By Neelam Rani and Darshan Gosalia
Budget 2021: The emerging markets have been experiencing high economic growth for several years now and are often the preferred destinations for foreign investment due to their high earning potential. To boost this potential, the governments step up public investment, funded through debt. The way Indian economy is managed is an example.
India is one of the fastest growing emerging markets in the world, and the government is incurring high revenue and capital expenditure to improve productivity and boost economic growth. This expenditure is funded through revenues in the form of tax and non-tax receipts as well as capital receipts. As the public expenditure is more than the public revenues, the deficit is funded through market borrowings.
Budget 2021: Rising government borrowings
The government’s borrowings are from both internal and external sources. Internal debt, which is raised from lenders within the country, consists of marketable securities such as G-secs, T-bills, and gold bonds. External debt is raised from foreign lenders. In the Indian context, internal debt comprises the major portion of public debt, with external debt constituting only about 6% of the total debt.
The total debt stood at about Rs 94 lakh crore as on March 2020. The budgeted FY21 borrowings were Rs 7.8 lakh crore. When the Covid-19 pandemic broke out, the government had to increase expenditure on healthcare and economic stimulus. This, coupled with the lower revenues forced the government to revise its budgeted borrowings to Rs 12 lakh crore in May 2020 and subsequently to Rs 13.10 lakh crore in October 2020. Budget 2021 is also expected to earmark a huge amount on healthcare and stimulus.
Double whammy: Covid-19 and economic crisis
The situation aggravated with the contraction in GDP by 23.9% in the first quarter of the current fiscal. According to the Economic Survey, the Indian Economy will contract by 7.7% in the entire financial year. This pandemic came at a time when India was targeting to become a $5 trillion Economy by 2025.
The pandemic and the lockdown resulted a slump in industrial production. The index of industrial production contracted year-on-year across primary goods, capital goods and intermediate goods in September 2020. However, the anti-China sentiment across the world and the Aatmanirbhar Bharat initiative of the Narendra Modi government led to a significant fall in trade deficit to $57.74 billion in the April-December period. Also, there was an increase in FDI and FPI inflows and a rise in forex reserves.
Owing to the contraction of the economy and the higher public expenditure, the fiscal deficit may rise to around 7.5% of the GDP, doubling from the budget estimate of 3.5% for the financial year 2020-21, according to rating firm ICRA. The increased government borrowings have critical implications at both micro and macro levels. Budget 2021 has its task cut out.
Budget 2021 must target cut in govt spending
At a macro level, higher levels of public debt would lead to increased interest obligations. As public debt rises to meet the fiscal deficit, the interest rates tend to go up. This increased interest obligation would be met from public revenues in the form of future tax raises or through cut in public spending.
A higher public debt combined with a simultaneous contraction of GDP would lead to a higher debt-to-GDP ratio, a measure of the country’s ability to repay its debt. A study by World Bank found out that a debt-to-GDP ratio in excess of 77% for an extended period slows down the economy. It has been estimated that the debt-to-GDP ratio in the current fiscal would reach 90% of the GDP. On the contrary, a high debt-to-GDP ratio does not necessarily indicate a country’s insolvency.
In fact, Japan has a debt-to-GDP ratio of over 200% with no sign of defaulting. Though a high debt-to-GDP ratio may not necessarily reflect India’s inability to repay its debt, it may have impact on other parameters such as sovereign ratings, higher interest rates and low foreign inflows in the future.
Standard & Poor’s (S&P) has rated India at a credit rating level of BBB-, being the lowest investment grade rating, with a stable outlook. In order to prevent a negative outlook, the government would likely bring about necessary changes in direct- and indirect-tax structures. Further, a larger government borrowing in the form of internal public debt would mobilise the money to the public sector and crowd out private spending. In a consumption-based economy like India, non-availability of funds for private spending has a negative implication on the economic outlook.
In order to prevent negative implications on government borrowing on the economy, the Reserve Bank of India has been trying to keep the interest rates down. For this, it has maintained the repo rate at 4% and bank rate at 4.25%. It has also pumped in funds into the financial system through buying of bonds.
To conclude, the government was forced to raise debt to meet the health crisis and the economic slowdown. A phased reduction in public debt should be the focus of Budget 2021. As the late Finance Minister Arun Jaitley mentioned in his first budget speech: “We cannot leave behind a legacy of debt for our future generations. We cannot go on spending today which would be financed by taxation at a future date.”
(Dr Neelam Rani is Associate Professor (finance) at IIM Shillong. Darshan Gosalia is a chartered accountant and PGP student at the IIM.)