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By B Yerram Raju

“Money begets money,” says Geoffrey Crowther. Absolutely true —  whether it is with individuals, institutions, or nations. Why should nations borrow? One should go back to the post-world war economy. People lost all their wealth and assets in the war. To provide money in people’s hands, Keynes propounded ‘dig holes and fill them up.’

Historical Perspective 

On the pangs of yet another recession, it makes sense to look at the recent history of the Great Recession of 2008 and the way global stability matters, particularly because the reaction of the Reserve Bank of India and the Government of India was along the same lines compared to the fight against inflation amidst growth resilience post-pandemic.

Even the Global Financial Stability Reports 2018 warned of a tough road ahead for all the governments and the need to avoid the risks that led the world into recession in 2008: “Higher inflation may lead central banks to respond more aggressively than currently expected, which could lead to a sharp tightening of financial conditions. Valuations of risky assets are still stretched, and liquidity mismatches, leverage, and other factors could amplify asset price moves and their impact on the financial system.”

In 2008, Lehman Brothers, the biggest home-mortgage lender, fully backed by the US government, became bankrupt and there were no lenders to lift it. The US Congress would not permit its nationalisation. This largest bankruptcy triggered global financial instability.

Fannie Mae and Freddie Mac —  federally backed home mortgage companies —   also collapsed with the US Congress unwilling to lend any support. Financial engineering led to the creation of subprime mortgages.

The blame for the 2008 recession rested at the doors of irresponsible lenders, rating agencies, mortgage brokers triggering unaffordable loans, loan appraisers inflating housing values, Wall Street investors, borrowers overstating the income levels on loan applications, lack of regulatory and government oversight and a surge of foreclosure activity.

2008 Redux?

Does this remind us of the recent Noida real estate firm filing bankruptcy before the Insolvency and Bankruptcy Board of India? Several such NPAs are hiding in the kid gloves of lenders and investors.

India’s political and macroeconomic climate now is just similar to the one in 2009. For two years, the Monetary Policy Committee and the RBI assured the nation of macroeconomic and financial stability against the backdrop of resilient growth and were treating inflation as a concomitant of growth.

The government in 2009 too asserted that the impact of the sub-prime crisis was moderate. It was caught in the grip of inflation — touching the highest double-digit in the post-reform era, like now.

Markets continue to be volatile despite several blue-chip companies and banks reporting encouraging results for Q1, 2022. Several FPIs and FIIs have pulled out crores of rupees during the last three months, notwithstanding the promised growth in the next year. “India’s financial sector is stable and healthy…Indian Banks affected only peripherally”. (RBI Bulletin, Nov 2008). Did the RBI Governor and Finance Minister not echo the same voice till recently? These events only prove that the rules of the International Monetary Fund (IMF) and Basel are necessary though not sufficient for nations to keep their antenna up in troubled times.

IMF Reforms

In our federal Republic, where some of the States have borrowed money from the public far more than several nations, the IMF felt that the States must have a fiscal discipline.

Fiscal Responsibility and Budget Management (FRBM) is a rule-based tool meant to bring fiscal discipline. Such discipline came into being as part of the first level of financial and fiscal reforms ushered in by the IMF. The debt to GDP (gross domestic product) ratio is another measure to monitor the financial discipline of governments. We discuss these two aspects in the context of financial prudence.

In order to ensure greater transparency in the fiscal operations of the government and to introduce a more equitable distribution of debt, in August 2003, the Vajpayee government, in furtherance of the fiscal reforms introduced by the previous governments, brought in the FRBM Act.

Under the FRBM Act, the Central government had to bring down its fiscal deficit to 3% of GDP by 2007-08. It was, however, extended several times right up to 2020-21.

 However, in the FY21 Budget, the target was relaxed to 3.5%. The Centre made use of the escape clause to deviate from the fiscal consolidation road map. The option allows the government to widen the deficit by 0.5 percentage points in times of exigencies such as a war or calamities of national proportion.

Because of higher expenditure and lower revenues on account of Covid-19, the fiscal deficit reached 9.3% of the GDP. In the Finance Bill 22-23, the government has targeted 6.8% but hopes to bring it down to below 4.5%.

The Vajpayee government in August 2003 brought in the Fiscal Responsibility and Budget Management (FRBM) Act to ensure greater transparency in fiscal operations and introduce more equitable distribution of debt

This ratio is an economic metric that compares a country’s government debt to its GDP, which represents the value of all goods and services produced in the country. This is the barometer for determining the stability and health of a nation’s economy. Oversized debt ratios above 77% could affect economic growth adversely and increase the default risk.

According to the World Population Review, Japan, Italy, the US, and Singapore crossed the debt to GDP ratio of 100% while Sri Lanka, Canada and the United Kingdom crossed 80%. India joined this league in FY21. Viewed from the angle of the population, India’s per capita debt is far less than all these countries. The sustainability of debt has to be viewed from the point of view of development and welfare of the population. Second, in the case of India, the debts of the State and Union governments are in the ratio of 30:58, according to the Budget Estimates of FY22. Till the pandemic broke out, India’s debt to GDP ratio stood at around 70%.

The RBI Report on Public Debt Management of governments succinctly puts: “Amidst heightened uncertainty created by the Covid-19 pandemic and its effects on the domestic and global economy and the financial markets, the Reserve Bank successfully managed the combined gross market borrowings of the central and the state governments, which increased by 61.3 per cent to Rs 21,69,140 crore during the year.”

