9th Five Year Plan (Vol-1)
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Macro-Economic dimensions and Policy framework
Growth and Investment Targets || Domestic Resources for the Plan || Sustainable Current Account Deficit and External Resources || Structure of Growth and the ICOR || Fiscal Balance, Inflation and the Monetary Stance || Issues in Aggregate Demand Management || Sectoral and Investment Pattern || Strategy for agricultural Development || Infrastructure and Basic Industries || The External Sector and International Dimensions || Issues in Finance Intermediation

Fiscal Balance, Inflation and the Monetary Stance

2.59 The Eighth Plan had witnessed a secular decline not only in the share of the public sector in total investment, but also as a percentage of GDP. This was principally the outcome of the efforts to bring about fiscal correction in a situation where the fiscal balance had been worsening steadily. Associated with this was the inability of most State governments to raise sufficient debt capital to finance their desired investment targets. The net result has been serious shortfalls in the creation of necessary economic and social infrastructure, the effects of which are starting to be felt. The Ninth Plan is predicated on a reversal of this trend, such that the share of public investment in total investment rises from the below 30 per cent level to which it had fallen in the terminal years of the Eighth Plan to about 33.4 per cent. Since the fiscal consolidation that had taken place during the Eighth Plan, by which the domestic debt to GDP ratio had been reduced from 59.7 per cent in 1991 to 56.5 per cent in 1997, was based mainly on severe compression of Plan expenditures in general and investment in particular, there may be an apprehension that a reversal of the trend may jeopardise the process of fiscal consolidation. This is a serious enough issue to merit careful consideration.

2.60 The long-term macroeconomic consequences of public debt accumulation depend on its rate of growth relative to growth in GDP, the ability of the private sector to generate sufficient savings for financing not only its own investment plans but also for absorbing the growing public debt, and the monetary consequences of increasing public debt, particularly on the inflation rate and rates of interest. The standard theoretical condition for stability of the debt/GDP ratio is that the real interest rate on public debt must be lower than the rate of growth of real GDP. While this condition ensures that the debt/GDP ratio will eventually converge to a stable long-run value, there is no assurance that this stable value of the ratio is consistent with the development needs of the country. Along the stable trajectory, the interest burden of the Government may actually rise quite significantly and put pressure on the development expenditure necessary to achieve and maintain a desirable structure of the economy. In fact, over the long-run, the growth rate of GDP itself may suffer and make the initial relations invalid. The recent experience clearly points to the dangers of relying entirely on such a definition of fiscal sustainability. During the past decade, despite the fact that the real interest rate on public debt, which on an average has been negative, has been significantly lower than the average growth rate of GDP of 5.7 per cent per annum, the combined interest burden of the Centre and States has steadily increased from 18.4 per cent of total government revenues during the second half of the 1980s to 27.4 per cent in 1996-97. In the case of the Central Government, the problem has become particularly acute in that 60 per cent of the total tax revenues was absorbed by interest payments in 1996-97.

2.61 In order to understand the implications of the burgeoning public debt and interest burden it is useful to examine the different measures of the deficit of the government. These are presented in Table 2-16. The difference between the fiscal deficit and the revenue deficit represents government investment as a percentage of GDP, while the difference between the fiscal deficit and the primary deficit reflects the interest burden of the government as a percentage of GDP. As may be seen, during the 1990s, the percentage of government investment to GDP has declined both at the Centre (from 2.2 to 1.2 per cent) and in the States (from 1.7 to 1.6 per cent), but the interest burden has continued to increase sharply from an aggregate of 3.5 per cent of GDP in 1990-91 to 4.5 per cent in 1996-97. It will further be seen that although the Centre has managed to lower its revenue deficit significantly, it has not been so in the case of the States, which have witnessed an increase, particularly since 1993-94. The principal reason for the inability of the States to reduce their revenue deficit is that the responsibility for operation and maintenance for most social services and infrastructure rests on the States, which restricts their ability to reduce revenue expenditures sharply. However, there is a need to emphasise the importance of reducing the revenue deficit of the combined Central and State Governments, and eventually bring it to a surplus, even if it impinges adversely on some services in the short run, since a revenue deficit requires that the returns on government investment must be significantly higher than the cost of financing for fiscal sustainability. The first step towards this would be to contain the interest burden.

