Fiscal Deficit, rising debt and bad ratings: Unjustified fears?

Three international rating agencies, Moody’s, Standard and Poor’s (S&P) and the Fitch Ratings have given the lowest sovereign credit ratings to India. They applied the standards of assessment applicable to normal times.

They are rising public debt, caused by widening fiscal deficits each quarter since the beginning of 2019, falling private sector investment, and delays over implementing structural reforms and, of course, an external sector with uncertain oil price impacting current account deficits and poor export performance.

While Fitch (‘BBB-‘) and Moody’s ( ‘Baa3’) ratings have an attached “negative” outlook, S&P rating (‘BBB-‘) has a stable outlook. The negative outlook is due to the perceived risks to the country’s growth and debt, which rating agencies fear would soon worsen.

The stable outlook of S&P is due to its expectation that the Indian economy and fiscal position would stabilise and start to recover from 2021 onwards.

Economy on the downward path since 2018

The Indian economy has already been on the downward path with the growth rate falling since the FY2018Q4. It fell from the 2017Q4 high of 8.7% to 5.6% in 2018Q4. The decline became steady in 2019 with growth rates 5.2% in Q2; 4.4% in Q3 and 4.1% in Q4. The FY 2020Q1 recorded the lowest at 3.1%, on the back of the lockdown imposed by the Covid-19 pandemic, resulting in a fall in production and exchange activities.

What began as a reduction in consumption demand consequent to loss of jobs and incomes, ended up finally in fall in supply as well. The latest forecast is that of June 18 from Asian Development Bank: The Indian economy will contract by 4% in FY21.

The challenges are also unprecedented as they involve saving lives, not simply jobs. Normal standards applied by rating agencies during normal times do not apply.

Deficits are imminent

Knowing the limitations of monetary policy, in April this year, the International Monetary Fund stressed the need for direct interventions. The IMF advised governments in developed and developing countries to ensure their “responses have to be swift, concerted, and commensurate with the severity of the health crisis, since the human cost of the pandemic has intensified at an alarming rate, and the impact on output and public finances is projected to be massive.”

The IMF’s initial provisional forecast for April was that the global public deficit would be up by 6.2 percentage points this year to reach 9.9% of national income, topping levels seen in 2008-09 following the financial crisis.

India’s response

The stimulus package of Rs 20 lakh crore was designed keeping in mind the available fiscal space was small. The fiscal deficit has been widening since 2019 as the tax revenue was decreasing, reflecting the declining economic growth and the need for stepping up public expenditure for stabilising the economy.

Fiscal deficit at 3.6% of GDP in FY2020 Q3 exceeded the target of 3% of GDP laid down by Fiscal Responsibility and Budget Management (FRBM) Act, 2003, and
the revised target of 3.8% in February 2020 as well. The FY2020 saw the fiscal deficit mounting to 5.3%, causing concerns about the rise in public debt.

Presently, the debt is estimated at 72% of GDP, which is feared to rise to 84%.
The package amounts to 10% of GDP. Concerned with the rising fiscal deficit, the government has kept the proposed free cash and food expenditure and cost components associated with collateral loans to a minimum.

Living with deficits and debt

We have to live with deficits; and so too with public debt. Deficits would be temporary. They have to be incurred to avert the permanent damage in terms of the morale of the nation as it involves loss of livelihood and provision of public health.

Debt servicing will be a future worry: There are several options now discussed widely which include financial repression, keeping low-interest rates, or inflation. They are all surrounded by controversies and bitter debates. Should they not wait?

Professor Carmen Reinhart of Harvard’s Kennedy School of Government, now appointed effective from June 15, as the World Bank’s Chief Economist and Vice-President for two years is well aware of how financial repression helped reduce and liquidate the massive stocks of debt accumulated during World War II.

Her IMF Working Paper of 2015 with Belen Sbrancia shows how deliberately kept low-interest rates by central banks reduced the average interest bill of 12 governments in the advanced countries by between 1% and 5% of gross domestic product from
1945 to 1980.

In May 2020, just before taking up the World Bank job, Professor Reinhart told the reporter when interviewed by the Harvard Gazette:

“First and foremost, when you are in a war, as we were in World War I and World War II, you worry about winning the war and then you worry how you’re going to pay down the debt.” She added, “I think that analogue applies here.”

(The writer is a Research Professor, Economics Department, University of Tunku Abdul Rahman, Malaysia and Honorary Adjunct Professor, Amrita School of Business, Bengaluru Campus.)