12/12/2009

LOVELY PROFESSIONAL UNIVERSITY | FARAZ ALAM

ECONOMICS

BUDGET DEFICIT & ITS IMPLICATION : INDIAN ECONOMY

Homework Title / No. : FARAZ ALAM Course Code : ECO-515

Course Instructor : MS.PREETI SINGH Course Tutor (if applicable) : __

Date of Allotment : OCTOBER Date of submission : 12-12-2009

Student’s Roll No._____ B35______ Section No. : RS 1901

Declaration: I declare that this assignment is my individual work. I have not copied from any other student’s work or from any other source except where due acknowledgment is made explicitly in the text, nor has any part been written for me by another person.

Student’s Signature :

FARAZ ALAM

Evaluator’s comments: _____________________________________________________________________

Marks obtained : ___________ out of ______________________

Content of Homework should start from this page only

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ON

(BUDGET DEFICIT & ITS IMPLICATION : INDIAN GOVERNMENT)

Submitted in the partial fulfillment of the Degree of masters of business administration

SUBMITTED BY:- GUIDED BY:-

Name : FARAZ ALAM MS.PREETI SINGH

Regd. No : 10906032

Roll No : RS1901 B35

SUBMITTED TO

Department of Management Lovely Professional University Phagwra .

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ACKNOWLEDGEMENT

I take this opportunity to present my votes of thanks to all those guidepost who really acted as lightening pillars to enlighten our way throughout this project that has led to successful and satisfactory completion of this study.

We are really grateful to our COD Mr.Devdhar shetty for providing us with an opportunity to undertake this project in this university and providing us with all the facilities. We are highly thankful to Miss Preeti Singh for her active support, valuable time and advice, whole-hearted guidance, sincere cooperation and pains-taking involvement during the study and in completing the assignment of preparing the said project within the time stipulated.

Lastly, We are thankful to all those, particularly the various friends , who have been instrumental in creating proper, healthy and conductive environment and including new and fresh innovative ideas for us during the project, their help, it would have been extremely difficult for us to prepare the project in a time bound framework.

Name - Faraz Alam

Regd.No - 10906032

Roll No. - RS1901 B35

.

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Indian Economy Overview :

The economy of India is the twelfth largest economy in the world by market exchange

rates and the fourth largest by purchasing power parity (PPP). India has been one of

the best performers in the world economy in recent years, but rapidly rising inflation and the complexities of running the world’s biggest democracy are proving challenging. India’s economy has been one of the stars of global economics in recent years, growing 9.2% in 2007 and 9.6% in 2006. Growth had been supported by markets reforms, huge inflows of FDI, rising foreign exchange reserves, both an IT and real estate boom, and a flourishing capital market. Like most of the world, however, India is facing testing economic times in 2008. The Reserve Bank of India had set an inflation target of 4%, but by the middle of the year it was running at 11%, the highest level seen for a decade. The rising costs of oil, food and the resources needed for India’s construction boom are all playing a part. India has to compete ever harder in the energy market place in particular and has not been as adept at securing new fossil fuel sources as the Chinese. The Indian Government is looking at alternatives, and has signed a wide-ranging nuclear treaty with the US, in part to gain access to nuclear power plant technology that can reduce its oil thirst. This has proved contentious though, leading to leftist members of the ruling coalition pulling out of the government.

As part of the fight against inflation a tighter monetary policy is expected, but this will help slow the growth of the Indian economy still further, as domestic demand will be dampened. External demand is also slowing, further adding to the downside risks. The Indian stock market has fallen more than 40% in six months from its January 2008 high. $6b of foreign funds have flowed out of the country in that period, reacting both to slowing economic growth and perceptions that the market was over-valued. It is not all doom and gloom, however. A growing number of investors feel that the market may now be undervalued and are seeing this as a buying opportunity. If their optimism about the long term health of the Indian economy is correct, then this will be a needed correction rather than a downtrend.

The Indian government certainly hopes that is the case. It views investment in the creaking infrastructure of the country as being a key requirement, and has ear-marked 23.8 trillion rupees, approximately $559 billion, for infrastructure upgrades during the 11th five year plan. It expects to fund 70% of project costs, with the other 30% being supplied by the private sector. Ports, airports, roads and railways are all seen as vital for the Indian Economy and have been targeted for investment.

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Further hope comes from the confidence of India’s home bred companies. As well as taking over the domestic reins, where they now account for most of the economic activity, they are also increasingly expanding abroad. India has contributed more new members to the Forbes Global 2000 than any other country in the last four years.

History : India economy, the third largest economy in the world, in terms of purchasing power, is going to touch new heights in coming years. As predicted by Goldman Sachs, the Global Investment Bank, by 2035 India would be the third largest economy of the world just after US and China. It will grow to 60% of size of the US economy. This booming economy of today has to pass through many phases before it can achieve the current milestone of 9% GDP.

The history of Indian economy can be broadly divided into three phases: Pre- Colonial, Colonial and Post Colonial..

Pre Colonial: The economic history of India since Indus Valley Civilization to 1700 AD can be categorized under this phase. During Indus Valley Civilization Indian economy was very well developed. It had very good trade relations with other parts of world, which is evident from the coins of various civilizations found at the site of Indus valley. Before the advent of East India Company, each village in India was a self sufficient entity. Each village was economically independent as all the economic needs were fulfilled with in the village.

Colonization : The arrival of East India Company in India ruined the Indian economy. There was a two-way depletion of resources. British used to buy raw materials from India at cheaper rates and finished goods were sold at higher than normal price in Indian markets. During this phase India's share of world income declined from 22.3% in 1700 AD to 3.8% in 1952.