Sustainability of debt has to be viewed from the points of view of development and welfare of the population

The fiscally conservative approach of the FRBM should be fine during normal times. But the debt-to-GDP ratio targets prescribed in that report, during crises, should be bound by economic necessity. The Economic Survey 20-21 also mentioned that excessive debt does not amount to financial recklessness. Right policies should be the barometer for incurring higher debt to GDP ratio.

Is FRBM sacrosanct?

The questions before us are: Is FRBM sacrosanct and are the deviations from FRBM permitted as a general rule or as exceptions? If the States indulge in excessive populistic measures and incur public debt either out of sheer necessity or as an instrument of competitive populism, will the Union government be in order in restraining such debt, when it has itself crossed the debt to GDP ratio beyond the limits?

Budgets from 1991 to ’96 focused on compliance with conditionalities and laid the foundation for FRBM. There is an inherent assumption that lower taxes would lead to better disclosures of incomes resulting in better compliance. But, one cannot be sure that taxpayers would disclose more of their hidden income if the tax burden were lower. The hopes of better compliance lie in detecting the erring taxpayer and penalising him stiffer.

If the States incur public debt either out of sheer necessity or as an instrument of competitive populism, will the Union government be right in restraining such debt, when it has itself crossed the debt to GDP limit?

Former RBI Governor Duvvuri Subbarao in his book, ‘Who moved my interest rate?’ chronicles the turbulent times between 2008 and 2013. Lehman imploded within ten days of his taking charge as Governor of the RBI, leading to the global crisis and its effect on India. Record high trade and fiscal deficits, and consequent rupee depreciation followed.

The Difference Now

Mark the change: India accounts for 33% of world’s GDP while that of China is 26%, according to Angus Maddison. Despite its $2,000 per capita income, mainly due to the continuing structural imbalances, India is counted as a super economic power. What was once a borrower, is now a lender and is a significant influencer in G20 nations, ASEAN and the UN.

It is time to look at the FRBM instrumentality in this federal Republic. Borrowing is always a liability. If the States build assets to sustain an enduring future for their citizens, the future is responsible for repaying the debt.

From this angle, States’ perspectives widely differ, and it is imprudent for the Union government to condition the States when they incur development expenditure not supported by the Union. RBI statistics show that the net borrowing of the Union government for 2020-21 shot up by as much as 269%. Market borrowings of States in 2020-21, however, remained at almost the same level as in the previous year.

15th Finance Commission

The 15th Finance Commission (FC), which covers five financial years from 2021-22 to 2025-26, on February 1, 2021, placed the vertical tax devolution from the Union to the States for the years 2021-26 at 41% of the divisible pool, slightly reducing the share mandated by the 14th FC (42%), but retaining the share recommended in its Interim Report given for 2020-21. The marginal reduction is primarily because of the elimination of the share of Jammu & Kashmir (0.8% of the divisible pool in 2018-19), according to RBI Bulletin, May 2022.

The 15th FC has graduated to using the 2011 census as a criterion for the inter se distribution of taxes among the States. To reward the States that have successfully brought down population growth between 1971 and 2011, which may otherwise get penalised because of this shift, a new criterion of demographic performance has been introduced — States with a lower fertility ratio will be scored higher on this criterion.

 The other major change is the re-introduction of the criterion for tax effort to incentivise States’ tax collection efforts and address concerns regarding fiscal consolidation. The weightage for forest and ecology has been increased while that of income distance has been reduced, though it continues to be the predominant criterion for tax devolution.

Grants-in-aid introduced State-specific and sector-specific grants. Sector-specific grants (12.6%) are recommended for three areas: social sector —  health, education; rural economy —  agriculture reforms, rural roads; and governance —  judiciary, statistics, aspirational districts, and blocks (mandals in Telangana and Andhra Pradesh). These grants compensate the losses incurred by the States due to cess and surcharge by the Union government while adding predictability to the quantum and timing of fund flow, thus reducing uncertainty. State-specific grant is to the extent of 4.8%.

Cutting into States’ Share

There is a State like Telangana, born just eight years ago, standing first in the country in all growth parameters and taking head-on with committed expenditures on health and education in FY23 as key to sustainable growth. This and next years are crucial with general elections in 2024. The State also has enviable social expenditure on cards. Its eligibility for grants cannot be contested on any basis as the budgeted expenditures for 2021-22 and 2022-23 are on a foundation built since its inception in sectors like agriculture, education and health, and programmes like Haritha Haram.

Telangana should have got the mandated grants, in addition to its demand for treating Kaleshwaram as a national project, and other lift irrigation projects that enriched its agriculture and for making it a granary of rice. Telangana’s fiscal prudence has not been rewarded appropriately.

Take another State. Kerala, on the verge of bankruptcy, has been denied FRBM higher leverage by the Union government. It faced severe natural calamities during the last three years like never before. Its beehive —NRI funding — took a severe beating due to the pandemic. With external resources starved and it losing the capability to generate internal resources, will it be prudent on the part of the Union government to restrict the State from additional borrowing?

These two extremities should demonstrate that the Union government is perhaps going beyond the brief of FRBM and making more politics out of economics.

 (The writer is an Economist and Risk Management Specialist) 

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Author: Howard Caldwell