While the financial world is riveted to the sanctions on Russia for invading Ukraine (freezing of its foreign assets, isolating it from SWIFT transactions, etc.), rising crude price due to the war and the Russian central bank’s dramatic interest rate hike from 9.5% to 20% (to ensure domestic financial and price stability), an interesting debate has been sparked by the International Monetary Fund (IMF) about economic management on the quiet.

In its latest issue of Finance & Development magazine (March 2022), the IMF is talking about a rethink on fiscal limits — debt-to-GDP ratio of 60% and fiscal deficit of 3% — in the post-pandemic world. Governments across the world have borrowed heavily to support households and businesses impacted by the pandemic disruptions in the past two years, taking their debt to unprecedented levels. Now is the time to pay and ensure that fiscal limits remain within sustainable levels even while continuing the support to the battered households and businesses. That is the context of the IMF’s advocacy, which marks a definitive change in its stand.

It was the IMF, in company with the World Bank, which imposed these fiscal limits in 1980s on poor countries who sought its loans to tide over financial crisis (India sought a bailout in 1990-91) and the Maastricht Treaty of 1992 brought those into the European Union.

Do the ‘magic’ numbers work?

For long, these two ‘magic’ fiscal numbers (60% and 3%) have been questioned. For instance, economist and one time advisor to the European Union Mariana Mazzucato traced the history and examined ground evidence to dismiss these numbers in her 2018 book ‘The Value of Everything: Making and Taking in the Global Economy’: “These numbers are taken out of thin air, supported by neither theory nor practice.”

Now the IMF is waking up too. Arminio Fraga, former president of Brazil’s central bank and one of the contributors to the magazine, calls those thresholds outdated (“The old fiscal rules have long been dead. We might as well design new ones.”) and that by 2019 (pre-pandemic), France’s debt ratio was already 98% and Italy’s 135%, which went up by 20 percentage points due to the additional pandemic borrowing.

What made it possible to take the debt-to-GDP ratio without creating a financial crisis? His answer is a dramatic fall in interest rates. He cites the case of Germany’s debt instrument Bund to prove his point. The Bund’s 10-year yields fell from more than 6% then (1992) to near zero now. The IMF’s Fiscal Monitor shows the average general government debt in advanced economies is 122% of GDP (much higher than 64% for emerging markets). While speaking about a rethink, Fraga points to three desirable features (provided in the IMF’s Fiscal Monitor) for a fiscal framework: “(1) sustainability of public finances; (2) stabilisation of the economy through counter-cyclical fiscal policy, when appropriate; and (3) for fiscal rules in particular, simplicity.”

Another economist Oliver Blanchard writes that debt becomes “unsafe” depending on the evolution of three variables: “primary budget balances (that is, spending net of interest payments minus revenues); the real interest rate (the nominal rate minus the rate of inflation); and the real rate of economic growth.” Therefore, determining an “unsafe” debt would have to be country and time specific, not by some numbers fixed by some rule. He reminds how the fiscal consolidation approach in the EU delayed its recovery from the global financial crisis (2007-09).

How any of it is relevant to India?

India’s fiscal austerity and accommodative interest regime

India too adopted fiscal consolidation, or fiscal austerity, during the pandemic crisis.

Several eminent economists like Amartya Sen, Abhijit Banerjee, Raghuram Rajan and others urged the Centre to keep such consideration aside and spend more (government expenditure was the only engine working then and now) because there was: (a) demand recession; (b) private investments had petered out; and (c) the pandemic disruptions caused widespread loss of jobs and businesses. India did raise fiscal spending but far less than the developed economies, and its GDP growth plunged far more to -7.3% in FY21 (now revised to -6.6%) when the average global growth was -3.1% and that of advanced economy -4.5% — as per the IMF’s World Economic Outlook of October 2021.

India’s debt-to-GDP ratio (Centre plus states) went up from 80.2% in FY20 (pre-pandemic) to 90.5% in FY21, as per the Economic Survey of 2021-22. Fiscal deficit (Centre plus states) went up from 9.2% in FY20 to 12.9% of the GDP in FY21. The past two budgets show the Centre’s approach towards fiscal management continues to be conservative.

Interest rate, as pointed by Fraga, has a big influence on the fiscal limits. At 4%, India’s headline interest rate is not anywhere near advanced economies.

The RBI has kept the repo rate accommodative and unchanged at 4% since May 2020. One of the key considerations is to keep the interest outgo low since most of Centre’s debt is from internal sources (about 94%) and its debt-to-GDP ratio was 59.3% in FY21.

Amidst rising inflation, the RBI was expected to raise the repo rate in February 2022 — the last time its Monetary Policy Committee (MPC) met. The consumer price inflation topped the RBI’s upper limit of 6% in January 2022. The Russia’s invasion of Ukraine has spiked the crude prices ($100 a barrel or more in the India basket) but until March 7, the last day of polling in the current round of state elections it is unlikely that the retail prices of petrol, diesel and cooking prices would rise. But once the retail prices are raised, inflation may touch or cross 7%.

The RBI’s MPC meets again in April and by that time it may be a tad late to raise the interest rate. It has, however, already caused concerns. Jayanth Verma, a member of the RBI’s Monetary Policy Committee (MPC) said the prolonged accommodative stance of the RBI “carries with it the risk of falling behind the curve.”

Need to rethink fiscal numbers and interest rate

The other significant reason for the RBI to keep the interest rate low is to maintain high liquidity in line with the Centre’s policy. The repo rate fixed in May 2020. In 2021, the RBI twice warned against continuing it any longer. Its Financial Stability Report (FSR) of January 11, 2021, said easy credit posed “macro-financial risks” to the economy as “unintended consequences” of the monetary and fiscal measures of the Centre to push recovery. It said if continued for a longer period, it would not only impair the economy but delay the recovery. Then in its February 2021 MPC policy statement, it warned again of the macro-financial risks, having declared India credit surplus.

Not just in India, the interest rate is likely to go up elsewhere too (due to the war and pre-war recovery pangs) but given the preference for low-interest regime worldwide, there may not be significant upward revision in the long run.

India also needs to revisit its fiscal limits (debt and deficit) to boost the recovery as other engines (private consumption, private investment and net exports) are not yet fully charged.

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