After India got independence from this colonial rule in 1947, the process of rebuilding the economy started. For this various policies and schemes were formulated. First five year plan for the development of Indian economy came into implementation in 1952. These Five Year Plans, started by Indian government, focused on the needs of Indian economy. If on one hand agriculture received the immediate attention on the other side industrial sector was developed at a fast pace to provide employment opportunities to the growing population and to keep pace with the developments in the world. Since then Indian economy has come a long way. The Gross Domestic Product (GDP) at factor cost, which was 2.3 % in 1951-52 reached 9% in financial year 2005-06

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Trade liberalization, financial liberalization, tax reforms and opening up to foreign investments were some of the important steps, which helped Indian economy to gain momentum. The Economic Liberalization introduced by Man Mohan Singh in 1991, then Finance Minister in the government of P V Narsimha Rao, proved to be the stepping stone for Indian economic reform movements.

To maintain its current status and to achieve the target GDP of 10% for financial year 2006-07, Indian economy has to overcome many challenges.

Challenges before Indian economy:

Population explosion: This monster is eating up into the success of India. According to 2001 census of India, population of India in 2001 was 1,028,610,328, growing at a rate of 2.11% approx. Such a vast population puts lots of stress on economic infrastructure of the nation. Thus India has to control its burgeoning population.

Poverty: As per records of National Planning Commission, 36% of the Indian population was living Below Poverty Line in 1993-94. Though this figure has decreased in recent times but some major steps are needed to be taken to eliminate poverty from India.

Unemployment: The increasing population is pressing hard on economic resources as well as job opportunities. Indian government has started various schemes such as Jawahar Rozgar Yojna, and Self Employment Scheme for Educated Unemployed Youth (SEEUY). But these are proving to be a drop in an ocean.

Rural urban divide: It is said that India lies in villages, even today when there is lots of talk going about migration to cities, 70% of the Indian population still lives in villages. There is a very stark difference in pace of rural and urban growth. Unless there isn't a balanced development Indian economy cannot grow.

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These challenges can be overcome by the sustained and planned economic reforms.

These include: Maintaining fiscal discipline Orientation of public expenditure towards sectors in which India is faring badly

such as health and education.

Introduction of reforms in labour laws to generate more employment opportunities for the growing population of India.

Reorganization of agricultural sector, introduction of new technology, reducing agriculture's dependence on monsoon by developing means of irrigation.

Introduction of financial reforms including privatization of some public sector banks.

Recent Growth Trends in Indian Economy :

India’s Economy has grown by more than 9% for three years running, and has seen a decade of 7%+ growth. This has reduced poverty by 10%, but with 60% of India’s 1.1 billion population living off agriculture and with droughts and floods increasing, poverty alleviation is still a major challenge. The structural transformation that has been adopted by the national government in recent times has reduced growth constraints and contributed greatly to the overall growth and prosperity of the country. However there are still major issues around federal vs state bureaucracy, corruption and tariffs that require addressing. India’s public debt is 58% of GDP according to the CIA World Fact book, and this represents another challenge.

During this period of stable growth, the performance of the Indian service sector has been particularly significant. The growth rate of the service sector was 11.18% in 2007 and now contributes 53% of GDP. The industrial sector grew 10.63% in the same period and is now 29% of GDP. Agriculture is 17% of the Indian economy. Growth in the manufacturing sector has also complemented the country’s excellent growth momentum. The growth rate of the manufacturing sector rose steadily from 8.98% in 2005, to 12% in 2006. The storage and communication sector also registered a significant growth rate of 16.64% in the same year. Additional factors that have contributed to this robust environment are sustained in investment and high savings rates. As far as the percentage of gross capital formation in GDP is concerned, there has been a significant rise from 22.8% in the fiscal year 2001, to 35.9% in the fiscal year

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2006. Further, the gross rate of savings as a proportion to GDP registered solid growth from 23.5% to 34.8% for the same period.

Budget Deficit :

A Budget Deficit is a common economic phenomenon, generally taking place on governmental levels. Budget Deficit occurs when the spending of a government exceeds that of its financial savings. In fact, budget deficit normally happens when the government does not plan its expenses, after taking into account its entire savings.A budget deficit occurs when an entity spends more money than it takes in. The opposite of a budget deficit is a budget surplus. Debt is essentially an accumulated flow of deficits. In other words, a deficit is a flow and debt is a stock. An accumulated deficit over several years (or centuries) is referred to as the government debt. Government debt is usually financed by borrowing, although if a government’s debt is denominated in its own currency it can print new currency to pay debts. Monetizing debts, however, can cause rapid inflation if done on a large scale. Governments can also sell assets to pay off debt. Most governments finance their debts by issuing long-term government bonds or shorter term notes and bills. Many governments use auctions to sell government bonds. Governments usually must pay interest on what they have borrowed. Governments reduce debt when their revenues exceed their current expenditures and interest costs. Otherwise, government debt increases, requiring the issue of new government bonds or other means of financing debt, such as asset sales. According to Keynesian economic theories, running a fiscal deficit and increasing government debt can stimulate economic activity when a country’s output (GDP) is below its potential output. When an economy is running near or at its potential level of output, fiscal deficits can cause inflation.Budgetary deficits when accrued for a very long span of time, say for several decades or centuries, is termed as Government Debts. Under such circumstances, a certain portion of the governmental expenditure is then utilized for repayment of such debts, with some maturity. This maturity is capable of being re-financed, through the issuance of fresh bonds on governmental level. However, it must be noted that while a budget deficit is considered to be a flow, a government debt amounts to a stock. In fact, government debts are nothing but an accrued flow of budget deficits.The definition of a budgetary deficit essentially evolves from that of governmental debt. When governmental debt is defined as the total amount owned by somebody, budget deficit refers to the amount by which savings enhances or a governmental debt develops. In fact, a practical example will clearly reveal the relationship existing between budget deficit and governmental debt: Before the war in Iraq, the Americans had a common tendency of mixing up the two different concepts of budget deficit and government debt. This made them believe that the U.S. government was under pressure of a huge budgetary deficit. The actual situation was that the American

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government was in possession of a substantial budget surplus. The deficit which actually existed in United States of America had in fact, worn out during 1998-2001. This has made the American population believe that the budgetary deficits have increased remarkably than it was earlier, when the condition was that there was sufficient surplus, even without the funds gathered from the Social Securities programs.

