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Who is afraid of India’s fiscal policy?

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With interest rates at record lows, global growth decelerating, and wide-ranging structural changes, there has rarely been a better time for the government to scale up investments.

By Ejaz Ghani

The World Bank has warned that a massive debt wave is building worldwide. Market analysts suggest that almost 40% of emerging sovereign external debt could be at risk of default in the near future. There are some rising concerns that India’s general government debt has increased, now close to 90% of GDP, and fiscal deficit is close to 9.5% of GDP. Is this fear about high fiscal deficit and debt well placed?

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Debt and fiscal sustainability are an integral element of macroeconomic stability. If fiscal policy can help sustain a rate of economic growth that exceeds the rate of interest, debt will remain on a sustainable path. Monetary policy generally takes the lead during a downturn, with successive outbursts of interest rate cuts, to revive growth. It seems that monetary policy may now be getting exhausted, and a full economic recovery has not yet been achieved, and fiscal policy is needed to revive growth. An active fiscal policy will also prevent the mistakes of the Great Recession of 2008-09, when just relying on monetary policy failed to engineer a full recovery.

It is often assumed that a high level of debt means little fiscal space for interventions. This may not apply to India due to its high debt-carrying capacity. Unlike in China and the US that have an ageing population, India’s demography is young and will remain so for decades to come. As young people save more than they consume, it increases the debt-carrying capacity of a country and creates more fiscal space for growth. When investment falls short of saving, and monetary policy fails to achieve full employment, fiscal policy can be used to achieve a rate of economic growth to exceed the rate of interest, and keep debt on a sustainable path (see Ejaz Ghani, ‘Reshaping Tomorrow: Is South Asia Ready for the Big Leap?’ With interest rates at record lows, global growth decelerating, and wide-ranging structural changes, there has rarely been a better time for the government to scale up investments.

Fiscal objectives

Conventional policy often tends to focus on fiscal targets rather than fiscal objectives. Rather than looking at fiscal deficits per se, growth and its determinants need to take a centre-stage in looking at fiscal policy. The amendment to the Fiscal Responsibility and Budget Management Act reflects this transition. The shift from fiscal targets to fiscal objectives allows policy advisors to more directly address the concerns of policymakers.

What can be done to boost public investment in infrastructure, green transition and job creation? India has made progress in raising tax-to-GDP ratio, but it still remains low, relative to the development needs of the country. India’s structural transformation—rise of the middle class, rapid pace of urbanisation, and young demographics—has positioned it well to raise the tax-revenue-to-GDP ratio. Policymakers also need to scale up the tax reform agenda from indirect to wealth tax, combined with more effective antitrust policies and enforcement, to strengthen revenue mobilisation.

India’s infrastructure financing gap remains huge. The biggest infrastructure gaps remain in energy, transport, ports, airports, education, health and urban development. India’s infrastructure financing gap is estimated at $1 billion a day, and it is growing exponentially. Can this be financed domestically? India has relied on domestic commercial banks as the principal source of debt funds for infrastructure projects, and less so on foreign borrowing. This has increased domestic financial instability. This was not the right vehicle, as banks lack the experience in financing infrastructure projects, and it crowds out lending to private entrepreneurs. Banks tend to attract short-term deposits, which create asset-liability mismatch in lending for long-term infrastructure investments.

Looking forward, given the low global interest rates, a glut in global savings, and that long-term institutional investors and pension funds are looking for new investment opportunities, there is a huge potential for India to tap financing from advanced countries. The traits of infrastructure projects, such as its market size, long-term steady revenue stream, and investment returns that exceed inflation, make these projects attractive for institutional investors.

Will a carbon tax be an appropriate instrument for infrastructure financing needs? Global carbon pricing is an essential part of any long-term solution to the climate crisis. But advanced economies will need to provide the developing world with highly concessional financing and technical expertise to help it decarbonise. India is still dependent on its plentiful coal reserves, and will likely remain so despite strong advances in solar power. The share of clean energy in global energy investment is still low at 30%, with wind-solar accounting for only 8% of global energy. We need a World Carbon Bank.

Managing fiscal risks

Policymakers can finance infrastructure investments through public private partnerships (PPPs). As this can be used to move public investment off budget, and debt off the government balance sheet, it can pose huge fiscal risks. A detailed examination of the global experience with fiscal contingent liabilities over the last two decades has shown that fiscal risks in bailing out PPPs are low (1-2% of GDP), compared to bailing out state-owned enterprises (5% of GDP), and bailing out banks (10% of GDP). PPPs should not always be viewed as a fiscal liability.

India has many success stories with PPPs, like building of the finest airports in the world through PPPs in Mumbai and Delhi. The next frontier for infrastructure investments will be in small cities and rural areas, where 60% of the population lives. Small cities now have a greater potential for growth compared to megacities, as the manufacturing sector is moving out from costly and congested megacities into the rural areas to remain cost-competitive.

The Ministry of Finance will need to play an active role in coordinating with line ministries and state governments to strengthen institutional and legal framework for PPPs that meets global standards. Problems of moral hazard and adverse selection can be overcome by reducing the opaque structures of projects, and by providing the information required to improve the risk-return profiles that match investors’ expectations. Integrating preparation, design and execution of investment projects also matter a great deal. Fiscal risks, today or in the future, need to be dealt with, ensuring an appropriate level of risk-sharing upstream and ensuring adequate budgeting of liabilities during project implementation. Sector-specific institutional frameworks with independent regulators need to be established.

Debt suspension initiative

High debt in developing countries not only limits their fiscal space for responding to the pandemic, but also limits their economic development. Advanced economies have the wherewithal to borrow cheaply and implement stimulus packages to build back better from Covid-19. But developing countries do not.

With little resources to tackle the pandemic and kick-start economic recovery, India should receive debt relief in exchange for a commitment to align economic policies and newfound spending capacity with infrastructure investments and green growth. The current G20 debt relief mechanism remains imprecise, and largely benefits private-sector creditors. This global downturn calls for a Green Carbon Bank that will provide debt suspension with a fiscal reform to promote green growth.

The author is senior fellow, Pune International Centre, has worked for the World Bank, and taught economics at Delhi University and Oxford University

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