Eco Survey 2020-21: Growth vs debt sustainability debate

Keynes is back with vengeance. Every time there is a depression, there is a demand for increasing public spending. Public spending boosts demand by increasing disposable income. Contrarians argue for fiscal discipline and rule-based governance. Rising budgetary deficit can add pressure on price, current account balance as well as exchange rate. It can create an inter-temporal imbalance by way of transferring the liability to the future generation. Increased deficit can also create macroeconomic instability with sudden outflow of capital as the investors become wary of the commitment. Credit rating downgrade, as a sword of Damocles, is a constant fear. India as well as several other countries are at this critical juncture and here goes the Economic Survey 2020-21.

Economic Survey 2020-21 is quite refreshing and Vol-I of the survey anchors key ideas that may shape the things to come. Fighting Covid-19, as well as measures to boost the economy, demands enormous government spending. Government revenue has fallen corresponding to the fall in economic activity. However, public expenditure is rising, and it would continue to rise further. Therefore, the key question before the government is—how much stimulus can it provide without getting into a debt trap? This question for centuries kept the lords and monarchs to the modern leaders confused—how much is too much for public borrowing?

Chapter 2 of the survey— “Does growth lead to debt sustainability? Yes, but not vice versa!”—tries to provide an answer to the above question. It is quite critical for the government to have a clarity on this point as there is no consensus on this issue.

The key argument of the chapter is based on a neoclassical view that if GDP growth rate (g) exceeds interest payment rate (r), there is less worry on the ground of debt sustainability. Denoting primary deficit to GDP ratio as Z and debt to GDP ratio as d, we can say the debt is sustainable, if the following conditions hold: z<=(g-r)d.

In simple words, if the right hand-side of the equation is higher than the primary deficit to GDP ratio, debt/GDP ratio would not spiral. Hence, the sustainability demands an upper bound on primary deficit (i.e., the government’s fresh borrowing to India’s GDP). This would be possible if the growth rate of GDP (g) is higher relative to r (interest payout rate). When the interest rate becomes higher than the GDP growth rate, the government should have primary surplus to make the debt sustainable. It is quite a difficult condition for the government to meet.

Let us get back to the argument given in the survey which advocates for an active fiscal policy to revive the economy from the slump. The survey argues that high growth rate that is witnessed in India makes debt sustainable. It hints that the interest rate that the government pays is historically low relative to the GDP growth rate and that is what keeps the debt to GDP ratio low. Citing Blanchard (2009), it says that the intertemporal budget constraint therefore does not hold. In simple terms, it does not adversely affect the destiny of our future generation under a burden of debt.

Like the previous round of the Economic Survey, it also highlights the importance of counterfactual or causal studies. The survey argues in the debate of ‘from growth to debt sustainability or vice-versa’, the direction is contextual or country specific. For example, in advanced countries, ‘potential growth’ is low unlike India where the potential remains high. It is empirically witnessed that growth causes debt to be sustainable in high growth countries while such directional conformity is not witnessed in low growth countries.

How do these learnings help?

The pessimism of the growth-debt sustainability debate should now settle down, as the survey argues, in favour of growth. Active fiscal policy can limit the potential damage to productive capacity. Fiscal multipliers would create a chain reaction that would start activating the dormant sectors/activities and enable economic factors to operate with their full potential. The survey argues as in the foreseeable future, interest rate is going to be lower than the growth rate, a fiscal policy (increased government spending or tax cuts) that provides impetus to growth would bring down debt to GDP ratio.

It would make the fiscal stronger and debt sustainable, without affecting the interest of the future generation. Empirically. the survey shows that till 2030, given India’s growth potential, debt sustainability would not be an issue. Hence, it asks for using fiscal policy as a policy instrument to revive the economy without being burdened by the worry of debt to GDP ratio.

What about India’s credit rating if the deficit rises? The Economic Survey has another chapter titled—“Does India’s Sovereign Credit Rating Reflect Its Fundamentals? No!”. While the survey lays an intellectual foundation for the government, how far would the government go is not necessarily always driven by economics.

Views are personal. Banerjee is Leader, Economic Advisory Services, PwC India; Pattanayak is Executive Director, Economic Advisory Services, PwC India.