The new Indian government unveiled a $210 billion budget that increases welfare and rural spending in an effort to stimulate economic growth, but also will likely widen the fiscal deficit to its largest gap in 18 years. Finance Minister Pranab Mukherjee said the government would make it a priority to reach 9% gross domestic product growth in the medium term and would seek to spend 9% of GDP on infrastructure development by 2014. Although world financial conditions have improved, there are still uncertainties on the revival of the global economy, Mr. Mukherjee said. "We can't afford to drop our guard," he told Parliament. "We have to continue our efforts to provide further stimulus to the economy."

Investors have bid up Indian shares since the ruling coalition, the United Progressive Alliance, won the general election in May. Many investors had been looking to the budget to outline a program of economic overhauls to attract foreign investment and the divestment of government stakes in state-owned companies to raise funds. But the budget was short on both, and the benchmark Bombay Stock Exchange Sensex index sank 5.8%, or 870 points, to 14043.

This budget gave little guidance on whether the government planned to pursue changes, such as opening the economy further to foreign investors and companies, during its five-year term. "The big picture and road map was missing in terms of attracting foreign direct investment and the disinvestment program to raise revenues," said Andrew Holland, chief executive for equities at Ambit Capital in Mumbai.

One of the major problems facing the Indian economy is your large budget deficit and the resulting high level of national debt. As you know, the budget deficit of the central government is about six percent of GDP and this rises to about 10 percent of GDP if the deficits of subnational governments are included. The combined government debt is now close to 75 percent of GDP. It is with these worrying figures in mind that I decided to speak today about the general problem of budget deficits and national debt.

India is certainly not alone in having budget deficits that are too high. France and Germany now have deficits that violate the European Growth and Stability Pact. In the United States, the budget deficit has risen from 1.5 percent of GDP in 2002 to 3.7 percent in 2003 and a projected 4.3 percent next year. Japan has the largest budget deficit among the major industrial countries at 8 percent of GDP. And among the

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emerging market economies, the average ratio of budget deficit to GDP is now about four percent.

I will not be so foolish as to suggest specific policies by which India can reduce its budget deficit. I know how difficult it is to prescribe policies in my own country. The political and economic complexities of India make it even more difficult for an outsider to offer specific suggestions here.

What I will do instead is to discuss the adverse effects of large budget deficits in general and the way in which such deficits can become unsustainable, leading to national insolvency and a debt default. I will consider the arguments that have been made by those academic economists over the years who have tried to justify a policy of large peacetime budget deficits. And I will consider in general terms the merits of different ways of reducing budget deficits.

Large fiscal deficits have a variety of adverse consequences: reducing economic growth, lowering real incomes, and increasing the risk of financial and economic crises of the type that we recently witnessed in several countries of Asia and Latin America. Since I am here in a central bank, I should add that, under some circumstances, fiscal deficits can also lead to inflation. Even if a central bank prevents such inflationary consequences , the other adverse ';real'; effects cannot be avoided. And under some conditions that I will discuss later, budget deficits can lead to higher inflation despite the attempt of the central bank to pursue a sound monetary policy.

To get a sense of the magnitude of these effects, consider just the impact of India’s recent deficits on capital formation and growth. If India did not have its current central government deficit of some 6 percent of GDP, the gross rate of capital formation could rise form 24 % of GDP to 30%. The net rate of investment would rise relatively more. Over the next decade, this greater rate of net capital accumulation would be enough to add nearly a full percentage point to the annual growth rate, raising India’s level of GDP a decade from now by about 10 percent. Eliminating the state deficits as well as the deficit of the central government would substantially increase the size of this effect. While such radical deficit reduction may not be achievable in practice, these calculations indicate what could be accomplished with even smaller deficit reductions.

Unfortunately, it is easy to ignore budget deficits and postpone dealing with them because the adverse effects of budget deficits are rarely immediate. Fiscal deficits are like obesity. You can see your weight rising on the scale and notice that your clothing size is increasing, but there is no sense of urgency in dealing with the problem. That is so even though the long-term consequences of being overweight include an increased risk of a sudden heart attack as well as of various chronic conditions like diabetes. Like obesity, government deficits are the result of too much self-indulgent living as the

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government spends more than it collects in taxes. And, also like obesity, the more severe the problem, the harder it is to correct: the overweight man has a harder time doing the exercise that could reduce his weight and the economy with a large deficit and debt is trapped by increasing interest payments that cause the deficit and debt to rise more quickly. I emphasize the analogy to stress the point that budget deficits need attention now even when their adverse effects may not be obvious.

Different types of budget deficits:

Early Budget Deficit : This prevailed prior to the invention of bonds. At that time, such deficits could only be funded with loans taken from either foreign nations or private financiers. However, large long-term loans had a high element of risk for the lender and consequently gave high interest rates. A permanent loan or deficit is associated with sufficient risk factors for the lenders. At a later stage, attempts were made on governmental levels to do marketing of such deficits or debts by issuance of bonds , payable to the bondholders or bearers, instead of the actual buyers. This indicates that such debts are saleable, provided a person lends it to the other through state money. This simultaneously brings about a reduction in overall rates of interest as well as the risks associated with the entire process.

