Why We Should Learn to Stop Worrying and Love the Fiscal Deficit

As long as the government wisely spends the money it borrows on high-return capital expenditure, it will crowd in private investment and ensure lasting and higher growth

Fie photo of Finance Minister Arun Jaitley with RBI Governor Raghuram Rajan. Credit: IANS

Fie photo of Finance Minister Arun Jaitley with RBI Governor Raghuram Rajan. Credit: IANS

About a month back, in what can arguably be called an overreach of his mandate, the RBI governor made no secret of what he would have the finance ministry do for the coming budget: stick to the fiscal deficit target at all costs, even if it means keeping government investment down.

Rajan’s statement was a loaded one, pithily highlighting some of the most hotly debated topics in macroeconomics. Citing the example of Brazil as an economy wrecked by high fiscal deficit, he underlined macroeconomic stability as the most crucial variable in a shaky global environment. Rajan added that sticking to the deficit target would signal policy consistency, which was crucial to investor sentiment, and went on to say that government expenditure would not have the intended multiplier effect.

Rajan failed to highlight the fact that Brazil, being a commodity exporter, stands to lose much more than India, which has reaped considerable gains from the crash in global  commodity prices. Despite this advantage, however, the finance minister has no easy choices to make between the fiscal deficit and government expenditure in the coming budget.

While Rajan’s view on sticking to deficit targets comes from his sole mandate of keeping inflation down, it is not hard to see why the government, which also has to ensure high (8%+) growth, is in two minds.

Need for growth

During the Indian economy’s golden years, the economy was powered by high exports and soaring private investment. However, the 2008 crisis dealt a body blow to both these components of growth. India’s chief economic advisor has pointed out that it is time for public expenditure to fill this gap.

As the graph below shows, private investment (excluding households) touched a peak of 18.8% of GDP in 2007-08, tanking to 12% the very next year, and continues to linger at similar levels. This has compelled the government to raise its investment levels.

graph 1

Ideally, the government ought to raise resources without excessive borrowing by ensuring higher tax revenues, plugging leakages, private sector investment through PPP, higher disinvestment receipts etc. But alas, that remains a pipe dream. Besides its mismanagement, what makes the government’s task more difficult are one rank, one pension (OROP), the Seventh Pay Commission, and tepid nominal GDP growth. Given the circumstances, borrowing is the most tempting, if not the inevitable, option.

The government must think carefully over how best – if at all it must exceed deficit targets – to spend the borrowed money to stimulate growth and counter the negative sentiment, as well as other ills, that a higher deficit might lead to.

In fact, if a modestly higher fiscal deficit now can set India on a high growth trajectory, it will help reduce the fiscal deficit as a share of GDP in the future, by reducing India’s debt-to-GDP ratio. This is because interest payments on accumulated debt (3.3% of GDP in 2014-15) are the dominant component of fiscal deficit. Any reduction in the interest payment-to-GDP ratio will mean a lower fiscal deficit.

So, how to spend borrowed money to ensure growth?

In a rare consensus, economists almost unanimously agree that the answer lies in increasing capital expenditure – which leads to a much higher level of investment (gross capital formation) in the economy – and reducing revenue expenditure. But it’s not just the amount of capital expenditure that matters, academic literature makes clear that in order to get the maximum bang for their buck, governments must also focus on the ‘quality’ of capital expenditure, as well as the sectors in which it is to be made. Further, the expenditure must be complemented by 1991-like reforms.

In keeping with its merits, successive Indian governments have paid lip-service to raising capital expenditure. But economics is often sacrificed at the altar of politics. Since revenue expenditure includes committed expenditure like salaries and pensions, it takes the lion’s share of the budget, with capital expenditure hovering between 10-14% of the budgeted expenditure since 2008-09. Worse, successive governments have happily slashed the budgeted targets of capital expenditure to meet fiscal deficit.

The graph below gives a better idea of this. The successively high fiscal deficits post-2008 have been blamed for India’s long battle with inflation and low growth. It is clear that the high volume of borrowing done was to make revenue expenditure.


For all its boasts about raising capital expenditure, the first year of the Modi government too saw capital expenditure falling well short of budgeted targets. However, the performance seems much better for this fiscal, and it is likely that capital expenditure will meet its budgeted targets.

What the academic literature says

Bose and Bhanumurthy (2015) and Guimarães (2010) estimate the multiplier from capital expenditure and revenue expenditure to be substantially higher and lower than 1, and conclude that capital expenditure crowds-in private investment.

As regards the sectors to be targeted for capital expenditure, the RBI (2002) notes that infrastructure investment by the public sector crowds-in private investment while public investment in manufacturing crowds-out private investment. On a global scale, the IMF (2015) holds the same view: “Efficient public investment, especially in infrastructure, can raise the economy’s productive capacity”.

