broad heads-i. Establishment (Rs. 7.5 thousand crore) and under Other Transfers (Rs.7.5 thousand crore entirely meant towards the capital assistance provided by the Central Government to the States, mostly North Eastern and other Himalayan States is clearly for aid/establishment kind of support. Therefore, only a little more than half of the expenditure budgeted as capital expenditure is actually justifiably capital expenditure. This leads to the conclusion that less than 25% (only 48% of fiscal deficit is budgeted for capital expenditure) of fiscal deficit is meant for productive economic investment in manufacturing, services or infrastructure capital investment.

As seen in earlier section, considerable amount of expenditure (largely of consumption nature) is incurred outside budget (food subsidy bill paid through NSSF, toilets/other assistance through Fully Serviced Bonds etc.). A number of public interest motivated people propose that, in times of economic slowdown, the Government should not worry about fiscal deficit and borrow funds for incurring capital expenditure. It is impossible for the Government to incur capital expenditure quickly. Going by the actual state of affairs, it is difficult to justify raising of debt, or running of large fiscal deficit by the Government, on the ground of making it for the capital expenditure.

How has gross pre-emption of financial savings affected growth- Growth enhancer or growth depressing?

India’s savings rate of about 30% is quite a decent savings rate, though one can always wish that India saves a lot more. However, it is only the financial savings of households and that of the financial institutions which are available for funding the fiscal deficit of the Government. These financial savings should ideally be used for funding equity investment of real sector enterprises. Converting these savings into debt does not really serve the cause of national development. Debt portion of the enterprises and even that of the Government can be funded from credit creation in the banking sector, including central bank. Trouble however is that the financial savings of the household sector and financial sector are relatively small. Household sector saves about 16-17% of GDP in all. Only a little over 1/3^rd of it (6.6% out of total household sector’s savings of 17.19% of GDP) in 2017-18, the last year for which data are available presently was the net financial savings of the household sector.

When the Central Government and the State Governments run large deficits- in excess of 6-7% together, a large chunk of financial savings of people get diverted to meet this fiscal deficit. In fact, entire financial system, consciously and unconsciously, get tooled/rigged to serve this objective of landing these savings in the Government. Today, Banks are required to keep about 20% of their deposits in government securities. Insurance companies are also like this. LIC had investment corpus of Rs. 28.75 lakh crore in the policy holders account as on 30^th June 2019. As much as 18.84 lakh crore (more than 65%) of this Corpus was invested in “Government securities and Government guaranteed bonds including Treasury Bills”. The Government runs large number of small savings schemes, which also nudge household savings towards government debt. It exceeds Rs. 15 lakh crore.

The financial system works to fund the Government Debt. In the process, it leaves little for the private sector or for the productive investment in the economy. As the demand for financial resources is much higher than its availability and a large chunk of it gets directed towards financing government debt, the price for the financial resources, interest, in the economy refuses to budge down. The spread between the policy rate and the bank lending rates remain quite high (over 400 basis points) in the country. There is rush today for Indian corporates to go abroad to borrow. While the flow to commercial sector from the financial system is down by over 70% in the first half, Indian corporates borrowed more than 30 billion dollars in external commercial borrowings and bonds in the year 2019.

The load of government borrowings or the fiscal deficit needs to be reduced in the larger interest of the economy instead of the fiscal deficit being relaxed even in the current situation of economic slowdown.

Should the National Small Savings Fund (NSSF) be wound down?

The Government of India provides a number of savings avenues to individuals and households in the form of national savings certificates, public provident fund account, kisan vikaspatra, savings and other deposit facilities in the post offices and some dedicated schemes for girl child, senior citizens and the like. These schemes are operated mostly through the Indian Post Department, with its multitude of post offices all over the country and some schemes through the banking system as well. Aggregate deposits/balances in these small savings accounts at the end of FY 2017-18 was Rs. 12.90 lakh crore. These are estimated to be Rs. 16.85 lakh crore at the end of FY 2019-20 as per BE 2019-20. Outstanding amount of all small savings deposits, certificates and accounts as on 31st March 2019 was estimated to be Rs. 14.81 lakh crore as per Revised Estimates given in the Budget 2019-20. The small savings outstanding balances are estimated to be growing by about 2 lakh crore every year during last two years.

The savings of people invested in the NSSF, like their savings invested in the mutual funds, are in a way, assets under management of the Government. As the AUMs with all the mutual funds was about Rs. 25 lakh crore at the end of 2018-19, the AUMs under NSSF at about Rs. 15 lakh crore make a significant share of people’s savings. Unlike Mutual Funds though, the Government invests these savings inflows with the Governments, now mostly Central Government as States have stopped taking these inflows citing higher costs thereof, and of late, the PSUs and Authorities of the Union Government.