Cyclical Budget Deficits : At the lowest point in the business cycle, there is a high level of unemployment. This means that tax revenues are low and expenditure (e.g. on social security) high. At the basic level of the commercial cycle, the rate of unemployment is pretty high. On the contrary, unemployment is low at the pinnacles of the commercial cycle. This enhances tax revenue and leads to a fall in the expenditure associated with social security. Conversely, at the peak of the cycle, unemployment is low, increasing tax revenue and decreasing social security spending. The additional borrowing required at the low point of the cycle is the cyclical deficit. By definition, the cyclical deficit will be entirely repaid by a cyclical surplus at the peak of the cycle.

Structural Budget Deficits : This refers to the deficit existing across the commercial cycle. Such budget deficit prevails when the general government expenses exceed the existing levels of tax. It is the deficit that remains across the business cycle, because the general level of government spending is too high for prevailing tax levels. The observed total budget deficit is equal to the sum of the structural deficit with the cyclical deficit or surplus.

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However in case of both Cyclic and Structural Budget Deficit, the visible total deficit is equivalent to the sum of either the deficits or their surplus. Some economists have criticized the distinction between cyclical and structural deficits, contending that the business cycle is too difficult to measure to make cyclical analysis worthwhile.

The fiscal gap , measures the difference between government spending and revenues over the very long term, typically as a percentage of Gross Domestic Product. The fiscal gap can be interpreted as the percentage increase in revenues or reduction of expenditures necessary to balance spending and revenues in the long run. For example, a fiscal gap of 5% could be eliminated by an immediate and permanent 5% increase in taxes or cut in spending or some combination of both. It includes not only the structural deficit at a given point in time, but also the difference between promised future government commitments, such as health and retirement spending, and planned future tax revenues. Since the elderly population is growing much faster than the young population in many countries, many economists argue that these countries have important fiscal gaps, beyond what can be seen from their deficits alone.

INDIA : Budget deficit as a ratio to GDP

It has become an accepted practice with the Finance Ministers to present deficit budgets and to relate the same as a ratio to the GDP, since a mild dose of deficit finance can be a stimulant to the growth of the economy. The Union Finance Minister presented the budget proposals for 2005-06 with a revenue deficit of Rs.95,312 crores and a fiscal deficit of Rs.1,51,144 crores. As a ratio to the GDP the revenue deficit would be 2.7 per cent and fiscal deficit 4.3 per cent.

He claims that the GDP-GFD ratio was brought down by 0.5 per cent in 2004-05 and that the deficit would be brought down further to the level fixed by the Fiscal Responsibility and Budget Management Act by 2008-09. However, the burden of deficits has been rising year by year. In 1970-71, the fiscal deficit accounted for only Rs.1,408 crores. It increased to Rs.8,299 crores by 1980-81, to Rs.44,632 crores by 1990-91 and to Rs.1,18,816 crores by 2000-01. There is thus a steep rise in the absolute size of the fiscal deficits over the years without any sign of a fall.

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Unreliable indicator

Admittedly, there is a consensus among the scholars that growth of deficit finance beyond a limit can undermine the economy. However, nobody is sure as to the precise limit up to which deficit can be resorted. Instead of prescribing such a safety limit, their approach seems to be to look at the GDP-GFD ratio as an indicator for evaluating the seriousness of the deficits in the economy and thereby to apply corrective measures. At the same time, the governmental approach seems to be to raise the GDP by applying further dose of deficits instead of reducing the expenditure or tax rates for populist reasons. Even the Fiscal Responsibility and Budget Management Act seems to rely on a reduction of GDP-GFD ratio as a sound measure for correcting the danger from deficit financing. The question is how far can GDP-GFD ratio be regarded as an authentic indicator for evaluating the seriousness of budget deficits in the Indian economy.

An evaluation based on GDP-GFD ratio by itself seems somewhat meaningless in a country like India for a variety of reasons. First, much of the statistical data needed for compiling the national product are inadequate and even unreliable. Secondly, the periodical revision of the GDP, undertaken apparently for the purpose of accommodating structural changes in the economy, very often results in an abnormal spurt in the very size of the GDP. The revision with 1993-94 as the base resulted in inflating the figure by 9 per cent in 1993-94, the base year itself, in comparison with the estimates based on 1980-81 series. In the case of Kerala, the revision resulted in a spurt of 18 per cent in the volume of SDP compared with the volume based on the previous base.

Such abnormal increase in the size of GDP can certainly reduce the GDP-GFD ratio. Changes in the data base as well as the methodology are stated to be the reasons for the increase in the value added by certain activities/services. In the case of ownership of dwelling houses for example, "the estimate of GDP in 1993-94 went up to Rs. 44,140 crores in the new series as against Rs.21,981 crores in 1980-81 series, showing an increase of Rs. 22,159 crores," apparently on account of the change in the methodology.

It may adopt new norms in the valuation of activities/services in the estimates of GDP in the context of what some state accountants speak of as underestimation in areas like that of the organised and unorganised service sector. In such an eventuality, budget deficits can be brought down to the level stipulated by the FRBM Act, without actually curtailing the deficits at all.

There is something definite about the volume of debt or the debt charges unlike the ambiguity regarding the real size of the domestic product. In 1970-71, the revenue

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receipts totalled Rs.3,293 crores. The interest charges on the other hand amounted to Rs.606 crores accounting for18 per cent of the revenue receipts. By 1990-91 the revenue receipts totalled Rs. 54,954 crores with the interest payments amounting to Rs.21,498 crores. The interest payments accounted for 39 per cent of the revenue receipts. The interest payments would be Rs 1,33,945 crores in 2005-06 against the anticipated revenue receipts of Rs.3,51,200 crores. As a percentage, it accounts for 38.13. Apparently, very little correction has been effected in the deficits so far. In addition to the interest payments of the Central government, the interest payments of the State governments are also increasing at an alarming rate which is sure to add new dimensions to the burden of the economy.

