An important contribution to the ongoing debate on the fiscal deficit has been made by Brian Pinto and Farah Zahir in a recent article in Economic and Political Weekly. They do not cry wolf about high fiscal deficits causing another crisis. Instead they argue, accurately, that high deficits jeopardise higher GDP growth. So they suggest, uncontroversially, that the government should redirect spending from subsidies to capital expenditure, and provide reform-linked central grants to states that reform.
Falling interest rates have moderated the cost of servicing public debt. But Pinto-Zahir point out that falling interest rates go hand in hand with falling inflation. This greatly increases the real interest rate on older debt.
So the overall impact on debt service is ambiguous. Besides, not even nominal interest rates have fallen for borrowers apart from the government and the biggest companies. Borrowers in recent years have faced real interest rates of 12%, according to RBI’s Rakesh Mohan. The investment famine of recent years suggests considerable crowding out.
Much has been written about the ruinous impact of the Pay Commission award on government finances. But Pinto-Zahir estimate that the Pay Commission raised the combined Centre-state deficit by only 1% of GDP. The impact of financial liberalisation, they estimate, was as large. Tax reforms reduced revenue by another 0.5 % of GDP.
So, the combined impact of financial and tax reform on the fiscal deficit was greater than that of the Pay Commission. This is not widely appreciated.
Few people know that the government used to extract huge implicit sums from the banking system through controls (which academics call financial repression). Pinto-Zahir mention a separate paper by Kletzer and Kohli estimating that revenues from financial repression fell by a whopping 3.1% of GDP between 1980-90 and 1992-98. If so, financial reform has been by far the biggest cause of continuing high fiscal deficits.
Financial repression in India used to take many forms. The government got financial repression revenues through a high Statutory Liquidity Ratio, forcing banks to buy government bonds and in effect subsidising the issue price of government bonds. Issuing ad hoc treasury bills at 4% interest was another way of borrowing at artificially cheap rates. Bonds sold to the RBI were financed by the RBI simply printing money. This then fuelled inflation, reducing the real value of government debt and real interest on that debt.
But not any more. Today, government bonds are floated at market rates. The issue of 4% treasury bills and the monetisation of government borrowing by the RBI ended in the late 1990s. Instead, we have a new phenomenon, reverse monetisation, arising from the sterilisation of dollar inflows. In effect, this increases the real public debt.
Let me elaborate. The official figure for the public debt is an exaggeration: it includes debt to the RBI, which is an arm of the government. Debt you owe to yourself is a fiction. Equally fictitious are interest payments to yourself (interest paid by the government to the RBI becomes RBI profits, which are then returned to the government).
Over the years the RBI accumulated a huge stock of government bonds, representing fictitious debt bearing fictitious interest. But in recent years dollars have poured into India, and the RBI has been buying these to increase forex reserves. Paying in rupees to buy dollars inflates the money supply, threatening major inflation.
To stem this, the RBI mops up the freshly created money supply by selling its accumulated stock of bonds on the market. This is called sterilisation. And it has a major fiscal effect.
By transferring government debt from the RBI to the banking system, sterilisation converts fictitious debt and interest into real debt and interest. This is only partially offset by interest earned by the RBI on forex reserves.
So, sterilisation increases the real public debt and real fiscal deficit. The Pinto-Zahir paper shows that whereas public debt as normally defined increased by 20% of GDP between 1996-97 and 2002-03, net public debt (taking into account RBI assets and liabilities) increased by 23% of GDP.
An unstated corollary is that economic reforms can have basic internal contradictions. The typical Bank-Fund reform package combines fiscal reform with financial liberalisation, cutting trade taxes, and export-orientation. What is rarely stated explicitly is that the financial liberalisation, reduced indirect taxes and export-orientation will all tend to worsen the fiscal deficit.
The end of financial repression means a huge loss of implicit revenue, and a rise in real public debt. Cutting direct taxes in India has, contrary to leftist fears, increased revenue as a proportion of GDP. But cutting excise duty and customs duty has led to a falling revenue/GDP ratio. Why? Because, in fair measure, of India’s growing export orientation.
Both excise duty and customs duty on inputs are waived for exporters. They pay concessional or zero duty on capital goods imports. They get export credit at low rates subsidised by the rest of the financial sector. And they get income tax breaks (some of which have been phased out recently, but continue in full force for software/BPO).
So, as the export/GDP ratio rises, the tax/GDP ratio tends to fall, worsening the fiscal deficit. Thus successful trade reform can sabotage fiscal reform. More exports can mean a bigger fiscal deficit. This is true not just of India but of many liberalising countries.
This should help us understand why so many well-intentioned reform programmes in so many countries have failed. The attempt to combine fiscal reform with financial and trade reform can have deep internal contradictions. These can rarely be resolved simply by cutting unproductive spending like staff salaries.
India has not resolved the problem at all. Its fiscal deficit continues as high as ever. But India has been saved by a flood of remittances and foreign direct and portfolio investment (worth over 6% of GDP last year), which offset the crowding-out impact of high deficits. Many other reforming countries have not been so fortunate.