Debt Sustainability and Exchange Rate Management

• 10 Jan 2024

For Prelims: International Monetary Fund, Exchange Rate Dynamics, Credit Ratings, Interlinked Factors Related to India's Rising Debt Levels, Tax evasion, Fiscal Responsibility and Budget Management Act, 2003, IMF’s Classification of Stabilised Arrangement

For Mains: IMF’s Projections Related to India’s Economic Outlook, Measures that India can take for Sustainable Debt Management

Source: TH

Why in News?

The International Monetary Fund (IMF) recently released its annual Article IV consultation report on India, addressing critical issues concerning the nation's debt sustainability and exchange rate management.

What are IMF’s Projections Related to India’s Economic Outlook?

• Debt Sustainability: The IMF flagged concerns about India’s long-term debt sustainability.
  • It projected that India’s general government debt, encompassing both the Centre and States, could potentially escalate to 100% of GDP by fiscal year 2028, particularly under adverse circumstances.
• Debt Management Challenges: The report highlighted the necessity for more prudent debt management practices, emphasizing the crucial need for financing to achieve climate change mitigation goals and enhance resilience against natural disasters.
  • The Indian Finance Ministry contested the IMF’s debt projections, dismissing them as a worst-case scenario rather than an imminent reality.
• Exchange Rate Dynamics: The IMF reclassified India’s de facto exchange rate regime to "stabilized arrangement" from "floating" for December 2022 to October 2023
  • This reclassification reflects observations about controlled fluctuations in the rupee’s value due to interventions by the RBI.
• Stagnant Credit Ratings: Despite being lauded as the fastest-growing major economy, India's sovereign investment ratings have remained stagnant for a considerable period.
  • Agencies like Fitch Ratings and S&P Global Ratings have maintained India’s credit rating at ‘BBB- with stable outlook’ since 2006, citing concerns about weak fiscal performance, burdensome debt, and low per capita income.

What is the Global Debt Landscape ?

• Rising Global Debt: Globally, public debt has surged dramatically, surpassing USD 92 trillion in 2022, a more than fourfold increase since 2000, outpacing the growth of global GDP.
  • According to the UN, in 2022, 3.3 billion people live in countries that spend more on interest payments than on education or health.
  • Developing countries accounted for almost 30% of the total, of which roughly 70% is attributable to China, India and Brazil, largely driven by diverse factors like the pandemic, cost-of-living crisis, and climate change.
• Debt Asymmetry Between Developed and Developing Nations: Developing countries, including those in Africa, contend with substantially higher borrowing costs compared to developed nations.
  • This disparity in borrowing rates compromises debt sustainability for developing nations, leading to increased interest spending relative to public revenues.

What is India’s Current Debt Scenario?

• Government Current Debt Levels: The central government's debt stood at ₹155.6 trillion, approximately 57.1% of GDP by March 2023. Meanwhile, State governments carried a debt of about 28% of GDP.
  • As stated by the Finance Ministry, India’s public debt-to-GDP ratio is 81% in 2022-23. This, is way higher than the levels specified by the FRBM target.
    • The 2018 amendment to the FRBM Act specified debt-GDP targets for the Centre, States and their combined accounts at 40%, 20% and 60%, respectively.
• Interlinked Factors Related to India's Rising Debt Levels:
  • High Fiscal Deficit: The government consistently spends more than it earns, leading to the deficit being financed through borrowing. This deficit can arise due to:
    • High Expenditure Commitments: Social welfare programs, subsidies, and defense spending significantly contribute to government outlays.
    • Slow Revenue Growth: Tax reforms haven't sufficiently boosted revenue collection, creating a revenue-expenditure gap.
  • Global Geopolitical Events: Events like the Russia- Ukraine war and rising commodity prices can lead to economic disruptions and higher import costs, forcing the government to borrow to maintain stability.
  • Informal Economy and Tax Leakage: India's large informal economy poses challenges for efficient tax collection.
    • Tax evasion and lack of formalization in sectors like agriculture and small businesses limit revenue generation, potentially forcing the government to rely on debt financing.
  • Guarantees and Contingencies: Government guarantees for loans taken by public sector entities or contingent liabilities, like potential losses from public-private partnerships, substantially add to the debt indirectly.
  • Exchange Rate Fluctuations: Fluctuations in exchange rates impact the cost of servicing foreign currency-denominated debt, potentially increasing the overall debt burden.
• Legislation for Debt Management in India:
  • Fiscal Responsibility and Budget Management Act, 2003 (FRBM Act): FRBM Act is an Indian law enacted to bring financial discipline to the government's fiscal operations and to reduce the country's fiscal deficit.
    • FRBMA aimed for specific debt-GDP targets for the Centre and States.
      • However, disruptions induced by the pandemic contributed significantly to elevated debt-GDP ratios, surpassing the specified thresholds.
    • Also, despite several years since its enactment, the Government of India has struggled to meet the FRBM Act targets.

What Differentiates Floating Exchange Rate Dynamics from Stabilized Arrangement?

• Floating Exchange Rate:
  • Market-Driven: Currency value is determined solely by supply and demand in the foreign exchange market, with minimal government intervention.
  • High Volatility: The exchange rate can fluctuate significantly in response to economic news, events, or market sentiment.
  • Promotes Flexibility: Businesses and individuals can adjust to changing economic conditions through market-determined exchange rates.
• Stabilized Arrangement:
  • More Managed than Purely Floating: The government or central bank may intervene in the foreign exchange market occasionally to smooth out excessive volatility or maintain a target range for the currency.
  • Moderate Volatility: Aiming for greater stability than a pure float, but still accepting some degree of fluctuation.
  • Offers Predictability: Businesses and individuals can plan with a more stable exchange rate environment.
• IMF’s Classification of Stabilised Arrangement:
  • The IMF classifies an exchange rate regime as a stabilized arrangement when it determines that the exchange rate has not moved beyond a 2% band in 6 months and that this stability has resulted from market interventions rather than market conditions.

What Measures can India Take for Sustainable Debt Management?

• Short Term: Fiscal Consolidation:
  • Targeted Reforms: Streamlining subsidies, reforming public sector enterprises, and reducing administrative inefficiencies and strict adherence to FRBM Act targets can free up resources for debt repayment and productive investments.
  • Improved Tax Efficiency: Strengthening tax administration and tackling tax evasion can significantly boost revenue without excessive borrowing.
• Long Term Growth-Oriented Strategies:
  • Skill Development and Education: Investing in human capital through education and skill development programs enhances productivity and competitiveness, leading to higher economic growth and improved tax collection.
  • Export Promotion: Diversifying export markets, incentivizing high-value exports, and addressing competitiveness challenges can boost foreign exchange earnings, potentially reducing the need for external debt.

UPSC Civil Services Examination, Previous Year Questions (PYQs)

Prelims:

Q. Consider the following statements: (2018)

1. The Fiscal Responsibility and Budget Management (FRBM) Review Committee Report has recommended a debt to GDP ratio of 60% for the general (combined) government by 2023, comprising 40% for the Central Government and 20% for the State Governments.
2. The Central Government has domestic liabilities of 21% of GDP as compared to that of 49% of GDP of the State Governments.
3. As per the Constitution of India, it is mandatory for a State to take the Central Government’s consent for raising any loan if the former owes any outstanding liabilities to the latter.

Which of the statements given above is/are correct?

(a) 1 only 
(b) 2 and 3 only 
(c) 1 and 3 only
(d) 1, 2 and 3

Ans: C

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Mains:

Q. Public expenditure management is a challenge to the Government of India in the context of budget-making during the post-liberalization period. Clarify it. (2019)