The annual budget for fiscal year (FY) 2022-23 will be released tomorrow. This is the second “Covid budget” that finance minister Nirmala Sitharaman will announce.

Last year’s budget revealed a record economic contraction of 7.3 percent for FY 2020-21 and an annual deficit that jumped from 4.6 percent to 9.4 percent of the gross domestic product, or GDP. Economic activity picked up in 2021, with the economy expected to grow 9.2 percent for FY 2021-22.

But the economy is still precariously placed with the ongoing third wave of the pandemic and the threat of new variants looming large.

Covid has stressed government finances worldwide due to increased spending demands coupled with decreased revenues. As a result, countries have accumulated record debt since 2020. This has put renewed focus on sovereign debt and debt sustainability, especially on emerging markets such as India. Fiscal debt and deficit are expected to be a major talking point of this year’s union budget, and possibly the next few annual budgets.

This article takes a closer look at India’s public debt in recent years, and the evolving narrative over sovereign debt in economist and policy circles.

Too much debt is a bad thing – and that applies to national debt too. It doesn’t take an economist to grasp this intuitive fact. At the same time, borrowing enables countries to finance initiatives that spur growth and provide important services to its citizens. So debt, within a certain limit, can actually be a net positive for a country and be a catalyst for development. But above this hypothetical limit, debt can become a burden which drags down the economy where servicing past debt encroaches upon the ability to fund new initiatives.

But how much is too much? Intuitively, we know that there must be an upper bound to borrowing, beyond which the debt becomes unsustainable. Absent such a constraint, a finance minister would be able to satisfy budgetary outlay requests from each ministry. But how does one quantify this upper bound of sustainable debt?

Before we attempt to answer this all-important question, it’s useful to clarify some economic jargon. Economists quantify sovereign debt using two commonly used-metrics: debt-to-GDP ratio and fiscal deficit.

The debt-to-GDP ratio is the total government debt (central and state) expressed as a fraction of the national GDP.

The fiscal deficit is the annual difference between the union government’s total expenditure and total revenue. The government’s annual expenditure can be further divided into capital expenditure and revenue expenditure. Another important deficit that is tracked in government accounts is the primary deficit (or surplus). The primary deficit is computed by subtracting the amount spent to service past debt. By excluding debt service, the primary deficit reveals if the government brings in enough revenue to cover the costs of the goods and services it provides, on an annual basis.

So, let’s see how these metrics have trended in recent years.

Figure 1 charts the annual fiscal deficit over the last decade.

The chart above shows that in the early years of the NDA-I, the fiscal deficit was brought down to 3.5 percent of the GDP by 2016-17, and stayed almost steady for three years. In 2019, the deficit spiked from 3.4 percent to 4.6 percent, as the economic growth slowed, reducing tax revenues.

Then Covid struck in 2020, which was a major blow to an already weakening economy. The GDP tanked, tax revenues shrank, and spending could not be cut back given the crisis at hand. As a result, the annual deficit ballooned to 9.4 percent of the GDP.

Economic activity has picked up from the rock bottom it hit in 2020. Based on early revenue estimates for FY 2021-22, the deficit is expected to come down to 6.5 percent.

Now, let’s look at the other debt metric mentioned earlier, debt-to-GDP ratio. Figure 2 charts the government debt-to-GDP ratio over the last decade.

Note that the computation for total debt at end of FY 2021-22 is a prorated extrapolation from the figures for September 2021.

The most striking feature of this chart is that total government debt was steady at around 70 percent of the GDP from 2011-12 to 2018-19, before a sudden jump to 90 percent in 2020-21. In 2015-16, the distribution of this total debt between central and state government debt changed a little as the central debt went down by 1-2 percent, and the state debt increased by that same amount.