There are primarily four ‘investment avenues’ for the small savings flows presently- a. investment in special securities issued by the Central Government, b. investment in special securities issued by the State Governments, c. investment in public enterprises and authorities of the Government of India and finally d. meeting fiscal deficit by providing cash balances. In addition, there is liability of the Central Government towards accumulated losses in the NSSF. The Central Government issues three kinds of special securities to the NSSF- a. Against the Balances lying on 31.3.1999, the day when the NSSF arrangement came into being (earlier the Government of India used to provide small savings loans against accruals of small savings in the States from the Consolidated Fund of India, b. against fresh accumulations in the NSSF from April 1, 1999 and c. against redemption of special securities by the Centre and the State Governments. At the end of March 31, 2018, the net investments in these three types of securities was Rs. 64567 crore, Rs. 134969 crore and Rs. 284381 crore, in total amounting to Rs. 483919 crore. Outstanding balance of securities issued by the States as on 31st March, 2018 amounted to Rs. 507245 crore.

The Central Government started making use of funds in the NSSF to provide loans to the Central Government entities from the FY 2016-17. First such loan was made to the Food Corporation of India when Rs. 70000 crore loan was extended (repayable in 5 annual instalments) in lieu of food subsidy claims of the FCI for the year 2016-17. During 2017-18, this practice was extended to other PSUs and authorities for both investment as well as subsidy support purposes. Investment loans were made to NHAI (Rs. 20000 crore), IRFC (Rs. 10000 crore) and Air India (Rs. 3000 crore). FCI was provided another loan in lieu of subsidy of Rs. 65000 crore, while FCI paid Rs. 14000 crore. A loan of Rs. 8000 crore was extended to cover housing subsidy claims. In all, the Loans to Public Agencies grew to Rs. 162000 crore at the end of 2017-18.

NSSF pays the interest cost on various savings instruments. It also pays a commission charge to the Department of Posts for managing the small savings portfolio. Interest from the securities issued to the Central Government and State Governments make up the income of the Fund. The Difference is loss for the NSSF. In 2017-18, NSSF’s income was Rs. 95400 crore, whereas its interest expenditure was Rs. 91222 crore and its management expenses (commission to the Department of Posts) Rs. 10822 crore which resulted in a loss of Rs. 6643 crore.

Government had adopted a policy decision many years back that the interest rates payable on different savings instruments would be aligned to the market interest rate on similar instruments. A small mark up only was to be added. A system got built in which interest rates were to be adjusted every quarter. However, this system of auto alignment of interest rates of small savings with the market rats, has not practiced more in breach during last few years. Interest rates have been virtually left untouched during the current financial year despite policy rates, rates on central government securities and other market instruments having come down notably. At the end of first quarter in June 2019, there was a nominal adjustment of .1%. There was no change in the interest rates at the end of September and December quarters. Interest rates on small savings instruments, with the safest security, are the highest compared to savings instruments of similar instruments even on nominal terms. If tax incentives associated with such savings instruments are taken into account, the effective rates are150% to 200% of the instruments of similar nature.

During the current year, the Government has announced corporate tax cuts and there is also considerable shortfall in collection of excise, customs, GST and personal taxes. The Government, however, has not revised borrowing programme, which remains pegged to fund fiscal deficit of 3.3% of GDP only. It seems that the small savings collections are being encouraged retaining the interest rates at higher levels to fund the higher fiscal deficit of the Government.

The justification for small savings schemes being run by the Government does not exist any longer. In this day and age of digital banking enabled by omni-present mobile phone networks, there is hardly any need for the Government to provide an avenue to park the savings. The post offices met this need in 20^th century, but are no longer required to play this role. With almost universal Jhan-Dhan accounts with the banking system (time has come to convert these zero minimum deposit accounts into normal savings accounts to enable poor people to use entire set of banking services), there is absolutely no necessity for the savings banks account services to be provided by the post offices.

Besides running smaller fiscal deficit, the Government should wind down the system of small savings. Incidentally, no state government (barring two-three who are also interested to get out) is now taking small savings these days. For many years, until the beginning of the first decade, there used to be big clamour to fund the state government deficits with small savings. All these savings are now landing with the Government of India. These small savings also interrupt the system of rate transmission in the banking system. Banks are unable to compete with these rates but cannot bring down their rates for transmitting the monetary policy signals as they would lose out the savings completely. The small savings system distorts the savings system in the country.

The Government should implement a five-year plan to wind up the small savings system.  

Does Fiscal Deficit end up only financing Interest Payments?