                                        Table 2-16 : Measures of Deficit of the Government
                                          (percentage of GDP)
                      90-91  91-92  92-93  93-94  94-95  95-96  96-97
1. Combined Centre and States :

(a) Fiscal Deficit      8.4   6.6    6.9    7.7    6.7    6.3    6.2
(b) Revenue Deficit     4.5   3.6    3.4    4.5    3.9    3.5    3.5
(c) Primary Deficit     4.9   3.1    2.6    3.7    2.2    1.9    1.7

2. Net Centre :

(a) Fiscal Deficit      5.7   4.0    4.3    5.7    4.2    3.9    3.4
                       (8.3) (5.9)  (5.7)  (7.4)  (6.1)  (5.5)  (5.0)
(b) Revenue Deficit     3.5   2.6    2.6    4.0    3.3    2.7    2.2
(c) Primary Deficit     3.4   1.5    1.7    3.0    1.3    1.0    0.5

3. States :

(a) Fiscal Deficit      2.7   2.6    2.2    2.0    2.5    2.4    2.8
(b) Revenue Deficit     1.0   0.9    0.7    0.5    0.6    0.7    1.2
(c) Primary Deficit     1.5   1.6    0.9    0.6    1.0    0.9    1.3
(1) Source of the above data is RBI Annual Report 1996-97.
(2) Combined fiscal deficit is different from the RBI definition in that it is net not only of the lending of the Central government to the States but also of the other lendings. Combined revenue deficit is net of inter-Governmental transactions in the revenue account. Combined primary deficit is the combined fiscal deficit minus net lending and net interest payments.
(3) The Net Central Government fiscal and revenue deficits exclude net lending of the Centre and the Net Central government primary deficit is the net fiscal deficit minus net interest payments. For ease of comprehension, the gross fiscal deficit of the Centre as recorded in the budget, i.e. inclusive of net lending of the Centre, is shown in brackets ().

2.62 The main cause of the steady increase in the interest burden has been different in the Eighth Plan as compared to the earlier period. Prior to the economic reforms of 1991, a more or less stable nominal interest rate on public debt was combined with a rapidly increasing fiscal deficit, and hence the stock of public debt, to raise the interest burden. Since there were limitations on the direct borrowings behaviour of the States, the fiscal deficit of the States did not increase in any appreciable manner, staying at about 3 per cent of GDP, and the bulk of the increase in the interest burden fell on the Centre, which witnessed practically the entire increase in the fiscal deficit. During this period, the interest rate on public debt was specified by the Government, and its acceptance was ensured by the high and increasing statutory liquidity ratio (SLR) requirements imposed on the banking sector. During the Eighth Plan, however, consequent to the policy decision to shift from a government-determined interest rate on public debt to a system of market-determined rates as part of the financial sector reforms, the interest rates on public debt increased sharply. In addition, there was a steady reduction in SLR requirements from a high of 38.5 per cent of bank deposits in 1991-92 to 25 per cent at present, which reduced the government’s access to bank finance, particularly for the States. The Centre adjusted partially to these developments by instituting a steady reduction in its gross fiscal deficit from 8.3 per cent of GDP in 1990-91 to 5 per cent in 1996-97. This fiscal adjustment, however, was not enough to entirely offset the increase in interest rates, and the interest burden continued to move upwards. The situation was much worse for the States, which were unable to effect any sizeable fiscal correction due to their reliance on the debt component of the Central assistance to State Plans for meeting the needs of developmental investment. The interest rate on such intra-government debt was also increased in line with the overall increase in interest rates. The reduction in the States’ gross fiscal deficit from 3.5 per cent of GDP in 1990-91 to 2.9 per cent in 1995-96 and 3.3 per cent in 1996-97 was primarily achieved by curtailing Plan outlays, particularly support to the State PSUs, and is reflected in the lower market borrowings. Despite this, the interest burden of the States has ballooned during the Eighth Plan and at present seriously jeopardises the prospects of the States’ ability to meet their investment obligations in the Ninth Plan.

