Coronavirus – Economic Issues

Where the “fiscal space” debate should focus?


From UPSC perspective, the following things are important :

Prelims level: Primary deficit, AQR

Mains level: Paper 3- Factors to be considered while deciding the size of stimulus package.

The article focuses on the “fiscal space” debate in India. So, what is this debate? This debate is focuses upon the size of the fiscal deficit this year in India, ways that could be used to finance it and upper limit of this deficit etc. But the author argues that we should focus on debt/GDP trajectory in the subsequent years. Besides this, he suggests what our policy intervention comprise.

Monetary policy and fiscal policy: Efficacy Vs. Space debate

  • In response to the economic disruption caused by Covid-19, monetary policy has moved swiftly and aggressively in many economies.
  • But questions remain on its incremental efficacy.
  • With a high level of uncertainty around, risk-averseness is evident in the financial systems.
  • This risk-averse tendency reduces the efficacy of lower rates and higher liquidity.
  • So, while monetary policy may have space, how much efficacy will it have?
  • Fiscal policy i.e. spending by the governments can have much efficacy.
  • But how much space does it have? Therein lies the debate.

Focus on Debt/GDP trajectory, not on level

  • The “fiscal space” debate in India has centred exclusively on this year’s deficit and how it will be financed.
  •  But a more holistic assessment of fiscal space should focus on two factors 1) the government’s inter-temporal budget constraint 2)  how India’s debt/GDP evolves in the coming years.
  • These two are the factors that rating agencies and foreign investors will eventually focus on.
  • Following are the question that debate should focus on.
  • How much will India’s debt/GDP jump up this year?
  • More importantly, what happens thereafter?
  • Will debt/GDP keep rising year after year? Or will it start declining?
  • As research has found, it’s typically the trajectory of debt/GDPmore than the level — that impacts future growth.

Evolution of debt

  • The evolution of debt is essentially a function of three variables:
  • 1) The primary deficit.
  • 2) Nominal GDP growth
  • 3) The government’s cost of borrowing.
  • The higher is the difference between growth and cost of borrowing, the greater is the depreciation of the existing debt stock.
  • High growth allows countries to “grow out” of their debts.
  • In contrast, high primary deficits worsen the debt burden.

Where does India stand?

  • India comes into COVID-19 with a debt/GDP of about 70 per cent.
  • A primary deficit across the Centre and states of about 2.5 per cent of GDP including the Centre’s extra-budgetary resources. — based on the Revised Estimates for 2019-20.
  • A weighted average sovereign borrowing cost of about 7.5 per cent (on the stock of debt) and an estimated pre-COVID nominal GDP growth of 7.5 per cent in 2019-20.
  • In other words, the favourable gap between growth and borrowing costs had closed.
  • With this backdrop, one can simulate what happens to debt/GDP in the coming years under different growth, fiscal and interest-rate scenarios.
  • What do we find?
  • Even under relatively benign scenarios –nominal GDP growth of 4 per cent and a fiscal expansion of 3 per cent of GDP this year- India’s debt/GDP will balloon towards 80 per cent by the end of the year.
  • But India will not be alone. Public debt is expected to balloon all over the world.
  • Instead, what will matter for sustainability is the trajectory of debt thereafter.
  • Does debt/GDP come down or keep going up in subsequent years?

 Fiscal space depends on potential growth in coming years

  • The subsequent trajectory of Debt/GDP depends overwhelmingly on medium-term growth.
  • Consider the following two scenarios and refer to the figure given below-
  • 1. Fiscal Deficit 6%
  • Consider that this year’s combined fiscal deficit widens by 6 per cent of GDP.
  • But the primary deficit is then consolidated back to 2 per cent of GDP in the next 3 years.
  • And as long as nominal GDP is 10 per cent in the medium term which corresponds to real GDP growth of 7 per cent.
  • Debt/GDP gets on to a constantly declining path after the third year.
  • This suggests a bigger fiscal intervention is sustainable but only if medium-term growth prospects are lifted in tandem.
  • 2. Fiscal Deficit 3%
  • Consider that this year’s deficit widens by “just” 3 per cent of GDP.
  •  But medium-term nominal GDP growth settles at 8 per cent that is, real GDP growth of 5 per cent.
  • Debt/GDP rises relentlessly for the next decade towards 90 per cent of GDP.

