Debt blues

Lower inflation has worrying implications for fisc, India Inc

It is one of economics' most basic laws that inflation benefits borrowers and hurts lenders. As the face value of debt declines thanks to inflation, borrowers find their debt easier to repay. There is an unfortunate corollary of this law that India's government, and its private sector, are slowly discovering. India's average wholesale price inflation in the four decades between 1970 and 2010 has hovered at 7.6 per cent and consumer price inflation in that period has been estimated at an average of over eight per cent. This has led to a certain complacency about borrowing. That is largely because even if the primary deficit (the excess of expenditure other than on interest over revenue) kept on adding to the face value of government debt, the debt-to-gross domestic product ratio continued to appear manageable. This is because the denominator, nominal gross domestic product (GDP), was constantly being inflated by six to eight per cent a year anyway.

But, in the recent GDP figures, something unusual happened: India's nominal GDP growth, at just over six per cent, was considerably lower than real GDP growth of 7.4 per cent. If this is not a passing phenomenon - and commodity price dynamics may sustain it for some time - then attention hitherto focused on India's fiscal deficit should also turn to the debt-to-GDP ratio. A path of fiscal consolidation premised on a comfortably growing denominator of nominal GDP may become more difficult if nominal GDP is instead growing less than expected. In other words, the government has been too sanguine about the positive impacts of fuel price decreases on its fiscal arithmetic. It has been considered a win-win - government revenues from taxes and the savings on subsidies have been boosted. This means the fiscal deficit target can be more easily met - as senior officials in the finance ministry have repeatedly insisted. However, the fiscal deficit target in a situation of lower nominal GDP growth is likely in general to become a little more tough. More importantly, the government's task of ensuring that its debt is kept at a sustainable level will become more challenging. As has been argued on these pages by Business Standard columnist Ajay Shah, a less inflationary environment means the debt dynamics have changed - and the government will have to make deeper cuts in spending. It cannot, after all, afford to cruise on the windfall from oil without making any structural changes to revenue or expenditure. The government has to become more prudent in its management of public finances.

It is not just the government that has to alter its expectations. Several Indian companies, including many infrastructure majors that are supposed to lay the groundwork for economic recovery, have a significant debt overhang. Cleaning up their balance sheets has been made much harder by the move to a lower-inflation environment. Earnings growth has long been moderate in the corporate sector, while interest costs will remain high. Over time, this mechanism will begin to bite, and make India Inc's efforts to gain financing even more difficult. For the government, this is a significant new threat to its attempt to get private investment moving again - an important component of returning to a high-growth trajectory.