2.63 One of the immediate concerns of the Ninth Plan would be to ensure fiscal sustainability of both the Centre and the States. For that, the interest burden as a percentage of current revenues of the Government has to be reduced and, as a policy objective, immediate measures should be taken to ensure that at least the interest burden to tax revenue ratios do not become any worse, and preferably improve, during the Ninth Plan period and beyond. Before entering into the issue of fiscal sustainability, however, the allocation of responsibilities for meeting the targets of public sector Plan outlays and investment, as given in Table 2-9, and the resource flows needed to achieve these ends have to be explicitly specified. These figures are presented in Table 2-17. The first point to note is that during the Ninth Plan, the Centre bears only a minor burden of 14.6 per cent of the total public investment necessary for meeting the Ninth Plan targets, and the major responsibility is that of the States (27.9 per cent) and the public sector enterprises (PSEs) (57.5 per cent). This pattern arises out of the need to strengthen the infrastructural base of the country, which largely falls in the domain of State governments and PSEs. Second, it may be noted that while the borrowings of the Centre are projected at Rs.384,700 crore for the five-year period, they are expected to increase sharply from about Rs.60,200 crore in 1996-97 to about Rs.76,900 crore each year on the average during the Ninth Plan period. However, the borrowings of the States will also need to increase substantially from Rs.16,800 crore in 1996-97 to about Rs.25,300 crore per year on the average during the Ninth Plan. These figures include the borrowings from small savings instruments, market borrowings and external debt. Thus, although the government as a whole will need to raise about 6.65 per cent of GDP as borrowings during the Ninth Plan as compared to 6.1 per cent in 1996-97, the share of States in the total borrowings will have to rise from 21.8 per cent in 1996-97 to 24.8 per cent during the Ninth Plan. The PSEs will also have to raise substantial funds from the market, amounting to Rs.17,500 crore per year on an average in order to meet their investment targets.

                     Table  2-17  :  Structure of Outlays and Resources of the
                          Public Sector in the Ninth Plan
                                       Rs. crore    % of GDP
Centre :
    Central Plan Outlay                374,000       4.86
      of which :
         (a) Support to State Plans    170,018       2.21
         (b) Support to CPSEs           38,000       0.49
         (c) Support to Ministries
              (i)  Investment          106,482       1.38
              (ii) Current Outlay       59,500       0.77
    Financed by :
         (a) Borrowings                384,700       5.00
         (b) Other resources         (-)10,700      -0.14
States :
    State Plan Outlay                  275,500       3.58
      of which :
         (a) Investment                202,000       2.63
         (b) Current Outlay             73,500       0.96
    Financed by :
         (a) Central Support           170,018       2.21
         (b) Borrowings                127,082       1.65
         (c) Other resources        (-) 21,600      -0.28
PSEs :
    Outlay/Investment                  417,718       5.43
    Financed by :
         (a) Central support            38,000       0.49
         (b) Savings (IR)              292,400       3.80
         (c) Borrowings (EBR)           87,318       1.13
(1) All Union Territories (UTs) are clubbed with the States.
(2) A part of the investment outlay of the States will be towards budgetary support to State PSEs for investment purposes. Since this quantum is not yet known, it is being carried in the State budgets.
(3) The `borrowings' of PSEs include all market-related funds including new equity issues, if any.
(4) `Other resources' of the Centre and the States include balance on current revenues(BCR),miscellaneous capital receipts (MCR) and external grants, less non-Plan capital expenditures.

2.64 The increased borrowing needs of the States and the PSEs during the Ninth Plan, as compared to the historical trends, have to be accompanied and supported by a considerable improvement in the fiscal and financial discipline of these agencies. In particular, the States will have to record substantial improvement in their revenue deficits and the PSEs will need to increase their collective savings or internal resources from 3.4 per cent of GDP in 1996-97 to 3.8 per cent. Unless the measures to attain these targets are implemented, the borrowing targets are both unlikely to be attained and, more importantly, can potentially make the financial situation of these agencies considerably more precarious in the long run. Even with such efforts, resource mobilisation of this magnitude by the States and the PSEs will not be easy to achieve due to the creditworthiness of most States and PSEs as perceived by the financial market place. On the other hand, the Ninth Plan targets are unlikely to be achieved unless this transition to larger market-based borrowings is effected smoothly and rapidly. Therefore, strenuous efforts will have to be made to enhance the ability of the States and the PSEs to access market borrowings at reasonable terms on the strength of their performance. This will require a deliberate build-up of investor confidence through careful cultivation of an investor-friendly image and through greater openness and transparency of operations. These measures are, however, likely to take time and, in the interim period, consideration also needs to be given to the Centre, which enjoys a much superior credit standing and investor confidence, playing the role of an intermediary in channelising such funds to the States, over and above the implicit transfers included in the Central support to State Plans. This role, however, does carry the danger of ‘moral hazard’ problems arising, whereby the impetus towards fiscal discipline among certain States may get diluted. It should, therefore, be made amply clear that the debt servicing obligations of such intermediated loans may have to be the first charge on the devolution of tax revenues and the modalities of effecting such a linkage would need to be worked out.

