India’s sovereign debt has reached unprecedented levels in 2020, partly due to the policy response to Covid-19, but also due to weak growth and high interest rates.
Some have argued that high debt levels may be less of a concern in a low interest rate environment. But there is also a significant body of evidence that points to several mechanisms through which high levels of sovereign debt can have negative effects on the economy.
In this context, we document stylized facts about the recent evolution of sovereign debt and public deficits in India and ask the following questions: what are the costs of a high level of indebtedness in India? Are there silver linings? What awaits us?
We analyze macroeconomic performance during and after periods of debt “push”, “stabilization” and “reduction” in India and other countries and ask whether past experiences of hikes and cuts shed light on the different policy options and trade-offs for India during the post-pandemic recovery period.
India’s Covid-induced debt spike was unique compared to its own history, but also larger than that of the average emerging market economy. The drivers of the debt spike were also different.
Fiscal expansion and growth slump played a proportionately larger role in India relative to the average emerging market, although higher inflation played a larger role in India’s debt reduction.
Despite the high level of sovereign debt, there are some upsides for India. The share of sovereign debt held by foreigners – an important predictor of crises in the literature – is low.
Moreover, although global waves of over-indebtedness have been followed by restructurings or defaults, India has not experienced such an episode so far. Moreover, real long-term rates remain low in India, comparable to the emerging market median. That said, we find substantial heterogeneity across countries. While India was closer to the 25th percentile over the past decade, it has now caught up to the median.
We document the substantial costs of high debt. One of the main ones is the lack of resources due to surprisingly high interest payments, which at almost 30% of overall revenues during Covid-19 are almost three times higher for India than the emerging market. typical.
High spending on interest payments reduces the resources available for countercyclical fiscal policies in the event of negative shocks such as Covid-19, as well as for social spending in critical areas such as health and education, where spending India’s public sector remains significantly lower than that of its peers.
Indeed, our analysis suggests that fluctuations in the business cycle explain a smaller fraction of the variation in debt in India relative to its peers, reaffirming the limits of countercyclical fiscal policy due to high debt levels.
Simple math suggests that cutting India’s income interest payments to the emerging market average by 10% would free up resources of nearly 6-8 trillion rupees, a figure comparable to government education spending. India’s general pre-Covid, and about three times its health spending. .
Another cost of high public debt in India is its impact on borrowing costs. Although real rates in India are low and in line with the emerging market median, we find that they have increased over time and that the elasticity of borrowing costs to a unit increase in debt is higher for India. India than for the typical emerging market.
For example, on average, an increase in debt to gross domestic product of 1 percentage point, or pp, increases long-term borrowing costs by 0.19 pp in India, whereas for a median emerging market , it only increases by 0.01 pp.
Finally, public debt also illustrates an important factor in ratings agency assessments, where India’s debt and deficits stand out as significantly higher than similarly rated peers.
In order to understand where to go from here, we look at India’s own history and also draw on experiences across the country. Since 1913, India has experienced nine episodes of debt overhang, five episodes of reduction and six episodes of debt stabilization.
Surges generally ended in stabilizations in India, whereas in an average emerging market, 75% of surges ended in reductions. In other words, India has been able to maintain debt at high levels without default or restructuring. During the downsizing episodes, India reduced its leverage ratios by 2 percentage points per year, compared to more than double the figure for the average emerging market.
We also find that episodes of debt booms are associated with poorer macroeconomic outcomes (low economic growth and public investment) compared to debt reduction episodes. Moreover, international data suggests that the greater the magnitude of the debt surge and the longer the episode lasts, the greater the associated reduction in growth around the surge.
What debt could India reduce? One way to approach this question is to look at interest payments and additional fiscal resources that could be generated by lower sovereign borrowing. For example, lowering interest payments to 22% – still much higher than the 10% emerging market average – would require reducing the debt-to-equity ratio to 70%, bringing it closer to the median for peers with a similar notation.
What is a possible path and how long would it take to get there? The higher the growth rate and the lower the borrowing costs, the lower the need for fiscal adjustment.
Simulation exercises suggest that if we assume constant values for the real GDP growth rate at 7% and the real rate at 2%, in line with the International Monetary Fund’s World Economic Outlook assumptions, a government deficit primary and fiscal below 1.7% and 5.9% of GDP, respectively, would be needed each year to reduce debt ratios to 70% over the next 10 years (and interest payments to 22% of income).
This would require a significant adjustment from the fiscal year 2022-23 primary and fiscal deficit, projected at 4.5% and 9.9%, respectively, according to the World Economic Outlook.
It is important to note that the higher the growth rate and the lower the interest rate, the smaller the adjustment required. For example, a growth rate of 9% or a real rate of 0% would open up more space with a primary deficit of over 3% of GDP instead of 1.7%, still ensuring the same debt reduction.
While the above calculations assume constant primary and fiscal deficits, allowing for some transition dynamics and smoothing the adjustment path, we present in Figure 5 illustrative debt and fiscal consolidation scenarios for the India over the next five years.
Indeed, evidence in emerging economies suggests that consolidations of the primary balance outside of recessions could, in fact, be successful in reducing debt and do not tend to be detrimental to growth, as the multiplier effects roughly offset the positive impulse from other channels such as higher confidence. .
Prachi Mishra is Chief of the Systemic Issues Division in the Research Department of the International Monetary Fund, Washington DC. Nikhil Patel is an economist at the International Monetary Fund, Washington DC.
The article was first published on India in transitiona publication of the Center for the Advanced Study of India, University of Pennsylvania.