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Global Crisis and India's Fiscal Deficit
The deviations seen in the structural relationship between the GDP and GFD in 2008–2009 and 2009–2010 can be attributed to the impact of the global economic crisis.
4.1 Global Financial Crisis
The sub-prime crisis that emanated from the United States (US) has led to liquidity and solvency problems all around the world. Even though India, like other developing countries, did not have direct exposure to the crisis, the effects have been felt through credit, exports, and exchange rate channels. India's engagement with the global economy has deepened since the 1990s, making it vulnerable to global financial and economic crises. The impact of the current global crisis has been transmitted to the Indian economy through three distinct channels, namely, the financial sector, exports, and exchange rates (Kumar 2009). However, four factors helped India to cope with the crisis and soften its impact. They are: (1) the robust, well-capitalized and well-regulated financial sector; (2) the gradual and cautious opening up of the capital account; (3) the large stock of foreign reserves, and (4) a greater dependence on domestic consumption as a driver of GDP growth. Consumption accounted for more than 70% of India's GDP and GDP growth was 7.3% during 2000–2007. India's GDP growth declined to 5.8% (year-on-year) in the second half of 2008–2009 from 7.8% in the first half. The growth improved to 6.1% in the first quarter of 2009–2010. ICRIER estimates the GDP growth rate for the Indian economy is likely to be between 6.5–6.8% in 2009–2010.
The contagion from the global financial crisis warranted appropriate monetary and fiscal policy responses to ensure enough liquidity in the economy, the orderly functioning of markets, and financial stability. Given the role of fiscal measures to fight the economic slowdown, the government's ability to raise resources for spending and the economy's existing fiscal health, there is need to study the viability of fiscal stimulus in India. In this section, we discuss the Indian fiscal response to the current crisis and attempt projections of fiscal deficit and public debt to check for their sustainability in coming years.
4.2 Trends in Fiscal Indicators in 2008–2009 and 2009–2010
As discussed above, India's fiscal situation improved significantly after the adoption of FRBM targets by successive governments since 2003–2004 until the global crisis hit the Indian economy in early 2008–2009. The high rate of GDP growth, which averaged 8.7% between 2003–2004 and 2008–2009, also contributed to revenue buoyancy and helped bring down both revenue and fiscal deficits.
The combined fiscal deficit in 2007–2008 was just about 4% and revenue deficit was very close to zero along with a primary surplus. However, the situation changed drastically in 2008–2009. The central budget in 2008–2009, announced in February 2008, seemed to continue the progress towards FRBM targets by showing a low fiscal deficit of 2.5% of GDP. However, the 2008–2009 budget quite clearly made inadequate allowances for rural schemes like the farm loan waiver and the expansion of social security schemes under the National Rural Employment Guarantee Act (NREGA), the Sixth Pay Commission award and subsidies for food, fertilizer, and petroleum. These together pushed up the fiscal deficit sharply to higher levels. There were also off-budget items like the issue of oil and fertilizer bonds, which should be added to give a true picture of fiscal deficit in 2008–2009. The fiscal deficit shot up to 8.9% of GDP (10.7% including off-budget bonds) against 5.0% in 2007–2008 and the primary surplus turned into a deficit of 3.5% of GDP (see Table 4.1 [ PDF 19KB | 1 page ]). The combined public debt, however, declined marginally to 74.7% of GDP because of a nominal growth in GDP of 12.7%. The revenue deficit increased substantially to 4.4% in 2008–2009.
The huge increase in public expenditure in 2008–2009 of 31.2% that followed a 27.4% in 2007–2008 was driven by the electoral cycle with parliamentary elections scheduled within a year of the announcement of the budget. The budget's fiscal expansion helped compensate the effect of monetary tightening and push up domestic demand, especially in the rural sector. This prevented a collapse in domestic demand when Indian exports suffered a huge collapse starting November 2008 in the wake of the global crisis. Therefore, it is important to include fiscal expansion undertaken by the Indian government in February 2008 as a part of the fiscal stimulus undertaken in response to the post-Lehman Brothers crisis.
Budget estimates for 2009–2010 indicate a further worsening with the fiscal and primary deficits rising in the current year. Fiscal and primary deficits are expected to be 10.2% and 4.5% of GDP respectively and the debt32 ratio is likely to deteriorate to 76.6% of the GDP. This has raised the issue of India's fiscal stability and debt sustainability once again.