2.65 The standard formulation for assessing fiscal sustainability (e.g. Joshi and Little; Stern) aims at deriving the level of fiscal deficit as a percentage of GDP which would stabilise the government debt/GDP ratio at its current level. The change in the debt/GDP ratio can be broken down into two components : (a) the primary deficit, which indicates the new borrowings required to finance the real expenditure of the government; and (b) the interest payment on the existing debt stock. Since the denominator of the debt ratio is GDP, the increase in the debt ratio on the latter count depends on the difference between the real interest rate and the growth rate of GDP. This formulation is similar to the analysis carried out for sustainability of the CAD earlier. This standard analysis, however, also needs to be slightly modified in the present context. It is usually assumed that the government faces a stable real interest rate on its borrowings, so that no distinction needs to be drawn between the gross and the net borrowings of the government. In India, however, there is a significant difference between the average interest rate paid on existing government debt, which was about 9.5 per cent in 1996-97, and the average interest rate on new debt, which was as high as 12.5 per cent. As a result, it is more relevant to assess the interest burden on gross borrowings rather than on the change in the debt stock or the net borrowings. Second, the standard approach argues for the inclusion of all public borrowings, including the borrowings of the non-financial public enterprises, in evaluating the public debt to GDP ratio. While this would certainly have been true earlier, when a very large component of borrowings by the PSEs was mediated by the government, it is no longer a compelling argument. In the last few years, the government support for borrowings by the PSEs has reduced substantially, except for some State PSEs, and there is now a greater willingness to set off the assets of the PSEs against their liabilities rather than reflect them as a claim on the government budget. Therefore, it is preferable at this stage to focus attention on the sustainability of the government’s budget per se.

2.66 It is also possible to argue from the point of view of medium-term management of the economy that the absolute level of the government debt to GDP ratio may not be as much a cause of concern in itself, as the high and increasing pre-emption of the government’s current revenues, particularly tax revenues, by interest payments. In order to achieve the objective of a stable or declining share of interest payments in total tax revenues, it becomes necessary to derive the maximum fiscal deficit that can be incurred so that the rate of build-up of public debt is limited to achieving a gradual reduction in the percentage of interest payments to total tax revenues. It can be shown that the sustainable level of fiscal deficit so derived is related positively to the growth rate of nominal GDP and the buoyancy of tax revenues, and negatively to the average interest rate on new debt. The current debt/GDP ratio and the average interest rate on existing debt are the important parameters. The behaviour of taxes and the buoyancies assumed for the Ninth Plan period are shown in Table 2-18. It is important to note that it is being assumed that during the Ninth Plan the devolution formula for tax sharing will be changed from the existing arrangement, under which roughly 27 per cent of Central tax revenues were devolved to the States, to the proposal for pooling all Central tax revenues of which the States will receive 29 per cent. This has the effect of decreasing the buoyancy of the net taxes of the Centre and increasing that of the States.

                                     Table 2-18 : Tax Receipts of the Government                   
                                                                           (Tax receipts as percentage of GDP)
                  Direct  Indirect  Gross   Devolution  Net
1996-97 :
    Centre         3.11      7.41    10.52    - 2.71   7.81
    States         0.18      5.66     5.84    + 2.71   8.55
    Combined       3.29     13.07    16.36            16.50
2001-02 :
    Centre         4.02      7.47    11.49    - 3.33   8.16
    States         0.18      5.80     5.98    + 3.33   9.31
    Combined       4.20     13.27    17.47            17.47
Implicit Buoyancies :
    Centre         1.59      1.02     1.17             1.09
    States         1.00      1.05     1.04             1.17
    Combined       1.55      1.03     1.14             1.14

2.67 Such limits on the sustainable fiscal deficit need to be computed not only for the government as a whole, but for each component, namely the Centre and the States, taken separately in order to ensure that the division of responsibility for meeting the Plan objectives can be carried out by all wings of the Government without running into serious resource problems. In doing so, it must be noted that the Central Government is the major creditor so far as the States are concerned, accounting for 62.5 per cent of the total outstanding debt of the States in 1996-97. Since the Centre does not provide these loans at concessionary terms, they need to be deducted from the gross outstanding debt of the Centre to arrive at its net debt position. Furthermore, the Central assistance to State Plans, on the average, includes a debt component of slightly above 50 per cent, and this pattern is assumed to continue during the Ninth Plan for the purposes of analysing fiscal sustainability.

