PUBLIC DEBT:

Emerging Issue for Indian

Economy?
A Project
submitted to the Department of Economics for the Partial fulfilment
of the Degree of B.Sc.(H).

SUPERVISOR SUBMITTED BY
Ms. Vaishali Gupta Shreya Mahour
Assistant Professor B.Sc. (H) Sem IV
30114

Department of Economics
IIS (deemed to be University)
Jaipur

(2020 – 21)
 Table of Contents

S. No. Topic Page No.

1. Introduction 3

2. Classification of Public Debt 4

3. Causes and Purpose 6

4. Methods of Debt Redemption 7

5. Burden of Public Debt 8

6. Role of Public Borrowing in A Developing 9

Economy
7. India Should Worry About Its Public Debt? 10

8. Conclusion 16

9. Bibliography 17
 INTRODUCTION
Public debt is the total amount, including total liabilities, borrowed by the
government to meet its development budget. It has to be paid from the
Consolidated Fund of India. The term is also used to refer to overall liabilities
of central and state governments, but the Union government clearly
distinguishes its debt liabilities from the states’.

Meaning of Public Debt:

Modern governments need to borrow from different sources when current
revenue falls short of public expenditures. Thus, public debt refers to loans
incurred by the government to finance its activities when other sources of public
income fail to meet the requirements. In this wider sense, the proceeds of such
public borrowing constitute public income. However, since debt has to be
repaid along with interest from whom it is borrowed, it does not constitute
income. Rather, it constitutes public expenditure. Public debt is incurred when
the government floats loans and borrows either internally or externally from
banks, individuals or countries or international loan-giving institutions.

The sources of public debt are dated government securities (G-Secs), treasury
bills, external assistance, and short-term borrowings. According to the Reserve
Bank of India Act, 1934, the RBI is both the banker and public debt manager
for the government. The RBI handles all the money, remittances, foreign
exchange and banking transactions. The Union government also deposits its
cash balance with the RBI.

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 CLASSIFICATION OF PUBLIC DEBT
1. Internal and External: 
When a state finds that it is not possible to obtain further money by taxation, it
resorts to borrowing from citizens and financial institutions within the
country.  This is ‘internal borrowing’. The state may accumulate funds by
raising short-term loans or long-term loans or by both. If the state is passing
through a very critical period, then it can borrow all the money which the nation
saves.  In that case trade and industry will suffer a lot because no money is left
to finance them.  In the normal period, however, the state can borrow only
surplus funds which are left with the businessmen after meeting all the needs of
the business.

External loan is that which is raised from international money markets, foreign
governments, and from international agencies like International Monetary
Fund.  When a state is in need of money, it tries to get as much loan as it can
from other states.  The foreign governments do not advance loans without a
limit.  They minutely study the budgetary position of the borrowing country, the
tax-bearing capacity of the nation, the per-capita income of the people and the
purpose for which the loan is desired.  If the position of the budget is sound and
the taxable capacity of the nation is high, then a foreign government may
advance sizable loan to the borrowing country.

2. Productive and Unproductive: 

The debt that is expected to create assets which will yield income sufficient to
pay the principal amount and the interest on it, is known as ‘productive
debt’.  In other words, they are expected pay their way; they are self-
liquidating.  J.L. Hanson has referred such a debt as ‘reproductive debt’.

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On the other hand, unproductive debt is the debt that is raised for financing
unproductive assets or heavy unproductive expenditures.  Such a debt is a
deadweight debt.  Debt invested on wars or prevention of war is a deadweight
debt.

3. Short-term and Long-term: 

The loans that are repayable within a period of one year, they are termed as
‘short-term loans’ and if they are taken for more than one year, they are referred
to as long-term loans.  Following are the reasons for raising short-term loans:

 If, at any time, the expenditure of the government exceeds the revenue,
then she takes recourse to short-term borrowing.

 If, at any time, the rate of interest in the market is very high and the
government is in need of large fund to finance her various projects, then it
raises loan for a short-period of time only and waits till the prevailing
high rate of interest comes down.

 The commercial banks find a very safe and profitable opportunity to

invest their surplus funds in the government short-term loans.

If the government is in need of large funds and the short-term loans are not
enough, then she takes recourse to long-term borrowing.  Long-term loans entail
following advantages:

 Long-term loan provides an opportunity to the state in undertaking large

projects like construction of canals, hydroelectric projects, buildings,
highways, etc.  As these loans are not to be repaid at a short notice, so the
government safely spends them on productive projects.

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  Long-term loans are also unavoidable for strengthening country’s
defence.

