Don’t cut direct stimulus fearing a debt overload. It can severely dent India’s economic recovery. – ET Prime

Clipped from: https://prime.economictimes.indiatimes.comPrime Minister Narendra Modi promised a mammoth INR20 lakh crore stimulus — at 10% of the GDP — to resuscitate the economy. But the fine print has disappointed many economists, who felt the government had been conservative in shaping the package to avoid a debt overload. This approach could dent India’s prospects in the months ahead, making a ‘V-shaped’ economic recovery — as predicted by chief economic advisor KV Subramanian — unlikely.

Let’s first consider the following facts.

Recently, the government enhanced the proposed borrowing programme for FY21 from the budget estimate of INR7.8 lakh crore to INR12 lakh crore, apparently to fund the stimulus. But it might be enough only to fund revenue shortages.

The INR20 lakh figure is not all government spending, unlike the stimulus packages in some other countries, including the US. It even includes the INR8 lakh crore of liquidity measures unveiled by the Reserve Bank of India (RBI) since March, among others. And then, of course, even at 10% it falls considerably short of the package announced by other countries, including the US and Japan.

In fact, after India announced the first set of stimuli in March — equivalent to 0.7% of its GDP — there was widespread clamour of a mega package. However, prospects of a bigger, liberal package raised fears of higher debt and an adverse rating shock. It prompted the Modi government to tread the conservative path where contingent liabilities (that may occur in the future), rather than direct handouts, constituted the major share. But it’ll come at a price.

Conserving debt through lower stimulus dents future growth and leads to higher budget deficits from slow earnings, pushing debts higher, and raising the threat of a rating downgrade. Higher growth, on the contrary, brings more tax revenue and eases the fisc, eliminating the need for higher borrowing programmes, thus reducing overall debt.

Indeed, demand–supply shocks following the coronavirus scare have mounted enormous pressure on governments to frame adequate policy responses, culminating in stimulus packages ranging from 5% to 20% of GDP. But the collateral damage of a debt overhang has worried policymakers globally.

Economies with comparatively low interest payments-to-GDP ratios may be in a better position to withstand the onslaught. Many emerging market economies don’t fall in that basket, including India, but the need for a qualitatively significant stimulus package with emphasis on capex generation is felt more than ever. There are ways to overcome the hurdles, as you’ll see. India has to adopt a two-pronged strategy — reduce the cost of debt and provide more stimulus to augment growth.

Debt accretion is not necessarily bad
It is a fallacy to assume that higher debt is bad per se. Think of today’s unicorns. All of them started with a debt overhang, which helped them scale up massively and achieve break-even revenues. These are true for countries also. While certain regions, such as the European Union and Greece, with high debt went bankrupt, there are many others like Japan, the US, and China that boast of better ratings despite massive leverage.

These countries have unveiled huge stimulus packages despite public debt-to-GDP ratios exceeding 100%. However, there are other factors too that encouraged them to tread a high-debt path. The US, for instance, has an interest cost-to-GDP ratio of just 1.7%. In the case of Australia, nominal GDP growth is 4.5%, well above its benchmark government bond yield of 0.85%, obviating risks to debt sustainability. In other major economies including the European Union and Japan, where quantitative easing leads to large scale purchases of debt, yields are likely to be kept under check, reducing the pressure on debt.

Moreover, the ongoing demand shock has led to a steep fall in commodities, with Brent once sliding into the negative territory, hinting that deflation, rather than an inflationary outcome, is more likely. Apparently, there cannot be a more opportune time to pile up debt and unleash the animal spirits of growth. Higher debt by itself may not lead to unsustainability if accompanied by economic growth.

Sovereign differs from individual in debt management
While bemoaning the damage caused by the stimulus-induced debt pile, the characteristics of public debt need to be appreciated. These are typically spread over many years. As long as interest payments are under control, there is nothing to worry about. The key is to ensure that bond yields lag nominal GDP growth.

The sovereign, which is the largest holder of debt, is not like individuals who might suddenly go bankrupt. In essence, public debt can be rolled over — the government can print more money or even request its central bank to purchase its bonds directly. Such possibilities provide an opportunity to indulge in a stimulus regardless of the costs to provide a big impetus to growth.

India’s disadvantage
India suffers from certain disadvantages, though. Its interest payments account for 6% of the GDP and 23% of revenues. Its public debt-to-GDP ratio of 70% is the highest among similarly rated peers and other emerging market economies.

Another INR2 lakh crore of borrowings may still be required to fund the direct component of the stimulus package. Consequently, the public debt-GDP ratio is likely to increase to 77%-80% for the current financial year, according to various estimates. Finally, with 1% real GDP growth and 3.5% average consumer price index inflation, nominal growth is likely to be a mere 4.5% for FY21, considerably lower than the 10-year benchmark yield, with risks to the downside. It may take years to get back to the 70% figure once the ratio overshoots 80% and, given the growth conditions, may never return to that level at all.

The NK Singh Committee that had reviewed the Fiscal Responsibility and Budget Management (FRBM) Act in 2017 had advocated a progressive reduction in public debt-to-GDP ratio to 60%. However, that looks highly improbable in the current environment of muted growth.

The recent five-tranche stimulus package, in which INR10 lakh crore is in the nature of contingent liabilities, is an upward risk to the debt metric, as a portion of this can crystallise in the future — the only solace being that the government need not immediately make any provision for this.

Should India desist from a debt-funded stimulus?
So, does this mean that India should fear a stimulus funded by debt? On the contrary, the intent should be otherwise. As for the debt-GDP ratio, the denominator holds equal importance as the numerator and a well thought out stimulus package will undoubtedly boost future growth and keep debt too under control. This is intuitively true as well.

Besides, India’s primary deficit (fiscal deficit-interest payments) is just 0.2% of GDP, implying most expenditure items are for meeting interest payments or in the nature of revenue expenditure, which is incurred to meet operational expenses. The revenue-deficit estimate for FY20 is 2.3%, which is 70% of the overall fiscal deficit. All of these establish the fact that capital expenditure, which is long term in nature, is on the lower side, which does not augur well for growth. Hence, the need for a qualitatively significant stimulus package with emphasis on capex generation is felt more than ever.

India should try to manage yields to reduce debt impact
To be sure, there are several ways to manage cost of debt (yields). The government can privately place its bonds with the RBI and monetise its deficit, which is an option. Other central banks such as the Bank of England, too, are keenly exploring this option. Alternatively, the RBI itself could conduct more open-market-operations to purchase bonds and bring yields down. Yet another option is bond switches by issuing longer-tenure securities in lieu of short-term bonds that help spread out interest payments over a longer time frame.

Decline in Brent crude prices, the prospects of a renewed Sino-US trade war, and a benign global interest rate environment are other enabling factors that facilitate a decline in bond yields, and thus should encourage the government not to shy away from debt-funded stimulus growth.

Meanwhile, as we have been arguing in our articles, India should continue efforts to list in global bond indices, which can bring in considerable inflows. There is strong appetite for Indian government bonds — it’s evident by the fact that almost 90% of the limits are utilised in auctions. A sovereign bond issue with a size of USD5 billion can be a good starting point.

The bottom line
To conclude, contrary to the popular perception that higher stimulus will lead to an unsustainable debt burden, the reality might be just the opposite. By propelling growth, debt-funded stimulus enables higher revenues to accrue to the fisc and helps sustain future debts by reducing the size of its borrowing programmes.

The ideal strategy would be a direct and targeted stimulus funded by lower- yielding debt so that sustainability is not under threat. The trade-off between growth and debt expansion can thus be managed well.

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