2.68 The analysis of the fiscal sustainability of the combined government, the Centre and of the States taken collectively for the Ninth Plan period as per the division of responsibilities and resources outlined in Table 2-17 by both the modified standard and the alternative interest burden formulae, are presented in Table 2-19. In deriving the values of the variables and parameters for the Ninth Plan period certain assumptions have been made, which need to be noted. First, although the inflation rate during the Ninth Plan has been assumed to be in the range of 5 to 7 per cent per annum, for the purposes of this exercise it has been assumed that the lower of the range, i.e. 5 per cent, would be targetted. Second, the nominal interest rates on new debt have been assumed to respond to the lower inflation rate so that they remain in the range of 4.5 to 5.5 per cent in real terms. Third, the annual rate of repayment of existing debt has been assumed to be 5 per cent, which is somewhat higher than experienced in the recent past. The most significant point that needs to be noted in Table 2-19 is that the condition required for stabilising the interest/tax ratio under the buoyancy rates assumed for the Ninth Plan is significantly less demanding than the condition for stabilising the debt/GDP ratio in all the scenarios. In other words, if the nominal interest rates on public debt are responsive to the lower rates of inflation and the appropriate steps taken to raise the tax/GDP ratios by both the Centre and the States, the government debt/GDP ratios can be permitted to rise without necessarily running the risk of increasing the pre-emption of tax revenues by interest payments. Indeed, as may be seen, the Central Government has already achieved the necessary level of fiscal correction by 1996-97. The States, however, still have some way to go.

                              Table 2-19 : Fiscal Sustainability of the Ninth Plan  
                 (Gross Fiscal Deficit (GFD) as Percentage of GDP) 
Sustainable Fiscal Deficit    Combined  Net Centre   States
1. Scenario 1
       Standard                 4.98    3.30 (4.36)    1.68
       Interest burden          6.61    4.42 (5.48)    2.19
2. Scenario 2            
       Standard                 5.57    3.71 (4.76)    1.86
       Interest burden          7.61    5.10 (6.16)    2.51
3. Fiscal deficit/GDP ratio
   in 1996-97                   6.13    3.35 (5.03)    2.78
4. Fiscal deficit/GDP ratio
   in the Ninth Plan            6.76    3.92 (4.98)    2.84

(1) The standard analysis defines fiscal sustainability as the level of fiscal deficit at which the Debt/GDP ratio remains constant. The relevant formula is :

f = b.[g + i - rn - a.(rn - re)] + int
where : f = fiscal deficit/GDP ratio
b = total govt. debt/GDP ratio
g = growth rate of GDP
i = inflation rate
a = rate of repayment of existing debt
re = interest rate on existing debt
rn = interest rate on new debt
int = interest payment on public debt/GDP ratio

The interest burden definition is the level of fiscal deficit at which the interest/total tax receipt remains constant.
The formula in this case is :
f = b.[E.re.(g + i) - a.(rn - ra)]/rn where : E = buoyancy of nominal tax revenues
(2) Scenario 1 assumes GDP growth rate at the Ninth Plan target of 6.5 per cent and nominal interest rate at the 1996-97 level of 10.5 per cent. Scenario 2 assumes GDP growth rate of 6.5 per cent and nominal interest rate of 9.5 per cent.
(3) The GFD of the Centre is defined as net of the loans and advances to the States. In order to derive the GFD as given in the budget (i.e. inclusive of loans and advances to States), for the Ninth Plan period, 1.06 per cent should be added to the figures given above. These are shown in brackets.

2.69 However, the behaviour of taxes estimated for the Ninth Plan period embody certain corrective measures which cannot be assumed to continue in the long run and the tax/GDP ratio will eventually stabilise, albeit at a higher level than at present. Therefore, it may not be entirely appropriate to use the definition of fiscal sustainability based on the interest/tax ratio for setting the long run sustainable target for the fiscal deficit, although it continues to be useful for indicating the extent to which the fiscal correction efforts can be allowed to be relaxed not only to take care of unforeseen circumstances, but also in the use of fiscal variables as a policy instrument for aggregate demand management. For the Centre, as may be seen, there is some cushion available for this purpose. For the government as a whole, however, stabilisation of the Debt/GDP ratio is perhaps a more prudent target to aim for in the longer run. It may be seen from Table 2.19, that even if the resource and expenditure patterns outlined in the Plan are adopted and adhered to strictly, the combined fiscal deficit of 6.76 per cent of GDP is likely to be significantly above the sustainable level of 4.98 per cent at a real interest rate on public debt of 5.5 per cent, which will imply a steady increase in the Debt/GDP ratio of the government but a very slight increase in the interest burden ratio. If the nominal interest rate on new government debt can be reduced to 10 per cent or less, implying a real interest rate of 5 per cent, the interest burden ratio of combined government will also exhibit a declining trend.