 Long-term loans provide good opportunity for commercial banks and

insurance companies to invest their surplus funds.  As the rate of interest
on long-term loans is higher than on the short-term loans.

 Long-term loans can be repaid by the government by the time which is

favourable or convenient to her.  She can also convert these loans at a
lower rate of interest later on.

  If at any time, the rate of interest is low, the government can contract a
long-term loan and with the amount thus raised some public work
programmes at lower cost.

CAUSES AND PURPOSE OF PUBLIC DEBT

Cause of Increase in Public Debt

 War or war-preparedness, including nuclear programme

 To cover the budget deficits on current account

 To undertake public welfare schemes

 Urge for economic growth

 Inefficiencies of public organisations and corruption

Purposes of Public Debt

I. Bringing gap between revenue and expenditure through temporary loans

from central bank. The Government issues what are called ‘Treasury
Bills’ which are repayable within one year.

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 II. To reduce depression in the economy and financing public works
programme.
III. To curb inflation by withdrawing the purchasing power from the public.
IV. Financing economic development esp. in under-developed countries.
V. Financing the public sector for expanding and strengthening the public
enterprises.
VI. War, arms and ammunition financing.

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 METHODS OF DEBT REDEMPTION
 Utilisation of surplus revenue: This is an old method and badly out of
tune with the modern conditions.  Budget surplus is not a common
phenomenon.  Even when there is a surplus, it cannot be used for making
any substantial reduction in the public debt.

 Purchase of government bonds: The government may buy her own stocks

in the market, thus wiping off its obligation to that extent.  This may be
done by the application of surplus revenues or by borrowing at low rates,
if the conditions are favourable.

 Terminable annuities: When it is intended completely to wipe off a

permanent debt, it may be arranged to pay the creditors a certain fixed
amount for a number of years.  These annual payments are called
‘annuities.  It will appear that, during the time these annuities are being
paid, there will be much greater strain on the government finances than
when only interest has to be paid.

 Conversion of high-interest-rated loans to low-interest-rated loans: A

government may have borrowed when the rate of interest was high.  Now,
if the rate of interest falls, it can convert a high-rated loan into a low-rated
one.

 Sinking fund: This is the most important method.  A fund is created for

the repayment of every loan by setting aside a certain amount every year
out of the current revenue.  The sum to be set aside is so calculated that
over a certain period, the total sum accumulated, together with the
interest thereon, is enough to pay off the loan.

BURDEN OF PUBLIC DEBT

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If the debt is taken for productive purposes, for e.g., for irrigation,
transportation, railway, roads, information technology, human skill
development, etc., it will not mean any burden.  In fact, they will confer a
benefit.  But if the debt is unproductive, it will impose both money burden and
real burden on the economy.

a. Burden of internal debt: Internal debt involves a series of transfers of

wealth within the country, i.e., from lender to government and then later
on at the time of redemption from government to lender.  Money is thus
transferred from one section of the community to other sections.  In this
case the money burden on the economy is zero.

But there may be real burden on the community.  In order to repay the interest
and the principal amount of the debt, the government has to levy taxes.  What
the taxpayers pay the lenders receive.  The lenders are generally rich people and
tax burden is fall on poor especially in the case of indirect taxes.  The net result
may be that the wealth is transferred from poor to rich.  This is the loss of
economic welfare.

b. Burden of external debt: External debt also involves a series of transfer of

wealth from the foreign lender to the borrowing country, and when it is
repaid the transfer is in the opposite direction.  As the borrowing country
paid interest to the foreign lenders, a direct money burden is fall on the
whole community.

The community is also suffered from real burden of external

debts.  Government has to cover the amount of interest to be paid to the foreign
lender by heavily taxing the income of the community.  As a result, the
production, consumption and distribution of income is badly

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affected.  Moreover, the foreign lender has direct involvement in the economic
activities of the country.

ROLE OF PUBLIC BORROWING IN A

DEVELOPING ECONOMY

1. Taxation should cover at least current expenditure on normal government

services and borrowing should resort to finance government expenditure
which results in creation of capital assets.
2. Public borrowing for financing productive investment generates
additional productive capacity in the economy
3. It is used as an instrument to mobilise resources which would otherwise
hoard in real estate or jewellery
4. It provides the people opportunities to hold their wealth in the form of
safe and stable income-yielding assets, i.e., government bonds
5. The management of public debt is used as a method to influence the
structure of interest rates.
6. Public has become a powerful tool of developmental monetary policy
7. There are two ways in which the governments of under-developed
countries raise resources through public loans:

 Market borrowing, i.e., sales to the public of government bonds

(long-term) and treasury bills (short-term) in the capital market
 Non-market borrowing, i.e., issue to the public of debt which is not
negotiable and is not exchange in the capital market, for e.g.,
National Saving Certificates

There are two forms of loans, i.e., voluntary and forced loans.  Forced loans or
compulsory borrowing is a compromise between taxation and borrowing.  Like

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a tax it is a compulsory contribution to the government but like a loan, it is to be
repaid with interest.