Accumulated debt

The conditions of buoyancy which the country now experiences may not remain forever. There are indications of the country falling into a debt trap. The accumulated debt of the Central and State governments put together adds up to Rs. 30,00,000 crores. Some of the State governments like that of Bihar have not been able to pay the salary of its employees for months on account of non-availability of funds. All such indicators point to the heavy burden on the economy brought about mainly by the growing volume of deficit financing. The positive factors like the accumulated foreign exchange reserves and the inflow of private transfer payments, which prop up the economy from crumbling under the heavy weight of the mounting deficit finance, may not be able to hold for long. Drastic reduction of the deficit financing and not adjustment of the GDP-GFD ratio is the only way out for salvaging the economy and keeping it intact.

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Primary deficit, total deficit, and debt :

The government’s deficit can be measured with or without including the interest it pays on its debt. The primary deficit is defined as the difference between current government spending and total current revenue from all types of taxes.The total deficit (which is often just called the ’deficit’) is spending, plus interest payments on the debt, minus tax revenues. Therefore, if Gt is government spending and Tt is tax revenue, then Primary deficit = Gt – Tt If Dt − 1 is last year’s debt, and r is the interest rate, then Total deficit = Gt + rDt − 1 – Tt Finally, this year’s debt can be calculated from last year’s debt and this year’s total deficit: Dt = (1 + r)Dt − 1 + Gt – Tt Economic trends can influence the growth or shrinkage of fiscal deficits in several ways. Increased levels of economic activity generally lead to higher tax revenues, while government expenditures often increase during economic downturns because of higher outlays for social insurance programs such as unemployment benefits. Changes in tax rates, tax enforcement policies, levels of social benefits, and other government policy decisions can also have major effects on public debt. For some countries, such as Norway, Russia, and members of the Organization of Petroleum Exporting Countries (OPEC), oil and gas receipts play a major role in public finances. Inflation reduces the real value of accumulated debt. If investors anticipate future inflation, however, they will demand higher interest rates on government debt, making public borrowing more expensive.

Budget deficit and Debt formula:Calculation of budgetary deficit is dependent on the following formula: To calculate a debt D, the formula used is: D = RBt - 1 + Gt(r - g) - Tt , where, R= real rate of interest ,Bt - 1= debt of the previous yearr=rate of interest ,g= rate of growth , Gt= government expenses and, Tt= tax revenue However, the budget deficit of every country has its individual factors responsible for such situation to arise, hence varies worldwide. This is precisely why the rising development of Indian economy is directly unfolds the inflationary impacts, which results from the financial deficits in such Asian countries.

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Deficits and Debt Ratios :

The appropriate size of the national debt, like the ideal weight for an individual, is a complex question. But basic common sense tells us that the ratio of debt to GDP should not be allowed to rise year after year. I may not know my optimal weight but I know that I am in trouble if I am gaining five pounds a year, or even three pounds a year. In fiscal terms, a country should recognize that it is in trouble if it sees its ratio of debt to GDP rising year after year.

There is therefore nothing arcane about the appropriate standard of a sound fiscal policy. The basic rule is that government revenue must exceed government non-interest outlays. The excess of revenue over non-interest outlays must be sufficient to finance enough of the interest payments on the public debt to avoid a rising ratio of debt to GDP. To make this operational, it is necessary to be clear about the definition of the budget deficit and about the role that the rate of interest on the national debt plays in determining the debt dynamics.

The budget deficit is traditionally defined as the difference between total government outlays, including the interest on the national debt, and the government’s revenue receipts. A more complete definition of the deficit is that it is the difference between the size of the government debt at the end of the year and the corresponding size of the debt one year earlier. These two are equivalent if the government debt is defined as the stock of outstanding bonds. A more general definition of the government debt, however, would include the value of off-budget liabilities like future social security pensions and such contingent liabilities as the cost of dealing with insolvent banks and money-losing state enterprises. Unfortunately, the available statistics on debt and deficits generally ignore these broader considerations. Although I will therefore not present data on this broader concept of the national debt, everything that I say today about deficits and debt should be interpreted in this larger context.

A budget deficit implies that the national debt is increasing. But since the GDP is also rising, the ratio of the national debt to GDP may or may not be increasing. That depends on whether the growth rate of the national debt is more than or less than the growth rate of GDP. A continually increasing ratio of debt to GDP runs the risk that the debt will get on an unsustainable path leading to national insolvency. Even if the debt ratio is not explosive in this way, a high ratio of debt to GDP has serious adverse consequences. It is important therefore to understand what drives the ratio of debt to GDP and, if it is converging to some equilibrium level, what determines that level.

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To do so it is useful to distinguish the standard budget deficit from the primary budget deficit. The primary deficit is the standard deficit minus the interest on the government debt. Equivalently, as traditionally measured, the primary deficit is government non-interest outlays minus total revenues.

To be more explicit, the total or standard deficit can be written as G + i * Debt - T where G is noninterest government outlays, i is the interest rate on the government debt, and T is taxes and other government revenue. The primary deficit is then G - T.

With this notation, it can be shown that the change in the ratio of debt to GDP can be written as

D { Debt / GDP } = [ G - T ] / GDP + { i - [ (D GDP )/ GDP] }( Debt / GDP)

i.e., as the sum of the primary deficit per dollar of GDP plus the difference between the interest rate and the growth rate of GDP ( D GDP )/ GDP ) multiplied by the initial ratio of debt to GDP.