2.70 In addition, the Central Government has instruments available to it which have not been taken into account at all in making the above calculations. These instruments lie in the domain of monetary policies and need to be discussed with some care. In making the above calculations, it has been assumed that the inflation rate will be restricted to 5 per cent per annum during the Ninth Plan. This target is in itself questionable in the specific economic environment that is being sought to be created in the Ninth Plan period. As has been mentioned earlier, the Ninth Plan is predicated on two major planks : (a) an accelerated growth in agricultural GDP, which in itself is contingent upon a steady improvement in terms of trade for agriculture; and (b) removal of, or a reduction in, a number of implicit and non-transparent subsidies through rationalisation of administered prices and higher collection of user charges. Both these processes are inherently inflationary since they do have cost-push effects, and any effort to contain the inflation rate excessively will have negative effects on real growth. This is, of course, a transient phenomenon and will apply only until the desired relative price structure has been attained.

2.71 Therefore, it may not be feasible to contain the inflation rate at the 5 per cent level, and it may rise to even 7 per cent per annum, at least for the first few years of the Ninth Plan. The sustainable level of fiscal deficits at a 7 per cent rate of inflation are presented in Table 2-20. As may be seen, the sustainable fiscal deficit limits by both methodologies and in all scenarios increase significantly at the higher inflation rate, with the increase being greater for the standard Debt/GDP measure than for the interest burden. This occurs principally due to the assumption that although there would be higher nominal interest rates consequent upon higher inflation expectations, the real interest rates could drop to within the 3.5 to 4.5 per cent range as a result of the reduced demand for government borrowings as a proportion of the available resources.

                          Table 2-20 : Fiscal Sustainability at 7% Inflation Rate
                                                   (Gross Fiscal Deficit (GFD) as percentage of GDP) 
Sustainable Fiscal Deficit    Combined  Net Centre   States
1. Scenario 1
       Standard                 5.56    3.70 (4.76)    1.86
       Interest burden          6.85    4.57 (5.63)    2.28
2. Scenario 2            
       Standard                 6.17    4.11 (5.16)    2.06
       Interest burden          7.79    5.21 (6.27)    2.58
3. Fiscal deficit/GDP ratio
   in 1996-97                   6.13    3.35 (5.03)    2.78
4. Fiscal deficit/GDP ratio
   in the Ninth Plan            6.76    3.92 (4.98)    2.84
NOTE : (1) Scenario 1 assumes GDP growth rate at the Ninth Plan target of 6.5 per cent and nominal interest rate at the 1996-97 level of 11.5 per cent. Scenario 2 assumes GDP growth rate of 6.5 per cent and nominal interest rate of 10.5 percent.

2.72 On the other hand, the acceptance of a higher rate of inflation, for the structural reasons mentioned earlier, would imply that the target annual rate of growth of base money can be increased from about 14 per cent to above 16 per cent, assuming an elasticity of demand for base money of 1.3 with respect to real GDP. This translates to an increase in the potential seignorage available to the Central Government of 0.3 per cent of GDP from 2.2 to 2.5 per cent of GDP each year. In the recent past, excessive inflows of external funds relative to the CAD have caused the foreign exchange reserves to grow much faster than desired as discussed earlier. As a result, almost 1.5 per cent of GDP have been transferred abroad in the form of seignorage through an excessive growth of foreign exchange reserves in each of the past four years, which could have been more productively used to increase the inflow of real resources through higher imports or to reduce the growth of government debt through a higher level of monetisation of the fiscal deficit. This behaviour needs to be changed during the Ninth Plan period. As has been indicated earlier, the required growth in foreign exchange reserves amounts to about 0.4 per cent of GDP per year on the average during the Ninth Plan. It is, therefore, possible for the Central Government to appropriate 1.3 and 1.6 per cent of GDP as seignorage in the two sets of inflation scenarios respectively through recourse to higher monetised deficit of the Government and yet leave sufficient cushion to absorb some unforeseen excess capital inflows. Although this measure does not reduce the debt build-up as recorded in the government budget since government securities will have to be issued to the RBI, it does reduce growth in government debt held by the public and also the net interest burden through higher dividend payments by the RBI. For this order of seignorage to be achieved, however, a certain degree of control needs to be exercised on the inflow of external capital resources. As has been discussed earlier, limitations would need to be continued on external commercial borrowings and perhaps imposed on foreign portfolio investment while significantly improving the conditions for attracting foreign direct investment.