Government of India has been following the policy of raising debt for financing its fiscal deficit by raising it from the market at market rates of interest for more than two decades. Present policy and practice are a far cry from the distortionary and off market policies and practices of 20th century, which caused lot of inflation, expropriated all savings for the Government and made the monetary policy completely redundant. Very early in 1950s, the Government of India had decided to issue adhoc treasury bills on the Reserve Bank of India mandating the RBI to fund as much as resources as Government of India needed by creating money. Rate of interest paid on such adhoc bills was also kept very low. RBI was not generating any meaningful surpluses in this era. In 1990s, the practice of issuing ad-hoc treasury bills was laid to rest. RBI and the Government agreed that the RBI will not subscribe to primary issuance of debt of the Government and would only operate a limited Ways and Means Advance (WMA) facility. RBI has dismantled various instruments used earlier to ensure flow of funds to GOI securities- very high SLR being one of these. Securities of the Government of India and also that of the State Governments are now issued at price discovered in the market.

The Government of India, on its own account, is a very large debt issuer. A large stock of debt securities have now built with GoI’s total Debt and Liabilities exceeding 45% of GDP. Large pre-emption of savings and credit created in the economy by the Government leads to interest rate ruling very high. All this has led to the interest expenditure of the Government of India balloon.  Government of India classifies interest payments in five broad heads- interest on internal debt, interest on external debt, interest on provident funds and other specific accounts in public account, interest on reserves funds and interest on other liabilities. Interest on internal debt constitutes bulk of interest payments now. In 2017-18, interest on internal debt amounted to Rs. 487527 crore, which was 89.71% of total interest paid (Rs. 543404 crore). Interest on market loans (usual dated long-term market securities issued by the Government of India) amounted to Rs. 404132 crore (74.37% of total interest paid). Interest on External Debt is quite small now as such loans on Government of India account are stabilized and will decline going forward. Only an amount of Rs. 5951 crore was paid on this account. As Provident Fund deposits grow at a steady rate only, interest payments under this head are also small and growing at very slow rate. In 2017-18, it amounted to Rs. 33135 crore, which actually had a negative growth rate of 2.48% over the interest paid under this head in 2016-17. Government of India earns some money usually as premium on the government securities issued. Likewise, it also earns some interest on market loans. The Finance and Accounts state this income on the revenue side, whereas Budget Papers and Analytical Reports display the interest payment net of these incomes. In 2017-18, such net receipts were about Rs. 14755 crore, which when netted made the net interest expenditure to be around Rs. 528600 crore.

Interest on Other Obligations actually represent the result of by-pass on fiscal deficit financing attempted from time to time by the Government of India. Interest paid on this head during 2017-18 was Rs.15975 crore. It included interest on Petroleum Bonds (Rs. 9583 crore), interest on special securities issued to Food Corporation of India (Rs. 1319 crore), to Oil Marketing Companies (Rs. 407 crore), interest on bonds issued to fertiliser companies (Rs. 1174 crore) and interest paid to SBI for the GoI bonds subscribed by SBI for enabling GOI to invest in the rights issue of SBI (Rs. 835 crore). Almost all of these obligations were taken on by the UPA Government between 2004-05 to 2012-13). NDA Government has also resorted to this route for recapitalizing the Public Sector Banks and also other financing institutions like EXIM Bank and IIFCL ltd. These bonds were first issued in 2017-18. First interest obligations for this came up for payment in 2018-19. As further bonds were issued in 2018-19 and 2019-20 and by now the amount of bonds issued exceed Rs. 215000 crore, interest payment on these obligations would exceed entire interest payment made during 2017-18 in this head.

Expenditure on interest payments is the largest head of payment and a little less than 25% of total expenditure of the Government of India. About 1/4^th of all the resources which the Government of India raises every year, tax, non-tax and debt all taken together, goes only to service interest on the debt and liabilities undertaken by the Government of India in previous years. This is an extra-ordinary large pre-emption of resources. In 2017-18, interest payment at Rs. 528900 crore out of total budgetary expenditure of the Government at Rs. 2141973 crore was at 24.6% of total expenditure. This has seen minor decline in the year 2018-19 as per the provisional numbers released. In this year, net interest payments amounted to Rs. 582675 crore out of total expenditure of Rs. 2311422 crore exceeding 25% of total expenditure at 25.21%.

With the Government being in no position to curtail fiscal deficit and issuance of liabilities outside the Budget also continuing unabated, there is every likelihood that the interest payment in 2019-20 will also exceed 25% of total expenditure.

Combined expenditure of the Central Government (actuals) in 2017-18 on interest payments (Rs. 528952 crore) and establishment (Rs. 473031 crore) was Rs. 1001983 crore, which turned out to be in excess of 45% of the total expenditure of Rs. 2141973 crore incurred. It needs to be remembered whenever we talk about the ability of the central government to adjust its expenditure that very close to half of all expenditure is simply not in control of the central government. It is the first charge on the revenues and debt raised and has to be so paid.