INDIA SHOULD WORRY ABOUT ITS

PUBLIC DEBT?
Till 1972, India’s general debt—for the Centre and states—rose steadily to
about 39% of gross domestic product (GDP) and then fell sharply in 1974. After
1996, it saw explosive growth, reaching 57% in 2005. And, in 2018, general
debt was approximately 57% of GDP (Chart 1).
Why should Indian policymakers worry about rising public debt? Does
excessive debt lower economic growth? Does high public debt lead to more
uncertainty and volatility in the economy which then leads to capital outflows
and a depreciation of the currency?
These questions have become especially pertinent in emerging market
economies in a post-covid world that lack the fiscal space for large stimuli.
Such governments are worried about the economic repercussions from a debt
overhang that a large fiscal stimulus will entail.
In a 2020 paper, economists Larry Summers and Jason Furman argue that the
pandemic has depressed real interest rates despite ballooning government debts
in the industrial world. They argue that very low interest rates provide a window
of opportunity to depart from Washington consensus-style debt orthodoxy.
Lower interest rates mean countries are less constrained by fiscal space. Large
fiscal expansions can thus improve fiscal sustainability by raising GDP more
than they raise debt and interest payments.
The numbers certainly seem to support this. Despite a ballooning US federal
debt/GDP ratio from below 50% in 2000 to about 100% in 2020, federal interest
payments in the US as a percentage of GDP in the last 10 years have hovered
between 1% and 2%. Summers and Furman suggest that a new (rough)

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guidepost for fiscal policy should be to keep real interest payments less than 2%
of GDP.
Some economists, like Olivier Blanchard, refer to this as the “new fiscal
consensus", i.e., the notion that in a world of low interest rates, advanced
economies can run limited primary deficits and still keep their public debt
stable.
Should India adopt this “new fiscal consensus"? We argue that it shouldn’t. Just
because interest rates are falling, this does not mean that debt servicing costs are
going down due to rising debt. We also find that high levels of public debt in
India have historically been associated with fiscal dominance, and more
uncertainty and volatility in the economy. Therefore, there are good reasons for
India to worry about its public debt.
Debt decomposition
In recent research, described in two pieces in Business Standard, we analyse the
components that drove the changes in public debt in India between 1951-2018
using a debt-decomposition exercise.
There are four components that change the debt-GDP ratio: the nominal interest
rate, inflation, the real GDP growth rate and a primary deficit/surplus. The
interest rate and primary deficit raise debt, while inflation, the primary surplus
and real GDP growth reduce debt.
When a rise in inflation reduces public debt, economists typically call this debt
liquidation by inflation. Debt can also be liquidated by high real GDP growth,
as it did between 2003-08 in our high-growth years, and economists usually see
this as a better way to reduce public debt.
Using the debt decomposition exercise on aggregate data between 1951 and
2018, we find that inflation’s negative contribution (liquidation) of public debt
was larger than the negative contribution exerted by real GDP growth except for
the single sub-period, 1999-2008. Overall, we find that inflation is the dominant
component in reducing India’s public debt, although the inflation component
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has begun to diminish after the de facto adoption of flexible inflation targeting
(FIT) in India in 2014.
In Chart 1, we also plot the interest rate component between 1960-2018
calculated from the debt decomposition exercise. The interest rate component
here is only based on an effective interest rate, since for historical aggregate
public debt data, it is hard to back out the interest rate pertaining to a security
for a particular maturity. However, we have granular security-level data only
from 2000 onwards that allows us to explicitly calculate an interest rate.
Since 2006, the interest rate component, helped by the enactment of the Fiscal
Responsibility and Budgetary Management Act, exhibits a marked decline. This
is encouraging. Post 2014, the falling interest rate component is also driven by
better inflation management due to FIT.
That said, in magnitude, the interest rate component continues to be high in the
post-reform (post 1991) period, averaging close to 15% between 1990-2018.
During 2008-18, it is close to 12% (i.e., of the 5% increase in India’s public
debt between 2008 and 2018, around 12%, is due to a single factor, the nominal
interest rate).
This is worrisome since a large interest rate component means fewer resources
for important development goals such as health, education and infrastructure.
Remember that the granular security level data for the Centre and states
(sourced from the Reserve Bank of India State Finances and the status papers
from the finance ministry) allows us to paint a much more accurate picture of
the interest rate component’s contribution to changes in public debt. The
maturity structure of public debt allows us to calculate an explicit interest rate
that is not possible with aggregate data. This takes care of measurement error in
the data and helps in lowering the residuals substantially.
Chart 2 plots the nominal weighted average interest rate for all outstanding
central securities from 2000 onwards based on hundreds of securities that we
have data for. For all outstanding central securities, the weighted average