2.73 Secondly, the overall level of real interest rates in the economy will need to be brought down from the excessively high levels that exist at present to the target range of 3.5 to 5.5 per cent, without jeopardising the viability of the financial sector. This change can only be done in a graduated manner, since the lending rates will tend to follow the deposit rates with some lag. In the interim period, if the real lending rates become too high, it will affect investments adversely. The decline in nominal interest rates helps the government’s fiscal sustainability quite considerably as can be seen from a comparison of scenarios 1 and 2 in both Tables 2-19 and 2-20. In view of this relationship, the Government needs to make a concerted effort at reducing the nominal interest rates. The containment of the combined fiscal deficit during the Ninth Plan will certainly help by reducing the pressure on credit demand, but more may need to be done, particularly as far as the deposit rates are concerned. In order to make a beginning, there is a strong case for reducing the interest rates on the various small saving schemes operated by the government. This alone should have a salutary effect on the overall structure of the deposit rates. There is little danger that such a step will reduce aggregate savings, since the empirical evidence suggests that there is at worst a negligible relationship between interest rates and aggregate savings. There may be some portfolio shifts in the short run, but these are unlikely to be large.

2.74 The aggregate effects of a carefully calibrated monetary stance on the fiscal sustainability of the government are, therefore, quite substantial. A viable monetary posture for the Ninth Plan would be to accept an average inflation rate in the region of 7 per cent per annum, which would justify a growth rate of money supply (base money) of 16 per cent per annum and a seignorage of 1.6 per cent of GDP. With appropriate measures, it should be possible to reduce the average interest rate on public debt to 11.5 per cent, if not lower going by current trends, yielding a real interest rate of 4.5 per cent, which is not unrealistically low by both historical and international standards.

2.75 However, as can be seen from Tables 2-19 and 2-20, the fiscal consequence of the Ninth Plan is divided asymmetrically between the Centre and the States. In the case of the Centre, the net fiscal deficit of 3.04 per cent arising from a gross fiscal deficit target of 4.1 per cent in the terminal year of the Plan will be substantially lower than that required for sustainability, implying a rapid reduction in both the Debt/GDP ratio and the interest burden; whereas for the States it will be above, which implies a growing problem of debt accumulation and increasing interest burden. Such a state of affairs is undesirable since it will not only jeopardise the fiscal viability of the States, but will also reduce their ability to raise debt from the market. As a consequence, public investment by the States will fall short of the Plan targets and will have serious adverse effects on those sectors which fall predominantly under the State jurisdiction such as agriculture, health, education and a number of infrastructural areas. In order to prevent such an eventuality, it is necessary for the States to vigorously pursue additional resource mobilisation (ARM) measures over and above those taken into account in computing the buoyancy rates. In the detailed discussions held with the Chief Ministers of all the States regarding the State Plans, it has been indicated that the States are collectively committed to implementing a number of ARM measures which would reduce the State fiscal deficit by above Rs. 13,000 crore additionally for the Ninth Plan period as a whole. Credit for these efforts has not been taken in the calculations of fiscal sustainability. If these commitments materialise, the fiscal deficit of the States, and therefore the combined fiscal deficit of the government, will be reduced by a further 0.17 per cent of GDP during the Ninth Plan.

2.76 A realistic assessment of the possibilities of improvement in the fiscal position of the States indicates that it may not be feasible to effect sharper fiscal corrections than have been indicated without seriously affecting the attainment of the Plan objectives. On the other hand, reduction in the Debt/GDP ratio of the States may not strictly be necessary in view of the relatively low level of this ratio (19.4 per cent) in the base year. However, the interest payment/tax revenue ratio at almost 27 per cent in 1996-97 is high enough to be a cause of concern, and it may not be desirable for this to increase further. It is, therefore, imperative that not only should the States achieve the resource mobilisation targets that have been committed by them, but also for the Centre to ease the pressure on the States by transferring a share of the improvement in its fiscal deficit, of at least 0.45 per cent of the GDP, to the States in order to make the State finances viable.

2.77 The proposed transfer of fiscal improvements is not as radical as it appears. In any case, the actual debt servicing receipts by the Centre tend to fall short of the dues due to the inability of a number of States to meet their commitments. In addition, the various Finance Commission awards have, from time to time, made appropriate adjustments for relieving the debt service burden of the States. Thus, this proposal seeks to legitimise an existing reality. There are, however, two distinct advantages of this proposal. First, it immediately affects the fiscal position of the States, which would improve their credit ratings and make it easier for them to access market borrowings. Second, it directly links the benefit to public investment by the States, rather than encourage increased consumption, which could otherwise be the case.

