Fiscal dominance, growth and inflation

Because of fiscal dominance, growth itself may be necessary for monetary independence and price stability

The Union Budget for 2022-23 has provoked considerable commentary, on topics ranging wide and far. But surprisingly little attention has been paid to the actual state of the public finances. This is a pity, since the fiscal position is worrisome, with important implications for growth and inflation. Fiscal dominance — monetary policy influenced by the public finances — is back, with a vengeance.

The government expects the Centre’s deficit to amount to nearly 7 per cent of gross domestic product (GDP) in 2021-22, with the consolidated debt amounting to an elevated 85 per cent of GDP. In part, these levels are the inevitable result of the pandemic. But it is also true that India’s deficits have been high for quite some time. As we wrote with Olivier Blanchard, persistently high deficits have created a distinctive fragility for India: The Centre needs to devote an extraordinarily large share of its revenue to paying interest, a development noted by T N Ninan and Suyash Rai at Carnegie. The interest-revenue ratio is budgeted to reach 42.6 per cent next year, an extraordinarily high level compared to other major countries, advanced or emerging.

As the table shows, even before the pandemic, India’s interest/revenue ratio was an order of magnitude greater than that in many other countries. It is even greater than Brazil’s, which hitherto had been considered the exemplar of a fiscally vulnerable, large emerging market.

 Why does this ratio matter? At one level, the answer is obvious. If nearly half of revenues needs to be devoted to interest payments, very few resources are left over for spending on other needs. Put differently, to spend 12.5 per cent of GDP in the 2021-22 budget on investment, social sectors and defence, the central government had to run a deficit of 7 per cent of GDP, which will lead to even higher interest bills down the road, squeezing further the scope for non-interest spending. 

But the ratio matters in another sense too. What happens if the government needs to reduce its deficit to a more prudent ratio? Suppose the tightening of monetary policy in the US results in a global financing squeeze, forcing India to reduce its fiscal deficit to 4.5 per cent of GDP as the government has undertaken. Since interest payments cannot be reduced, non-interest expenditure will have to be cut.

Consider the arithmetic, compared to a better-placed country like Korea. If Korea needs to improve its fiscal balance by 2.5 per cent of GDP, non-interest spending would need to be reduced by 11 per cent (2.5 percentage points divided by non-interest spending of 22.3 percentage points). This would be a tall order. But it might be feasible.

Illustration: Binay Sinha

In contrast, in India the same reduction in deficit would require non-interest spending cuts of 20 per cent (2.5 percentage points divided by 12.7 percentage points), nearly double the reduction in Korea. This would be politically impossible and not desirable either.  

What is the way out? The chart gives some clues. It shows that India was actually in a more difficult situation in the early 2000s, when the interest/revenue ratio exceeded 50 per cent. That time, India managed to escape the squeeze because the economy boomed during the mid-2000s. Growth pushed up revenues and reduced deficits, the combination of which reduced the ratio by a stunning 22 percentage points to 31 per cent in 2007-08.

But India is unlikely to boom the way it did during the mid-2000s. For one thing, the global environment is simply not as favourable as it was back then. For another, India’s inward turn could render domestic industries uncompetitive, unable to take full advantage of the global opportunities that will remain. Is there, then, another way out?

Another look at the chart suggests a further possibility. After the Global Financial Crisis of 2008, growth slowed sharply and fiscal deficits expanded considerably, as the then-government tried to stimulate the economy. But the interest/revenue ratio did not rise because double-digit inflation pushed up revenue in nominal terms, counterbalancing the increase in interest payments.

Summing up: Reducing the burden of and vulnerability from high interest payments requires rapid growth, but engineering a boom will be difficult. Alternatively, the government could inflate its way out of the fiscal bind but it certainly does not want to do so. After all, the counterpart to the reduction in the real value of the government’s debts is a reduction in the private assets of ordinary people, including pensions, bank accounts, and life insurance assets.  

What, then, will it do? Most likely, it will have to muddle through, trimming the deficit gradually and hoping that no major shocks arrive in the meantime.  At the same time, it is likely to put pressure on monetary policy to keep interest rates low, so that its interest bill is contained and public sector banks and the Reserve Bank of India (RBI) do not suffer capital losses on their holdings of securities, which would reduce their profits and dividend transfers to the government.

There’s a technical term for this situation: Fiscal dominance, meaning that fiscal considerations limit the scope for an independent and prudent monetary policy. To be sure, the Centre will always want the RBI to keep interest rates low as former RBI deputy governor Viral Acharya argued cogently in his recent book. But fiscal dominance becomes particularly acute when budgetary interest payments become so high. And already there are unnerving hints. Over the past two weeks, the RBI cancelled the auctions of government securities, because banks were requiring interest rates the government considered too high.

For a long time, the received wisdom has been that reasonably low and stable inflation was the precondition for durable growth. That remains true. But now we have a situation where because of fiscal dominance, growth may well be necessary to secure monetary policy integrity. In other words, the trajectory of growth could shape the fate of inflation.

For the sake of the economy, India and the government need rapid growth. Ironically, the RBI may need it even more badly, to escape uncomfortable choices and preserve the reality — and appearance — of its independence and effectiveness.

The writers are, respectively, former chief economic advisor to the Government of India and  former IMF resident representative to India