View | A primer on debt

A certain section of commentators has raised concerns regarding the sustainability of India’s debt levels. They have observed the high debt levels and have pointed out the economic implications of the same.

Unfortunately, much of the discussion is too often focused on the Union Government and its fiscal arithmetic rather than focusing on the heterogeneity in fiscal health across various state governments.

Abstracting away from issues relating to differences across states, there is an attempt to argue that the Union Government is suffering from a precarious debt profile. Such a narrative is unfortunate given that there is little merit in drawing such conclusions.

India’s Union Government debt has certainly increased due to the pandemic, but in recent years it has started to return to the pre-pandemic levels. Much of this increase in public debt was on account of providing necessary support to vulnerable households during the pandemic, followed by a round of fiscal push to revive growth.

The revised estimates for 2021-22 and provisional estimates for 2022-23 show a decline in the central government debt to total liabilities.

The increase in public debt levels during the pandemic was not unique to India. Every country experienced an increase in their total liabilities as they attempted to cushion the impact of lockdown on their respective economies.

For the sake of simplicity, let us assume a counterfactual wherein the government did not undertake a necessary expansion in public debt. The implication of this is the lack of a fiscal stimulus during the pandemic resulting in massive bankruptcies and destruction of capital stock in the economy.

In simpler words, it would have meant settling for a lower growth rate, slower pace of economic recovery and a lower level of total employment post pandemic.

Let us assume another counterfactual where the government did not increase the debt levels by as much in the 2020-21 period. Under that scenario, the pace of economic recovery would have been lower than what we experienced, with some risks surrounding the natural or potential growth rate settling at a lower level.

This would have meant a permanent or at least a mode medium-term impact of COVID-19 pandemic on India’s growth ambitions.

It is evident from the policy advice that government received during the early days of the pandemic that public debt levels were to increase. Recall how the consensus view at that time (barring a few, including the authors) was to spend without worrying about fiscal space.

Some of the non-conformists had stressed on the temporal implications of stimulus such as heightened inflation in the event of massive stimulus during lockdowns. In many ways, these complex trade-offs were managed well by following an iterative policy approach to designing the stimulus. Such an approach was crucial in restricting fiscal spending to a point where it became unsustainable.

The second issue that we highlight is the issue of debt sustainability. As of March 2023, India's external debt stood at $624.7 billion, marking a notable decline in the external debt to GDP ratio to 18.9%, compared to 20.0% the previous year. This improvement is significant when viewed against the backdrop of the ratio being 23.2% in 2014.

In a comparative analysis with other Low-and Middle-Income Countries (LMICs), India's external debt scenario appears robust. One of the critical measures of this robustness is the share of short-term debt in the total external debt, where India's figure stands at 18.7%.

This is relatively lower than that of other LMICs like China, Thailand, Turkey, Vietnam, South Africa, and Bangladesh, which have higher percentages. A lower proportion of short-term debt is beneficial as it implies less immediate repayment pressure.

Further, when considering the ratio of total external debt to Gross National Income (GNI), India emerges as the third least indebted country among all LMICs. This is a vital indicator of a country's ability to handle its external debt.

Additionally, the ratio of India's total external debt to its exports is at 91.9%, positioning it as the fifth least indebted country in this aspect among LMICs.

It is expected to continue this trajectory, more so as revenues and growth both remain buoyant. Moreover, the reduction in inflation would allow the government to manage its debt more effectively going forward as interest rates gradually return to the pre-pandemic levels.

A key overall increase in net borrowings in India is driven by the massive outlays on developing physical infrastructure, both in public and private sector. The private sector had luckily managed to reduce their leverage in the years preceding the pandemic, and many of them are gradually borrowing money to make fresh investments.

Another important trend following massive financial inclusion in India is the subsequent expansion of credit, much of it in the form of personal loans, in the form of buy no pay later or credit card debt. This is not unique to India and is perhaps to be expected given the increasing importance of finance and improvement in financial literacy.

Notwithstanding the irrationality of pessimism surrounding India’s public debt profile, there are reasons to reflect on the economic incentives that are offered to Indian states. The latter is perhaps more important, and often much ignored.

When badly run states are able to borrow money at similar rates than states that are prudent in their fiscal management, it is natural to wonder if the incentive structures encourage bad behavior?

This is particularly true during state election cycles that often see unsustainable fiscal promises being made in an effort to generate political capital at the expense of public resources.

Central government has already introduced policy measures which have linked reform with borrowing incentives aim to improve efficiency and performance and will enable states to borrow additional funds. This is a step in right direction.

OSD to the Finance Minister and Karan Bhasin, is New York based Economist.