2.78 The combined effects of the fiscal and monetary measures outlined above are presented in Table 2-21. As can be seen, by the end of the Ninth Plan, the fiscal position of the Government and each of its components is likely to be considerably better than in the base year. In so far as the Central Government is concerned, the potentially sustainable net fiscal deficit can be as high as 3.70 per cent of GDP, even without recourse to any seignorage or inflation tax, which translates to a gross fiscal deficit figure of about 4.76 per cent. This target should not be difficult to attain during the course of the Ninth Plan period. At this level of fiscal deficit, both the Debt/GDP and the interest/tax ratios of the Centre will decline steadily. The position of the States, however, is not so comfortable. Considerable fiscal discipline will need to be exercised in order to achieve the specified targets even with the transfer from the Centre. During this period, although the interest/tax ratio will decline, the Debt/GDP ratio will continue to increase slowly. However, the increase in the Debt/GDP ratio will be sustainable, provided the process of fiscal consolidation is carried on beyond the Ninth Plan period. Once these targets are achieved, it should be possible to take more stringent measures for bringing the inflation rate down even further without jeopardising the process of fiscal consolidation.

                             Table 2.21 : Fiscal Sustainability with Adjustments
                                    Combined  Centre  States
                                    --------  ------- ------
1. Sustainable FD/GDP ratio as per   5.98      3.70    2.28
   Table 2.20, scenario 1

2. Transfer of fiscal benefits          0     -0.45   +0.45

3. ARM measures by States           +0.17         0   +0.17

4. Potential seignorage to Centre   +1.60     +1.60       0
                                     -----    -----    -----
5. Sustainable FD after adjustments  7.75      4.85     2.90

6. Ninth Plan fiscal deficit         6.76      3.92     2.84
NOTES : (1) The sustainable fiscal deficit to GDP ratio for the Centre is based on the standard Debt/GDP criterion, while that for the States is based on the interest payment/total tax criterion.

2.79 The transfer of the fiscal improvement from the Centre to the States during the Ninth Plan can be done in a number of ways. At present, a little above 50 per cent of the Central support to State Plans is in the form of loans. In order to effect the proposed transfer of the improvement in the Centre’s fiscal deficit from the Centre to the States, this debt component may be reduced to about 30 per cent, which would reduce the addition to the debt owed by the States to the Centre by Rs. 32,000 crore over the Ninth Plan period. As one possible modality to achieve this reduction in the debt component, it is suggested that the loan component of normal Central assistance to non-special category States be reduced from 70 per cent level at present, to an average figure of 40 per cent. However, in doing so, attention is drawn to the fact that all States are not at the same level as far as their fiscal situation is concerned. Some States in particular have not displayed the same degree of fiscal discipline as others and, as a result, are in a considerably worse position. It is, therefore, suggested that as an alternative modality, the loan component may be reduced to 50 per cent for all non-special category States, and the balance of about Rs. 8,000 crore be reserved for providing additional relief to a few select poorly performing States. These benefits, however, have to be made conditional on the State implementing credible fiscal reform measures and attaining the stipulated resource mobilisation targets which have been agreed upon and which are contained in the State Plan documents.

2.80 It will be seen therefore that the share of interest payments in the total tax revenues of the government can be realistically brought down by limiting the fiscal deficit as suggested in the present exercise, which will also permit retirement of some of the existing public debt of the Centre. Given the size of the debt, such retirement would achieve only a relatively small reduction in the debt burden of about 6 percentage points over the Ninth Plan period. However, through the sale of seized contraband gold and of some government lands and through disinvestment of PSU shares, substantial funds can be raised and used for additional retirement of debt. The State Governments, in particular, can sell off many of their enterprises in the non-core sectors and use the proceeds for the debt retirement, which would certainly ease their fiscal position and improve their ability to raise further resources for investment in economic and social infrastructure.

2.81 Finally, it needs to be mentioned that the above exercises have fully factored in the estimated effects of the implementation of the Fifth Pay Commission recommendations by both the Centre and the States, amounting to additional burdens of Rs.51,000 crores and Rs.110,000 crores respectively for the Ninth Plan period. Therefore, although the fiscal pressures will be intense during the first two years of the Plan, the above targets can still be achieved if the growth rate is not allowed to slip from the target. Otherwise, the achievement of fiscal sustainability will become considerably more difficult. Therefore, care needs to be taken that the fiscal stringency of the first two years does not fall on the public investment programme. The above results have been obtained by allowing the fiscal deficits to widen in the first two years in order to accommodate the higher burden of salaries and wages. If revenue expenditures can be curbed, it will certainly help in achieving the fiscal targets sooner, but it is not strictly necessary.

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