As mentioned earlier, the quality of capital expenditure matters too. Warner (2014) analyses the impact of public investment drives on growth in several developing countries, and concludes that, with the possible exception of Ethiopia, there is a weak link between the two, in part due to the crowding out of private investment. However, in what should be carefully heeded by the Indian government, the paper blames rent-seeking, absence of analytical vigour, and crippling delays for the poor planning and execution of these drives that led to their failure. The paper concludes that public capital can be very productive when it is directed at resolving bottlenecks and major binding constraints. However, there is no guarantee, nor evidence, that public investment will be aimed at projects with high returns.

Furthering the caution, Rajaram and others (2014) stress on transparent and rigorous project appraisal and approval procedures for best results. In another important paper, the authors conclude that public investment crowded-in private investment only in the period post 1980, which was attributable to reforms that started then, and accelerated 1991 onwards.

Perils of fiscal deficit

Does the above make a simple case for incurring the right kind of capital expenditure through borrowing? There are no simple answers, for the fiscal deficit has been blamed for the ‘crowding-out’ of private expenditure, inflation, and hindering the independent conduct of monetary policy.

Theoretically, it is not difficult to see why excessive borrowing by the public sector should result in the crowding-out of private expenditure. For a given level of money supply in the economy, more public sector borrowing would leave less funds for the private sector, thereby raising interest rates. A rise in interest rates would naturally discourage private expenditure. This link should be stronger for India given most government borrowing is domestic. The crowding-out theory is supported by some of India’s leading economists.

However, the limited academic literature available on this subject in India’s context is conflicting. Chakroborty (2012), focusing on the period between 2006-07 and 2010-11, asserts that the increase in the fiscal deficit does not cause a rise in interest rate, though studies to the contrary do exist.

As a counter-argument, proponents of the crowding-out theory could argue that the demon of bad loans has taken full shape only now, and in such an environment, the banks would be much happier lending to the presumably safe public sector, effectively raising interest rates for the private sector. However, it is also doubtful whether the heavily stressed banks would be willing to lend easily to the private sector at all, even in the absence of government borrowing, which makes a strong case for the latter.

A higher fiscal deficit could also compromise the RBI’s autonomy. The RBI buys or sells government bonds, through a process called open market operations (OMO), to maintain the targeted level of money supply in the system.

However, the RBI could be forced to buy government bonds beyond its intended target, if the government is seen to be sucking out liquidity from the system through huge borrowing. Also, the transmission of rate reductions by the RBI could be hindered if the government borrows heavily to put upward pressure on interest rates, as discussed earlier.

Talking of 2008-09, the RBI (2013) mentions that, “unprecedented” fiscal slippage that caused “the sudden large extra market borrowings in the last quarter” resulted in interest rates on government bonds jumping by 2 percentage points, which forced the RBI to buy government bonds worth Rs.89000 crore to ensure liquidity and avert a possible “interest rate shock”.

Thus, despite the considerable increase in fiscal-monetary harmony, a low fiscal deficit enhances the RBI’s independence. But, given that the Indian economy is doing far better than the 6%+ fiscal deficit and low growth of the period mentioned above, there might be room for some more borrowing without hurting the conduct of monetary policy.

The high fiscal deficit post-2008 has been rightly blamed for India’s six year battle with high inflation. It is well known that this period saw the stalling of important projects and low capital expenditure. If inflation is defined as “too much money chasing too few goods”, the right kind of capital expenditure can create enough goods to prevent a spike in inflation. Also, the RBI is now more resolute in its anti-inflation policy.

The road ahead

Rangarajan and Srivastava (2005) make a strong case to revisit the Fiscal Responsibility and Budget Management Act (FRBM), to set a more suitable deficit target than the arbitrarily determined 3% target of the present, to make it sensitive to cyclical fluctuations and the debt-to-GDP ratio.

Irrespective of the target, the government must strive to change the composition of expenditure to incur higher productive expenditure, without borrowing. However, given the current constraints and the push for growth, there is a possibility that the fiscal deficit target of 3% might be pushed ahead by yet another year.

There is no denying the blow to India’s perceived macroeconomic stability if that happens. But, as far as the more tangible negative effects are concerned, they can be minimised through high-return capital expenditure that crowds in private investment, thereby ensuring lasting growth. That should help improve perceptions too.

Prabhat Singh works for the Finance department of Andhra Pradesh government. He tweets at @singhK_P

  • shashank

    I never quite understand this argument for infrastructure spending, it is not as if you can decide this week to build a thousand bridges. All infrastructure projects take a long time in planning , clearances and even the construction itself, so a fiscal deficit slack of 0.3-0.4% for a year or two to my mind does not seem very significant in terms of its impact on growth. I would much rather not take unnecessary risks for mostly imagined gains in a troubled global economy , lets just stick to the targets.