Although I have expressed this relation in terms of the nominal interest rate and the nominal growth rate, the same rule holds if we replace the nominal interest rate with the real interest rate (i minus the inflation rate) and the nominal growth rate with the real growth rate ( ( D GDP )/ GDP minus the inflation rate).

This equation tells us that the ratio of debt to GDP will unambiguously rise if there is a primary deficit (i.e., if government non-interest spending exceeds revenue, G - T greater than zero) and if the interest rate on the national debt exceeds the growth rate of GDP. The logic of this is clear. The primary deficit adds to the national debt and the positive difference between the interest rate and the growth rate of GDP means that the interest payments alone cause the debt to rise faster than GDP.

To reduce the ratio of debt to GDP there must be either a primary surplus (i.e., revenue must exceed noninterest outlays) or the economy must grow faster than the rate of interest, or both. If only one of those conditions holds, it must be large enough to outweigh the adverse effect of the other.

The relation between the interest rate and the GDP growth rate varies from time to time and from country to country. In the United States over the past five years nominal GDP grew at an annual rate of 4.7 percent while the implicit interest rate on the government debt was 7.1 percent. Over those same five years, the U.S. also had a primary surplus of 3.2 percent of GDP. With an average debt to GDP ratio of 40 percent, the ratio of debt to GDP declined by about 2 percent per year, from 0.45 in 1997 to 0.34 in 2002.

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The future may not be as favorable. Recent calculations by the official U.S. Congressional Budget Office based on plausible policy assumptions imply that the primary deficit could average about 0.8 percent of GDP over the next five years if the economy grows at a moderate rate of 3 percent a year. Over the same five years, the Congressional Budget Office estimates that the rate of GDP growth will exceed the interest rate by 0.7 percent. Combining these figures with the initial ratio of debt to GDP implies that the debt to GDP ratio would rise from 39.6 percent of GDP at the end of 2004 to 42.9 percent at the end of 2009. Policy actions could of course reduce that primary deficit. And faster economic growth would reduce the primary deficit (by increasing tax revenue) and could cause the interest rate to be smaller than the growth rate, further reducing the debt to GDP ratio. Even a relatively small increase in the growth rate could prevent the rise in the debt to GDP ratio.

In India in recent years the primary deficits have been above 1.5 percent of GDP and the implicit rate of interest on the national debt has exceeded the nominal growth rate of GDP by more than three percentage points. The ratio of the central government debt to GDP was about 60 percent on average over these years. Combining these figures in the way implied by the basic equation implies that the ratio of debt to GDP will rise at about three percent per year. That is what was happening until recently. The debt to GDP ratio rose from 54 percent in 2000-01 to 65 percent in 2003-04. That’s the bad news. The good news is that cutting the deficit, and therefore the primary deficit, by about 1.5 percent of GDP could prevent this rise in the debt to GDP ratio. I will return later to discuss approaches that any country must consider as it tries to reduce the primary deficit and the relative level of public debt.

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Rising Debt Ratios :

Experience around the world shows that a rising ratio of debt to GDP increases the probability of some kind of debt default or debt restructuring. The financial markets are forward looking and respond to that risk by insisting on higher interest rates to induce investors to hold government bonds. But those higher interest rate cause the debt to grow even faster. It is in that way that high debt ratios can become unstable without any increase in the primary deficit.

While an increase in the debt ratio can in principle be reversed, it becomes harder to do so as the interest rate rises, accelerating the growth of the debt and decreasing the growth of GDP. A continuing rise in the ratio of debt to GDP is a path to insolvency and economic crisis. But even a stable but high ratio of debt to GDP has serious adverse effects on the economy by crowding out private capital formation and imposing a higher tax burden to service the debt.

What determines the stable level of the debt to GDP ratio? The basic equation for the growth of the debt to GDP ratio implies that there is no change in the ratio when the primary deficit as a fraction of GDP is equal to the product of the debt to GDP ratio and the difference between the interest rate and growth rate:

(G - T) / GDP = [ D GDP/ GDP - i] (Debt/GDP)

This implies that a stable ratio of debt to GDP must satisfy

(Debt/GDP) = {(G - T) / GDP} / [ (D GDP/ GDP) - i]

For example, a primary deficit equal to one percent of GDP and a growth rate that exceeds the interest rate by 2 percentage points, will eventually produce a debt to GDP ratio of 50 percent. Doubling the primary deficit would cause the equilibrium debt ratio to double as well. But even with no change in the primary deficit, a fall in the difference between the growth rate and the interest rate from 2 percentage points to 1 percentage point, would also cause the debt ratio to double.

It is clear from this arithmetic that it is very easy for an economy to shift from a stable debt ratio at a low level to one at a substantially higher level in response to a relatively small change in government spending, taxes, interest rates or economic growth.

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Pro-deficit Economic Arguments :

Budget deficits and debt ratios have not always been as high as they are now. And while deficits during major wars were common, peacetime deficits were unusual. In the United States, the entire national debt, including the substantial debt incurred during the Civil War, was fully paid off by a series of surpluses in the latter part of the 19th century.

In retrospect, it is quite remarkable that the political process supported the opposition to budget deficits and national debt for such a long time. Without a strong intellectual and moral opposition to deficits, powerful populist political pressures can lead to large budget deficits. Budget deficits are potentially popular because they allow higher levels of government spending and lower levels of taxation. Deficits shift the fiscal cost to future generations that are not yet voters. And deficits impose burdens on the economy that, unlike the very tangible benefits of more spending and lower taxes, are not directly visible to current voters.

