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Why fiscal deficits spell crises 

ARVIND PANAGARIYA

The combined fiscal deficit of the centre and the states in India has been running at around 10% of the GDP since 1999. India has also accumulated a large public debt that stands between 80 and 85% of the GDP currently. These facts have led many to suggest that India may be heading towards another macroeconomic crisis.

Fiscal deficit is said to exist when the total expenditures of the government exceed its total revenues. Just like the households living beyond their means, the government must borrow to bridge the gap between its expenditures and revenues. The borrowing adds to the debt. If the borrowing is from domestic sources, it contributes to the 'internal' debt and if it is from foreign sources, it increases the 'external' debt.

The debt-to-GDP ratio is a key indicator of the government's solvency. If this ratio is excessively high, lenders conclude the government lacks the means to repay the debt. For example, the future tax liability or expenditure cuts necessary to generate surpluses, large enough to retire the debt, may be too large to be economically feasible or politically acceptable. So as the debt rises, other things being the same, lenders become reluctant to lend more, demand ever-increasing interest rates and at some point refuse to lend altogether. When that happens, a crisis is at hand, as happened to India in June 1991.

A high rate of growth of the GDP can arrest the growth in the debt-to-GDP ratio. But this has its limits: if the interest rate is itself high and the deficit excluding the interest payments (the so-called primary deficit) is also large, the debt-to-GDP ratio will keep climbing up, as has been the case in recent years. Therefore, the attitude of complacency taken by many recently due to a slight edging up of the growth rate, which may prove temporary anyway, is dangerous.

The key question is how high a debt-to-GDP ratio is too high. Unfortunately, since the debt-to-GDP ratio is only one (albeit important) indicator of the government's ability to service the debt, we cannot point to a single magic number. And depending on how one weighs the other indicators, judgements on the likelihood of a crisis differ. To explain, it is best to consider the internal and external debts separately.

If the debt is primarily external, absent free international capital mobility as in India currently, the export performance, management of the real exchange rate, availability of foreign exchange reserves and the maturity structure of the debt make the greatest difference to the likelihood of a crisis. A large and rapidly growing export base means that the foreign exchange required to service the debt will be forthcoming. If the domestic currency is not allowed to become overvalued in real terms, the risk of exports becoming uncompetitive in the future is low. If the country has substantial foreign exchange reserves in relation to its short-term debt, lenders can expect to be paid back in the near term. Finally, if the debt is primarily long term, the risk of capital flight is minimal.

Immediately prior to the June 1991 crisis, a large proportion of India's debt was of foreign origin and many of these conditions were absent. In particular, the foreign exchange reserves were low, interest payments abroad in relation to the export earnings were high and the short-term debt as a proportion of foreign exchange reserves was also high. Currently, India is on relatively firm ground along all these dimensions so that the risk of an external payments crisis is low despite the high overall debt-to-GDP ratio.

The story is different when the government finances deficits mainly through borrowing domestically as is the case currently. The government typically sells securities that promise a fixed interest in return for cash. In India, banks and other financial institutions buy the bulk of these securities using the deposits they receive from the public. The banks and financial institutions make a profit and remain solvent as long as the interest they receive on the government securities is higher than the return they pay the public.

But as the debt-to-GDP ratio grows, the confidence in the ability of the government to pay the promised interest on its securities and to retire the existing debt through ever-increasing deficits declines. That leads the banks to opt against investing in government securities, which may eventually force a default by the government. An alternative for the government is to force the banks and financial institutions to hold its securities even if they would prefer not to do so. But that will undermine the confidence of the public in the solvency of the banks themselves. It will realise that the assets, meaning the government securities, held by the banks are worth much less than their face value due to the possibility of a future default by the government. In turn the public would choose to withdraw its deposits and force a banking crisis.

Of course, fears of a future default and the economic downturn in the economy that follows such default may lead to the downgrading of the sovereign ratings and an exit of the foreign investors. The latter may happen through panic sales of stocks and companies owned by the foreign investors. Then, as these investors try to take their money out of the country, the rupee may fall precipitously, making the crisis explicit.

At present, the chances of these scenarios playing out are slim. Public confidence in the banks is strong and the government has gone out of its way to avoid bank failures (though this is a mixed blessing since it makes the banks irresponsible). The scope for the exit of the foreign capital is also limited since the more stocks and companies are sold, the lower the prices they fetch. But this comfort is only temporary: markets can come to punish complacency with surprising speed.

Economic Times WEDNESDAY, MAY 18, 2005

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