Mostly the interest burden implications of running large fiscal deficits are ignored. Decisions to recapitalize the PSBs’ equity by issuing special securities without considering the net impact on fisc in terms of the interest paid on these bonds are sub-optimal decisions.

Massive burden of interest payment is a good reason to consider moderating fiscal deficit and debt overhang.

Is India’s credit rating affected by the large deficit and debt overhang?

Sovereign credit ratings are quite material in determining access to internal credit and also the price at which such credit can become available to sovereign, sub-sovereign and private corporates. Indian corporates- in public and private sectors have borrowed close to $30 billion dollars in 2019 from international debt markets. India has investment grade sovereign debt rating from all the major rating agencies. Sovereign credit rating works as the base of credit rating for the corporations. No corporate from India can get a rating better than the sovereign’s credit rating.

Fiscal Strength is one of the three major rating parameters, which in case of Moody’s feeds in determining Government’s Financial Strength. India’s Financial Strength has been rated consistently for quite sometime at M+ level i.e. a medium strength. The biggest weakness in the metric of Fiscal Strength is very large debt burden. India’s general government debt and liabilities (a little less than 70%) is one of the highest in comparably rated sovereigns. Deterioration in fiscal metrics is considered one of the largest negative credit event. Therefore, worsening fiscal deficits and/or perception that India’s is unlikely to stick to its path of moderating stock of debt and liabilities to less than 40% for the central government by 2024-25 is likely to put India’s credit rating at a risk. Moody’s which upgraded India’s rating to one notch further in the investment grade has recently placed India on negative outlook. It would be big negative if India’s credit rating were lowered to the lowest investment grade by the Moody’s.

Should the FRBM Act be revisited again?

Ever since FRBM Act was enacted in 2003-04, India has revised and reaffirmed its commitment to that elusive fiscal deficit target of 3% of GDP three times. The last restatement was made in 2018-19. FRBM Act was amended by the Finance Bill 2018 to very specifically state two commitments. One, India would reduce its fiscal deficit to 3% by FY 2020-21 and maintain it at or lower level thereafter. Second, Union Government’s Debt and Liabilities would be brought down to less than 40% of GDP by FY 2024-25.

Fiscal developments in last two financial years since then have not gone to ensure that these two statutory commitments could be adhered to. India revised its fiscal deficit from 3.2% in FY17-18 BE to 3.5% in FY17-18 (which was also the actual) and announced its headline fiscal deficit at 3.3% for FY 2018-19 (there were some expenditures/ investments pushed off-budget, which has been explained above). Expectation was that there would be some further compression in 2019-20 and finally the target of 3% would be achieved in FY2020-21. However, FY 2018-19 turned out to be fiscally more difficult than planned. Headline Fiscal Deficit (the number in the budget papers representing the fiscal deficit in the Consolidated Fund of India) was revised to 3.4% for FY 2018-19 (RE) and BE fiscal deficit for 2019-20 was first announced at 3.4% in the Interim Budget and later on brought down to 3.3% in the final budget presented in July 2019.

Considering the revenue and expenditure performance in FY 2019-20, it is unlikely that headline fiscal deficit would be anywhere less than 3.5%. Real fiscal deficit will be much higher. I have analysed this in the next section. Given further that the revenues are unlikely to see any sharp uptick in next FY 2020-21 and flexibility to compress expenditure is almost not available, it is almost impossible to keep even the headline fiscal deficit to 3.0% for FY2020-21.

Likewise, the debt and liabilities trajectory is moving quite in reverse direction than the one which was possibly expected while determining the deadline of 2024-25 for achieving the goal of 40% debt to GDP ratio.

It seems quite likely that the FRBM Act will be amended again to push both the fiscal deficit goal of 3% to let us say 2025-26 (to coincide with the new five yearly budgetary cycle with finance commission recommendations) and debt and liabilities goal of 40% to, let us say, 2030-31. It would be sound more convincing if this fiscal deficit goal is defined to include all budgetary and off-budgetary liabilities (which currently are around 4.5% of GDP. A five-year roadmap for brining real fiscal deficit down from 4.5% of GDP to 3% of GDP is quite reasonable and rigorous. A lot of people would become somewhat more cynical about Government’s real commitment for fiscal consolidation considering non-achievement of this goal even after 15-16 years of its original adoption and it being pushed for newer date every 5-7 years. However, if the Government were to disclose and incorporate all its fiscal expenditures into the fiscal deficit and state the fiscal road map (.25 to .3% reduction consistently every year) in the budget, the fiscal correction and consolidation would sound more credible.

Debt and Liabilities ratio to GDP is more autonomous. If the Government were to reform the small savings regime and lay down the fiscal consolidation path as suggested above, it is quite likely that the Debt to GDP ratio would also be achieved in this time-frame, most likely even earlier.

SUBHASH CHANDRA GARG

NEW DELHI 15/01/2020