The reality of India’s Debt
A month ago?—?during the Union Budget?—?economics nerds were all talking about something called ‘fiscal deficit’.
What’s that, you ask?
It’s simple really?—?if the government spends more money on infrastructure or welfare schemes than what it earns from taxes and other income sources, it creates a deficit. So the government has to resort to borrowing money in order to bridge this gap. And that is called the fiscal deficit.
Now, you don’t need to have taken Economics 101 in college to know that borrowing a lot of money isn’t a good thing. You have to pay interest on it. And if there’s a dip in your income, it can be quite catastrophic?—?you’ll struggle to make interest payments and at worst, you could even end up defaulting.
The government can suffer the same fate if it borrows excessively too. So everyone keeps their fingers crossed hoping that the government manages its finances prudently and avoids running a high fiscal deficit.
Now defining what constitutes a ‘high’ deficit is quite subjective. There’s no magic number. Let’s just say it’s best to keep it as low as possible.
So, let’s revisit something from the Union Budget and talk numbers, shall we?
If you parse through the Budget documents, you’ll see the number 4.8% stand out. This means that our economy’s fiscal deficit is worth 4.8% of the overall GDP for FY25.
And this made the econ nerds happy because this deficit was close to 7% during Covid and the government promised to bring it down. And since they seem to have done exactly that, everyone was pleased at the outcome.
But wait, there’s a twist in the tale.
This number does not include the deficits of the 28 state governments!!!
Yup, states have their own bills to pay. And they can issue bonds and raise money to fund their needs. If you tack that on, the overall fiscal deficit or the ‘general government deficit’ actually rises to 7.3% for this financial year.
When we saw that number, we had to dig into a recent RBI report on the finances of state governments in India just to check whether this was a worrying sign or not. And the results were quite…interesting.
Now there are 2 key bits we want to highlight here:
While the Centre has consistently reduced its fiscal deficit number every year, the same can’t be said about States. Overall, the combined state fiscal deficit has inched upwards from 2.8% of GDP to 3.2% of GDP this year.
So while it is a slow burn, the rise in their deficit is something to keep an eye out for.
2. The overall debt levels of the States are significantly higher than the prescribed limits.
While the Fiscal Responsibility and Budget Management (FRBM) Review Committee says that it should be kept below 20% of their GDP, States have reported debt levels of 28.5% of GDP as of March 2024. In fact, Punjab and Himachal Pradesh are already above 45%.
And this is an important metric to track because India wants to do away with fiscal deficit tracking in the 2030s. Instead it wants to focus on the total debt to GDP ratio.
Now if you’re wondering why that’s important, the short answer is that while the fiscal deficit just measures the yearly difference between expenses and revenues, the total debt captures the cumulative effect of fiscal decisions taken over time. So it adds up how much debt is on the books over years and decades. It’s more holistic.
And these high levels of debt and fiscal deficit aren’t a good thing for the Centre.
Why?
Okay. So imagine you want to teach your child some financial discipline. You take out an add-on credit card from your bank and hand it over to him. You tell him that he’s in charge of repaying his dues.
But in the back of your mind, you know that any recklessness on his part can affect your credit score. If he swipes the card to the maximum extent of the credit limit often and even delays payment, it drags your score down.
It’s the same concept here. Credit rating agencies such as Moody’s and Fitch look at the overall figure when they assign a rating to a country. So even if the Centre exercises restraint, excess borrowing by the States hurts the country’s credit rating.
And the thing is, these ratings actually decide at what rate the central government of India gets to borrow from foreign investors?—?lower the rating, higher the interest demand.
So you can see why the Centre has to often remind States to be fiscally responsible.
But the problems don’t end there with just excess borrowing. It also involves how the money is being spent.
And let’s go back to the credit card example to understand this. Now sure you can set a limit on the card in order to prevent your child from runaway spending. But you can’t really control what your child can spend on?—?they might buy books to make themselves smarter about the world or they might splurge on the latest fashion that’ll find its way into the back of a cupboard within 3 months.
Arguably, books serve us better in the long run, no?
In much the same way, the Centre cannot lay down the gauntlet and tell states what they can and cannot spend on. So States have been quite frivolous with their spending habits?—?populist measures such as farm loan waivers, free electricity, and cash transfers have dominated expenses especially in the lead up to elections. In fact, as per an analysis by Mint, “Most states that went to polls in 2023 or 2024 saw their fiscal deficit as a share of the gross state domestic product (GSDP) rise compared to the previous non-election year…”
Sure, a country like ours needs welfare-related support from local governments, but if it crowds out spending on developmental or infrastructural spending, then it becomes a problem.
So, the only question is?—?How can we fix this?
Well, if you look into the Budget docs, you’ll see that the Centre wants States to know that reckless spending isn’t the way to go.
It said, “You know what, we want you to spend money on building infra and not just freebies to win votes. So not only are we giving you a bigger grant from our pockets for capex, but we want you to take a 50-year interest free loan worth ?1.5 lakh crore. But to get this, all you have to do is prove you’re improving housing, reforming urban planning, or even setting up digital libraries in panchayats.”
So it’s a ‘cash for development’ push.
But, is that strict enough to get states to change their bad habits?
Maybe not.
Because if you ask Barry Eichengreen of the University of California, Berkeley, and Poonam Gupta of the National Council of Applied Economic Research (NCAER), they’ll tell you that the Indian government should be resorting to sticks and not carrots to get States to fall in line.
In a paper published last week, they highlighted quite a few things for the Centre to consider, and we’re going to list down 2 of the more radical ones.
Firstly, they think the RBI should stop babying the States.
See, the central bank is basically the money manager for States and the Centre. So when States want to issue bonds and borrow money, the RBI is involved. But the RBI also actively ensures that there’s not much variation in the rate of interest that States have to pay. That means, a state that is prudent with money ends up paying almost the same interest rate as one that’s fiscally profligate.
That doesn’t seem fair, no?
So Eichengreen and Gupta say that the RBI should back off and let markets do their own thing because, “without market discipline, there can be no fiscal discipline.”
Secondly, they’re calling for a fiscal “grand bargain”.
What that means is that the Centre takes over a portion of the debt of the States that have racked up too much of it. And by doing so, it gives more breathing space to the States that won’t have large interest payments to deal with anymore. But in return, the States give up some of their autonomy when it comes to managing money in the future and fiscal decisions are handed over to the Centre.
We told you it’s radical, didn’t we? And the authors say it has worked out for Brazil quite well.
So yeah, with State debt in India projected to rise even further over the next decade, maybe the Centre will eventually have to resort to such radical measures to ensure that things don’t become fiscally unsustainable for India.
What do you think?