It is unfortunate that, starting with the 1940s, economists developed a series of different arguments that encouraged the political process to accept larger and larger peacetime deficits. These analyses started with simple arguments and were followed by new theories of economic growth, theories of household saving behavior, and models of the global capital markets. The arguments were intellectually quite different from each other but they all lead to the same conclusion: that budget deficits in peacetime were not a problem for the economy.

This conclusion ran counter to earlier analyses that emphasized that savings increased the rate of growth by increasing the amount of capital per worker. The reason for the new conclusion was the recognition that the higher capital intensity of production that resulted from a higher saving rate would eventually require an even higher saving rate to maintain the increased rate of growth. With no further increase in the net saving rate, the rate of growth of aggregate income would eventually converge back to the sum of the growth rates of population and productivity.

Although the new theory was technically correct, it was also misleading in focusing on the very very long run. With reasonable economic parameters, a rise in the saving rate could actually raise the growth rate by a significant amount for several decades. Moreover, even as the growth rate returned to its initial value, the level of real per capita income would remain permanently higher. With time, these technical aspects of the neoclassical analysis became understood among economists. But for at least a generation of economists who had grown up with the neoclassical growth models, there remained a residual sense that a higher saving rate is not the path to increased growth and , even more incorrectly, to higher real incomes.

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It is of course difficult to know how influential a change in professional economic thinking is in changing economic policy. It is my judgement that the general acceptance by mainstream economists of the notion that budget deficits do not reduce long-term growth played an important role in decreasing the opposition to large peacetime budget deficits. This was reinforced in the 1960s by the widespread professional acceptance of the original Phillips curve theory that implied that an expansionary fiscal policy could permanently reduce the rate of unemployment if the economy accepts a permanently higher rate of inflation. With the additional view that inflation had at most a derisively small economic cost (the ';shoeleather'; costs of households making extra trips to the bank) and might actually increase productivity (by encouraging the replacement of cash balances in households’ portfolios with claims on real capital), the case for budget deficits seemed quite compelling.

By the late 1970s the economics profession was coming to reject all of these arguments. A higher saving rate was seen as important for growth and for raising real incomes, the long-run Phillips curve was discredited, and the high rate of inflation in the 1970s was recognized as a serious problem. But the 1980s brought yet another example of the ';deficits don’t matter'; argument, the so-called Ricardian-equivalence proposition. Here the argument is that budget deficits do not change national saving because individuals increase their personal saving to offset exactly the rise in the budget deficit.

The key assumption of the Ricardian-equivalence model is that successive generations are linked by an operative bequest motive. If I plan to bequeath some amount of money to my children and the government cuts my taxes (or gives me additional benefits through government spending) while increasing the future taxes that will have to be paid by my children, I will offset this government action by increasing my saving to keep my real income and the real incomes of my children unchanged. While this seems plausible enough once the premise of an operative bequest motive is accepted, there are so few planned bequests that this is not empirically significant. The absence of significant planned bequests is not surprising in an economy in which economic growth raises the incomes of future generations so that even an altruistic parent sees no need to reduce his own consumption in order to raise the consumption of his adult children after he has died. By now many, I would think most, economists have recognized the practical irrelevance of the Ricardian-equivalence theory and concluded that budget deficits do reduce national saving.

There is yet one more line of argument that implies that budget deficits are not as important in the capital accumulation process as they might seem at first. A fully integrated global capital market implies that the domestic levels of investment, capital stock, and productivity in an economy do not depend on the domestic saving rate.

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Capital flows among countries to equate the real rate of return. A country with a high saving rate exports capital to the rest of the world and a country with a low saving rate imports capital. In this context, a large budget deficit that reduces national saving will not hamper domestic investment but will instead induce a capital inflow from abroad.

Although an integrated global capital market is a helpful analytic abstraction, it is not a description of the actual global capital market. Charles Horioka and I showed some years ago that persistent differences in national saving rates among industrial countries translates into persistent differences in investment as a share of GDP. The global capital market is surprisingly segmented, with about 80 percent of a sustained rise in incremental savings retained in the saving country. This finding has been replicated with more recent data and shown to hold for a wide range of developing as well as industrial countries. The implication is clear: a country that reduces its national saving by a large budget deficit will have a similar adverse effect on the its national investment rate.

Economic Crises :

In addition to the adverse effects of budget deficits on capital accumulation, economic growth, future tax rates, and inflation, budget deficits can also be the source of the kind of financial crises that were experienced in Latin America and south Asia in the past decade. This is particularly true when the budget deficit is financed by borrowing abroad in a different currency like the dollar or euro. A country that borrows dollars to finance its budget deficit runs the risk that an unwillingness of foreign lenders to keeping rolling over existing debt will cause a substantial decline in the exchange rate, leading to a financial crisis.

This is what happened in Thailand in 1998 when foreign lenders decided to stop rolling over Thai dollar obligations. They did so because the growing accumulation of foreign debts denominated in dollars raised doubts about the eventual ability of the government of Thailand and its private sector borrowers to be able to repay foreign obligations. When this happened, the exchange rate shifted from 25 bhat per dollar to about 50 bhat per dollar. Thai companies that owed dollars to foreign lenders or to domestic banks saw the value of their obligations double when measured in bhat. For many highly leveraged borrowers, the doubling of their debt meant bankruptcy. Thai banks that had made dollar loans to these borrowers were unable to collect but still owed dollars to foreign creditors, forcing the banks themselves into bankruptcy. With companies and banks in bankruptcy, the economic activity collapsed and the county suffered a severe crisis.