Key takeaway: focus on medium-term growth

  • This suggests even a relatively-conservative fiscal response this year becomes unsustainable if medium-term growth prospects are diminished.
  • Small changes in medium-term growth have large implications for fiscal sustainability.
  •  How much fiscal space India has to respond in the crisis year will depend crucially on what potential growth is likely to be in the coming years.
  • The more that India’s policy response can preserve, protect and boost medium-term growth — both through the nature of the policy intervention this year and the accompanying reforms — the larger the fiscal response India can mount.
  • Put more starkly, the fiscal debate between “need” and “affordability” is endogenous.
  • The medium-term sustainability of any fiscal package this year will depend on the nature of growth-enhancing interventions and reforms that accompany it.

So, what could the interventions comprise?

1. Keep small business afloat

  • Policy must ensure that all viable enterprises can survive the pandemic.
  • If economically-viable but illiquid small and medium enterprises go under, the implications both for unemployment and India’s underlying production capacity could be severe.
  • The government’s credit-guarantee scheme is, therefore, very important and should hopefully induce banks to provide much-need working capital to keep small businesses afloat.

2. Reforms in the finance sector

  • It is important to jump-start a risk-averse financial sector into funding an economic recovery, more broadly.
  • Last week’s bond market interventions which involved special liquidity and partial guarantee funds are important to ease conditions at the financial periphery.
  • Over time, however, liquidity must give way to capital and reform.
  • Following steps will be crucial to strengthening the financial sector-
  • 1)Pre-emptively recapitalising public sector banks for growth and resolution capital.
  • 2) Conducting an AQR for the NBFC sector after pandemic.
  • 3) Then converting well-run NBFCs into banks to avail of a stable deposit franchise.
  • 4) Modifying the incentives under which public sector banks operate.
  • Higher potential growth is only feasible if the financial sector is able to fund it.

3. Reforms in the other sectors

  • Real reforms must accompany those in the financial sector.
  • The government’s announcement on unshackling agriculture — if carried through to its logical conclusion — is potentially game-changing for farmers and will be a landmark reform for the sector.
  • As COVID-19 hastens the reorganisation of supply-chains within Asia, India must seize the moment to integrate into the Asian supply chain.
  • Revisit a Special Export Zone (SEZ) model with the appropriate regulatory environment to avoid the pitfalls of the past.
  • Path dependence will be key. If the first one or two SEZs succeed, it would create a powerful demonstration effect both externally to help attract more firms into India.
  • And internally inducing different states to compete to create their own SEZs to drive jobs and investment.

4. Social infrastructure and ways to pay for it

  • If the virus has taught the world anything, it’s the criticality of social infrastructure.
  • India will not be able to fundamentally alter its growth potential without crucial investments in health and education.
  • The government’s announcement to boost health spending is, therefore, very welcome.
  • But how will this be paid for? This is where policy must get creative.
  • Existing assets on the public sector balance sheet must be aggressively monetised to fund growth-enhancing investments in physical and social infrastructure.
  • This will simultaneously take the pressure off the fiscal and financial sectors, and deliver a productivity-enhancing swap on the public sector balance sheet.

The article is helpful to consolidate the basic understanding of the macroeconomic parameters of economy. Consider the question asked by UPSC last year “Do you agree with the view that steady GDP growth and low inflation have left the Indian economy in good shape? Give reasons in support of your arguments”


Higher potential growth is the antidote to many pressures, from incomes to jobs to debt sustainability. To the extent this unprecedented crisis creates political space and capital to reform, the opportunity must be seized.

Back2Basics: Nominal GDP

  • Nominal gross domestic product is gross domestic product (GDP) evaluated at current market prices. 
  • GDP is the monetary value of all the goods and services produced in a country.
  • Nominal differs from real GDP in that it includes changes in prices due to inflation, which reflects the rate of price increases in an economy.

Primary Deficit

  • Primary deficit refers to the difference between the current year’s fiscal deficit and interest payment on previous borrowings.
  • It indicates the borrowing requirements of the government, excluding interest.
  • It also shows how much of the government’s expenses, other than interest payment, can be met through borrowings.

Debt/GDP ratio

  • The debt-to-GDP ratio is the metric comparing a country’s public debt to its gross domestic product (GDP).
  • By comparing what a country owes with what it produces, the debt-to-GDP ratio reliably indicates that particular country’s ability to pay back its debts.
  • Often expressed as a percentage, this ratio can also be interpreted as the number of years needed to pay back debt if GDP is dedicated entirely to debt repayment.

AQR- Asset Quality Rating

  • An asset quality rating refers to the assessment of credit risk associated with a particular asset, such as a bond or stock portfolio.
  • The level of efficiency in which an investment manager controls and monitors credit risk heavily influences the rating bestowed.
  • And because asset quality is an important determinant of risk that profoundly impacts liquidity and costs, analysts go to great lengths to make sure they issue the most accurate evaluations possible.
  • After all, their pronouncements can greatly affect the overall condition of a business, bank, or portfolio for years to come.

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