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nominal return continues to be high and has averaged around 7% in the last five
years.
Chart 3 does the same for all outstanding state securities (SDLs) from 2005. For
all outstanding state-level securities, the weighted nominal return is around 5%
in the last five years. Coupled with rising debt, this calls for caution.
The link to volatility
We argued earlier that we find that inflation is the dominant component in
reducing India’s public debt historically. We now ask: Does debt liquidation by
inflation in India historically lead to more volatility and uncertainty in the
economy? And if India’s adoption of FIT de facto in 2014 reduced the extent of
debt liquidation by inflation, would this imply that uncertainty and volatility in
the economy had fallen?
We focus on three variables that could be distorted by inflation-induced fiscal
dominance: households’ savings (in financial and physical assets) as a
percentage of GDP, the REER (real effective exchange rate), and an uncertainty
index (following the seminal work of Nicholas Bloom of Stanford University
and his co-authors), which is available for India on the FRED database since
2003.
We compare the volatility in the pre-FIT (2003-2014) period compared with the
post-FIT period (2014-2018) in these variables. In addition, we look at co-
movements of these variables with the inflation and growth components over
the entire period, 2003-2018, estimated from the debt-decomposition exercise.
The findings: in the pre-FIT (2003-2014) regime, the volatility in all the
variables was higher when compared to the post-FIT (2014-2018) years. The
drop in volatility is considerably higher in the inflation component and the
uncertainty index in the post-FIT years when compared with the pre-FIT years.
This suggests that since 2003, higher values of the inflation component have
been associated with more uncertainty in the Indian economy. We also find that
the relation between the growth component and the uncertainty index is
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negative. This means that higher growth in the Indian economy has been
associated with lesser uncertainty in the period 2003-2018.
These results suggest that while debt liquidation by growth tends to bring down
uncertainty, debt liquidation via inflation led to more uncertainty in the
economy.
There are two other findings of significance. We find a positive co-movement
between REER and the growth component, but negative co-movement between
the inflation component and REER. This suggests inflation-induced pressure on
the Indian rupee to depreciate.
Also, in the post-FIT period, the growth component co-moves positively with
household savings. This suggests that higher economic growth in India has been
associated with a rise in household savings in physical and financial assets in
the last 15-odd years.

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 CONCLUSION
Debt stabilization is the proper objective of fiscal policy. The recently-tabled
N.K. Singh Finance Commission report gets this right. However, a long period
of high public debt-to-GDP ratios in emerging markets like India can alter the
interactions between monetary policy, fiscal policy and government debt
management.
A long period of high public debt raises the spectre of fiscal dominance. As our
research shows, since 1951, inflation’s growing contribution to lowering public
debt shows how the sustainability of Indian public debt has been helped by debt
liquidation in an environment of fiscal dominance.
Encouragingly, the interest rate component on public debt in India has begun to
trend down in recent years. This can be seen in Charts 2 and 3. Using aggregate
debt data (on just the consolidated fund), the interest payments/GDP ratio has
averaged about 1% of GDP in the last few years according to our calculations.
This may suggest there is fiscal space, but this view is misleading. The interest
rate component of public debt, despite trending down, continues to remain
elevated. Debt servicing costs will remain a cause of concern especially in a
post-covid world when public debt in India is expected to rise substantially.
It is a travesty of justice that both public health and education allocations will
suffer with rising debt-servicing costs given that in recent years the spending on
these items as a share of GDP are already abysmally low.
India really needs to worry about its public debt.

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 BIBLIOGRAPHY

https://www.livemint.com/news/india/india-should-worry-about-its-public-debt-
11612797538032.html
https://www.business-standard.com/about/what-is-public-debt
https://sites.google.com/site/maeconomicsku/home/public-debt
https://dea.gov.in/divisionbranch/public-debt-management-cell

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