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In an open economy with no capital account restrictions a rising ratio of government debt to GDP can lead to an economic and financial crisis even if the debt is not to foreign lenders and is not denominated in dollars. As the debt to GDP ratio rises, domestic individuals and businesses will seek ways to transfer funds abroad to invest in alterative assets in order to avoid the risks inherent in domestic banks and domestic bonds. This shift of funds can reduce the exchange rate, raising domestic interest rates and weakening domestic banks.

In short, while a high ratio of debt to GDP can do substantial damage to the economy, a debt to GDP ratio that is rising can signal fiscal insolvency and cause a financial and economic crisis.

Ways to tackle Deficit :

There are only three basic ways to reduce the fiscal deficit and one additional way to reduce the equilibrium ratio of debt to GDP and the risk that the debt ratio will reach an unstable level. The three ways to reduce the budget deficit are to cut non-interest government outlays, to increase tax or other revenue, and to reduce the rate of interest on the government debt. A faster rate of economic growth would also reduce the equilibrium ratio of debt to GDP and the risk of a shift to an unstable path of debt to GDP. Let me consider each of these options in turn.

Reducing non-interest outlays is always politically difficult but it is not impossible. Fortunately, what matters is not the absolute level of government outlays but the ratio of outlays to GDP. It is necessary therefore only to slow the growth of noninterest spending to less than the growth of GDP. Despite the difficult of doing this in a democracy, the United States did succeed in reducing the ratio of noninterest outlays to GDP during the eight years of the Ronald Regan presidency from 20.8 percent of GDP in 1980 to 19.4 percent of GDP in 1988. Nondefense discretionary spending – i.e., spending excluding defense and the so-called entitlements that are not subject to annual Congressional appropriations (like Social Security pensions, Medicare benefits, etc) – fell one-third from 4.7 percent of GDP in 1980 to 3.1 percent of GDP in 1988.

Spending reductions must of course be made program by program even if overall spending goals and limits help to achieve that aggregate spending reduction. In many emerging market countries, stopping support for money-losing state owned enterprises by imposing a hard budget constraint or by privatizing the entity can be a major source of spending reduction. The key to thinking about all forms of government expenditures is to recognize that the cost of providing a government outlay includes not only the direct outlay itself but also the deadweight loss associated with raising the revenue to

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pay for that outlay. That incremental deadweight loss depends on the means of financing the increased outlay. An increase in the income tax that distorts work behavior and the form of compensation or an increase in the budget deficit that reduces national saving can produce deadweight losses that are as large as the outlay itself, thus doubling the true cost of the outlay. Paying attention in this way to the total cost of spending may help to reduce the level of spending therefore that source of the deficit.

Raising revenue is the alternative way to reduce the primary deficit. The way in which that revenue is raised in very important. An increase in the tax on labor income or investment incomes can entail large deadweight losses. That form of tax can also reduce the rate of economic growth, raising the ratio of government outlays to GDP, increasing the equilibrium ratio of debt to GDP, and increasing the likelihood that the economy will shift to an unstable path.

It is far better to seek ways to increase collections with the existing law by reducing pure tax evasion. A second best strategy is to find ways to reduce loopholes that allow technically legal but unjustifiable tax avoidance. Finally, tax reforms that strengthen incentives can raise revenue by increasing output and by causing more output to be treated as taxable income rather than disguised in other non-taxable forms of compensation.

Taxes are not the only source of non-debt government revenue. Charges for government services can be an important source of revenue, especially in an economy like India where the government provides such a wide range of public services. Charging for some public services may also make it possible for private providers to offer these services, covering their own costs with charges and making a profit as well. But it is also important to recognize that raising charges for the use of public services can lead to the suboptimal use of those services. Tolls on highways and bridges can bring in revenue but may not be optimal if they discourage the use of otherwise uncongested facilities.

The optimal user charge is however more complicated than the traditional rule that the user charge should be no more than marginal cost. The traditional rule must be modified to recognize that all sources of revenue involve deadweight losses. The optimal charge for the use of an uncrowded bridge should not be the zero marginal cost but a positive price that makes the deadweight loss per rupee of revenue equal to the deadweight loss of generating revenue in other ways. For example, if raising an incremental rupee of revenue with the income or value added tax involves a deadweight loss of one-half rupee, the appropriate charge for the uncrowded bridge should also be such that the toll generates a deadweight loss of one-half rupee per rupee of revenue.

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Reducing the interest rate on the government debt is of course another way in principle to reduce the budget deficit and the equilibrium ratio of debt to GDP. Although the government cannot reduce that interest rate directly, it can do so indirectly by actions that make the debt less risky. A sound monetary policy that reduces inflation risk can reduce the real interest rate. Budget policies that reduce expected future primary deficits can also reduce the real rate of interest.

Finally, an increase in the rate of economic growth would lower the equilibrium ratio of debt to GDP and reduce the risk of an unstable rising ratio of debt to GDP. Since a lower primary deficit permits more investment and therefore faster economic growth, any policy that reduces the primary deficit brings an extra benefit in this way, creating a virtuous circle. There are of course many other things that a government can do to raise the rate of economic growth: increasing market flexibility, improving infrastructure, reducing regulations, and removing financial and legal barriers to individual entrepreneurship. India is clearly engaged in a wide variety of such pro-growth policies. If they are successful, they will reinforce sound fiscal management to achieve lower budget deficits and to reduce the relative size of the national debt. It is important that such pro-growth policies as well as explicit deficit reduction initiatives be adopted in the years ahead.

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References :

Managerial Economics – Tata McGraw Hill

www.economywatch.com

www.indianeconomy.org

www.wikipedia.org

www. finmin.nic.in

www.cmie.com

www.rbi.org.in

www.bloomberg.com

www.indiadaily.com

www.indiabudget.nic.in

www.mostlyeconomics.wordpress.com

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