The measures taken by the government to counter the effects of the global meltdown on the Indian economy have resulted in a shortfall in revenues and substantial increases in government expenditures, leading to a temporary deviation in 2008–2009 and 2009–2010 from the fiscal consolidation path mandated under the FRBM Act. The revenue deficit and fiscal deficit in 2009–2010 BE are, as a result, higher than the targets set under the FRBM Act and Rules. The combined government expenditure was 31.2% of GDP in 2008–2009 and is expected to increase to 31.9% in 2009–2010 (Table 4.1). The combined revenue expenditure is estimated to increase from 26.3% in 2008–2009 to 27.1% in 2009–2010. Owing to policy interventions for inflation management and subsequently for providing a stimulus to growth, the government had to forego substantial revenues from excise and customs duties. Consequently, despite the buoyancy of direct tax revenues and service tax collections, the fiscal consolidation process has received a setback. The combined tax revenue of both the central and state governments is expected to come down by 0.6% in 2009–2010 due to a further reduction in indirect taxes.
4.3 Fiscal Stimulus Packages
In their response to the global crisis, governments of different countries have put through an unprecedented, globally coordinated fiscal stimulus package. Consequently, in India also, three fiscal stimulus packages have been unveiled since December 2008 to help the economic recovery. These have been largely in the form of a reduction in taxes and duties and, to some extent, incentives to the export sector. As we discussed above, the government had already allowed the fiscal deficit to expand beyond the originally targeted levels both in 2008–2009 and in early 2009–2010. Thus, luckily for India, its electoral cycle pushed up public expenditure and coincided with the global recession, helping India overcome the negative impact of the crisis.
The first fiscal stimulus package was introduced on 7 December 2008, the second on 2 January 2009, and the third one on 24 February 2009. These included an across-the-board central excise duty reduction by 4%, additional plan spending of Rs 200 billion, additional borrowing by state governments of Rs 300 billion for planned expenditure, assistance to certain export industries in the form of interest subsidy on export finance, refund of excise duties and central sales tax, other export incentives, and a 2% reduction in central excise duties and service tax, i.e., combined reduction of 6% in central excise duties. The total fiscal burden for these packages amounted to 1.8% of GDP in 2008–2009. Along with the expansion undertaken in the two budgets, the total fiscal stimulus over the last two years can be estimated at 3% of the GDP.
The authors made projections of the shares of the combined fiscal deficit and public debt (combined outstanding liabilities) to GDP for six to seven years down the line. The projections are given in Table 4.2 [ PDF 27.6KB | 1 page ]. We projected both fiscal deficit and public debt as a share of GDP based on the past trends. The estimation33 is carried out from 1980–1981 to 2007–2008. The optimal number of lags in the estimation was selected by using the Akaike Information Criteria (AIC)34.
The projections show that the fiscal deficit as a percentage of GDP will increase from 8.9% in 2008–2009 to 10% in 2009–2010 and probably remain at the same level for 2010–2011. While these projections indicate that there will be a subsequent reduction in the deficit, the decline is insignificant until 2015–2016. If, however, the stimulus is withdrawn and GDP grows faster than the underlying rate that has been assumed, then fiscal deficit may return to the path prescribed by FRBM targets in the near future. The share of public debt in GDP will increase at a marginal pace. What these figures indicate is that the fiscal situation might deteriorate further if appropriate measures are not taken to control the deficit and public debt.
4.4.1 Debt to GDP Ratio
The basic rule in debt dynamics is that the debt ratio will rise if there is a primary deficit and if the interest rate of debt exceeds the growth rate of GDP. Therefore, to reduce the ratio of debt to GDP, there must either be a primary surplus or the economy should grow faster than the rate of interest, or both. If one condition holds, it must be large enough to outweigh the adverse effect of the other35. We have estimated36 various scenarios of India's debt to GDP ratios from 2009–2010 to 2015–2016 on three alternative assumptions of nominal GDP growth rate (12%, 13%, and 14%), interest rate on debt (7%, 8%, and 9%) and primary deficit as percent of GDP (3%, 4%, and 5%). These are shown in Table 4.3 [ PDF 19.5KB | 1 page ], Table 4.4 [ PDF 19.5KB | 1 page ], and Table 4.5 [ PDF 18.4KB | 1 page ]. Here g = nominal growth rate, i = nominal interest rate, p = primary deficit.
From the above alternative scenarios, the best-case scenario is when GDP is growing at 14%, primary deficit is 3% of GDP and interest rate on debt is 7%. In this case, the debt ratio will decline to 65.4% in 2015–2016 from 74.7% in 2008–2009. The worst-case scenario is when GDP is growing at 12%, primary deficit is 5% of GDP, and the interest rate on debt is 9%. In that case, the debt ratio will rise to 94.1% by 2015–2016. For the current year, with a nominal growth rate below 12.0%, a primary deficit of 4.5% and an interest rate of about 7.5%, the emerging debt position is not a sustainable one. The policy implication is that India should strive to reduce primary deficit or achieve a primary surplus, raise the growth rate, and reduce the interest rate. The growth is in nominal terms and there is surely the option of inflating a pathway out of debt. However, this is not feasible given political sensitivity regarding inflation.
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