In 2019-20, the total debt inched up to 72 percent of the GDP and then the pandemic struck. As we saw in Figure 1, in FY 2020-21 the GDP fell while the fiscal deficit jumped to 9.4 percent. This was a double assault on the debt-to-GDP figure, as the numerator increased more than it typically did each year, and the denominator reduced. As a result, the ratio soared to 90 percent. Even with the improved revenue expectation for FY 21-22 and the expected 9.2 percent growth in GDP, the debt ratio will only come down to around 88 percent.

So, what do these charts convey? And is the steep rise in government debt over the last two years a cause for concern?

There are two recent government reports that provide some contesting insights and answers.

In 2016, a committee of economic experts headed by NK Singh was formed to recommend changes to the Fiscal Responsible and Budget Management Act with an eye towards fiscal prudence. To understand the evolving consensus on public debt in India, it is useful to trace the arc of the FRBM Act.

The act was first passed in August 2003, in response to growing debt in the late 1990s when the annual fiscal deficit rose to over 10 percent of the GDP. There was a growing realization among economists and policymakers that a formal roadmap with legal backing was needed to force fiscal discipline. The FRBM Act set targets to reduce annual deficits in a phased manner, with a goal of bringing down the annual fiscal deficit to three percent of the GDP by March 2009.

After the enactment of the FRBM Act, there was a clear improvement in the fiscal position of the government. In fact, the central government deficit declined to 2.5 percent of the GDP in 2008-09 a year in advance from when the three percent deficit target was to be achieved. The debt-to-GDP ratio also declined during this period from 83 percent in 2002-02 to 71 percent in FY 2007-08.

Then the global financial crisis hit in 2008, and fiscal targets had to be put on hold as the government had to inject stimulus to counter the crisis. Even after the financial crisis passed, fiscal consolidation was not a top priority and the FRBM was amended in 2012 and 2015 to dilute the fiscal constraints set by the act.

In this context, the FRBM review committee of 2016 was formed, which submitted its report in January, 2017. Many of its core recommendations are pertinent to our discussion. An extended excerpt from this report is instructive to understand their view on the primacy of managing public debt as a policy objective. Chapter 1 of the report states:

“The Committee believes that a transparent and predictable policy framework is one that is rule-based. Central to a credible framework is the concept of an anchor. An anchor ties down the final goal of policy, and the expectations of economic agents adjust accordingly. By acting as a constraint on policy discretion, an anchor dis-incentivizes time inconsistency, including due to pressures from interest groups. There are four key economic arguments that form the basis for moving to debt. First, the standard government solvency constraint suggests debt to be the ultimate objective of fiscal policy. Second, there was broad consensus that a debt ceiling combined with fiscal deficit as an operational target can jointly provide a robust fiscal framework for India. Third, India, with a public debt close to 70% of GDP, currently stands out as among the most indebted countries amongst the relevant peer group of emerging markets. Finally, public debt exemplifies an important factor in the assessments of rating agencies. In addition to these economic arguments, a non-economic, albeit powerful and convincing rationale for moving to debt as the anchor put forth by several members of the committee, and considered to be particularly relevant in the Indian ethos, was that 'debt' and 'debt repayments' are concepts that can be communicated easily to the public, and are also embedded in the psyche of the ordinary citizen.”

To paraphrase, the committee strongly advocated targeting a certain debt-to-GDP ratio as a policy objective. It argued that the benefits of having such a rule-based constraint far outweighed the drawbacks. The committee also laid out a roadmap to reduce total debt (central and state governments) from 70 percent of the GDP in 2017 to around 60 percent of the GDP in 2023, with central government debt coming down to roughly 40 percent and the state governments’ debt staying at roughly 20 percent of the GDP.

The year-by-year targets set by the committee are given below in Table 1.

Of course, as we know from Figures 1 and 2, these numbers have not been met. The deviations from the benchmarks set here were small till 2020, but have diverged dramatically over the last two years. To be fair, the FRBM committee also recognised the need to forego the fiscal constraints during periods of economic shocks and crisis. And Covid is the mother of all crises. So, the fact that the finance minister has been unable to stick to the FRBM roadmap is both understandable and expected.

