DP5502 | India's Public Finances: Excessive Budget Deficits, a Government-Abused Financial System and Fiscal Rules

Publication Date

09/02/2006

JEL Code(s)

Keyword(s)

Programme Area(s)

Network(s)

Abstract

Capital formation is a key driver of the growth of potential output. With continuing widespread capital controls and persistently small inward FDI the volume of capital formation in India is constrained by domestic saving. The national saving rate in India (the sum of the saving rates of households, enterprises and the state) is depressed by the continuing large public sector deficits (and much below the near 40% of GDP saving rates achieved by China). Even this saving rate should be able to support a higher growth rate than has been achieved thus far. The reason it does not is that the intermediation of this saving into domestic capital formation is inefficient. Since the middle of the 1990s, India's public debt has risen steadily as a share of GDP, but remains below the levels achieved at the time of the 1991 currency crisis. The composition of this debt is, however, significantly different from that in 1991: external public debt is modest and international gold and foreign exchange reserves stand at historically high levels. The domestic debt is rupee-denominated. For all these reasons, government solvency may not be a pressing issue at this stage. Globally, risk-free rates at all maturities and all imaginable credit risk spreads are extraordinarily and unsustainably low. Continuation of the pattern of recent years - a steady increase in the debt-GDP ratio - will sooner or later raise the public debt to unsustainable levels. The fiscal rules adopted by the Indian Central Government under the Fiscal Responsibility and Budget Management Act do not address the key distortions imposed by the authorities on the private sector through financial repression, misguided regulations and inefficient ownership and incentive structures. Nor do they address the underlying fiscal sustainability problem faced by the Indian state. In addition, they create a mechanism for macroeconomic volatility-enhancing, pro-cyclical fiscal policy.