But how Sitharaman navigates the path back to lower deficits and debts will be closely watched. If one is to use the FRBM committee report as the guiding light, the focus would be to quickly glide back to a pre-Covid fiscal deficit (within a couple of budgets) of around 3.5 percent of the GDP with a focus on lowering the debt-to-GDP ratio.

There is also another government document that offers a different take on the fiscal path to follow. The Economic Survey of 2020-21 makes a case for relaxing strict debt and deficit targets to allow the government some fiscal space to increase spending, even if that means higher levels of debt.

In its own words , “While acknowledging the counterargument from critics that governments may have a natural proclivity to spend, the Survey endeavours to provide the intellectual anchor for the government to be more relaxed about debt and fiscal spending during a growth slowdown or an economic crisis. The Survey’s call for more active, counter-cyclical fiscal policy is not a call for fiscal irresponsibility. It is a call to break the intellectual anchoring that has created an asymmetric bias against fiscal policy”.

Building upon the theory proposed by French economist Oliver Blanchard in his 2019 presidential address to the American Economic Association, the Economic Survey’s argument hinges on the relatively low cost of borrowing. According to Blanchard, as long as the economic growth rate is higher than the interest paid on government debt, there is no risk of debt explosion. This measure – the interest rate-growth differential,or IRGD – really determines the leeway a country has in incurring debt as well as the ease with which it can reduce its debt-to-GDP ratio.

Without getting into the mathematics of debt dynamics, the effect of IRGD can be understood with this basic illustration from the Economic Survey.

The figure above assumes a nominal GDP growth of 12.8 percent, and an interest rate (for government loans) of 8.8 percent – historical averages for the last 25 years. The IRGD is thus negative (8.8 - 12.8), which allows the government to either spend Rs 4 extra, if it wants to keep the debt-to-GDP ratio unchanged, or use the extra Rs 4 to pay down past debt.

Even with this simple example, the key takeaway is that a government can run a primary deficit (difference between government revenue and government spending, minus interest payments) each year while still keeping the debt-to-GDP ratio steady, as long as the negative IRGD condition holds. The more negative the IRGD, the easier (and quicker) it is for the government to ensure debt sustainability. Conversely, if the IRGD is positive, the harder (and slower) it is for the government to ensure debt sustainability. A negative IRGD thus creates an enabling environment for debt sustainability

The Economic Survey points out that in India’s case, this IRGD has almost always been negative since 1996. This is shown in Figure 4 below.

Note that the data shown in Figure 4 is only upto 2019. In FY 2020-21, IRGD did become positive, since growth dipped below zero, but this was likely an aberration given the unexpected and extreme shock of the pandemic. For FY 2021-22, nominal GDP is expected to be over 17 percent – almost 10 percent points over the interest rate, and the negative IRGD scenario is restored.

It should be pointed out that the FRBM review committee report of 2017 did not ignore the IRGD environment prevailing in India and its effect on debt dynamics. But it was of the opinion that relying on the negative IRGD climate to prevail over the medium and long term was not prudent.

So, how does one reconcile the apparently conflicting guidance by these two reports, both compiled by economic experts?

It seems the sensible thing to do is to take the fiscally conservative approach advocated by the FRBM review committee during “normal” times. Of course, the debt-to-GDP targets prescribed in that report are unattainable now, but the benefits and methods of gliding towards lower debt levels still hold. At the same time, the Economic Survey of 2020-21 makes a compelling case that relaxing stringent debt targets during the time of a crisis is not financially reckless. In fact, it might be the right thing to do, to revive growth in a stagnating economy provided additional debt is used to finance the right policies.

Given these two playbooks, the job of a policy maker is to recognise the conditions they are operating in to employ the right set of tools. And then to transition smoothly from policies that work during a crisis to policies that are better suited for the “normal”.

This year’s budget will reveal whether the finance minister has the finesse to strike this tricky balance.