Is India Heading Into Another Debt Crisis?

By Scott B. MacDonald

PWhile international analysts usually focus on external debt as a key factor of a country's creditworthiness, domestic debt must also be considered. This is an issue for Brazil, Latin America's largest debtor. Increasingly it is an issue for one of the Asia's largest economies - India. Public sector debt (domestic debt) to GDP is currently at its highest ever level of 70.5% of GDP in FY2002. This is from a recent low of 56.5% in F1997. There is a good chance that the debt level could climb even higher, to around 75% by FY end 2003. What is alarming about the rise in domestic debt in India is that both state and central governments do not appear to be unduly concerned about the trend and there is little sign of any relief in the medium term.

The ongoing threat of war with Pakistan, the interrelated security concern with terrorism, the ongoing turmoil in Kashmir, and the larger game of geo-political manuevering vis-a-vis China all appear to be overriding considerations to trimming the budget and bringing public debt under control. Although it is too early to proclaim that India is heading into another debt crisis, it does not take a great leap of the imagination to see that if current trends continue, the South Asian country will have substantial debt management problems.

India's has had problems with its debt burden before. In the late 1980s domestic debt rose substantially, This proved to be a major problem when the international environment turned highly negative in 1991, ultimately causing a balance of payments crisis. In the aftermath of the 1991 crisis, the Indian government worked hard to reduce the onerous debt burden. Public sector spending was controlled and new economic reforms helped bolster growth, which brought in greater revenues. Despite security concerns, Indian finances improved through the first half of the 1990s. However, there was considerable policy erosion in the late 1990s as coalition governments led by the Hindu nationalist-Bharatiya Janata Party (BJP) were forced to strike deals with regional parties to maintain parliamentary majorities. Having a coalition of two dozen parties did not help the policy process. In particular, it weakened debt management.

While central government finances worsened, state governments were allowed to spend in a relatively unconstrained fashion. The end result was that internal debt rose to an all-time high of 70.5% of GDP in FY2002. Prime Minister Atal Bihari Vapayee has remained in office for two terms, but his government is paying the price. Consequently, three key trends mark India's finances - the consolidated fiscal deficit is on the rise, state finances are eroding at a faster pace than before, and off-balance-sheets liabilities are climbing. According to Standard & Poor's, India's budget deficit is expected to reach 6% of GDP in the current fiscal year (ending March 31, 2003). Counting state finances it could be higher, closer to 10% of GDP.

Standard & Poor's is forecasting that the consolidated debt of the central and state governments could exceed 80% of GDP this year, while the public-sector borrowing requirement, including all levels of government and the enterprises they control, may exceed 12% of GDP. Interest payments alone are likely to consume nearly half the central government's revenue. S&P also noted: "Its largely unreformed public sector, whose inefficient operations constrain prospects for economic growth and pose a contingent liability to the sovereign. For example, the cost of bailing out government-owned financial institutions (including the Unit Trust of India, the country's largest mutual fund, which had been bailed out once before in 1998 but not restructured) may exceed 1.5% of GDP. At the state level, the annual losses of electricity boards exceed 1% of GDP, weakening already-poor state finances."

India is not sitting on the brink of another debt crisis - so far. However, the trends are worrying. Unlike in the late 1980s and early 1990s, India has seen strong inflows of foreign exchange over the last few years, with reserves reaching $29.4 billion (5.1% of GDP). In the balance of payments, India's growing flow of "invisibles".i.e., remittances, sofware exports and tourism has helped to reduce pressure. In fiscal year 2002, invisibles accounted for close to $36 billion, equal to 5% of GDP. At the same time, interest rates have declined - always a help for large-scale debtors.

Yet, prospects for resolving the looming debt crisis are mixed at best. The political situation remains complicated, security concerns command policymakers attention and the ability of the government to forge ahead with privatization sales that could help reduce fiscal pressure are bogged down in nationalist and coalition politics. In its most recent Article IV report on the Indian economy, the International Monetary Fund clearly stated its concerns, that "recent trends-large primary deficits, growing debt, and the sharp narrowing of the growth rate-interest rate differential-are creating conditions for potentially unsustainable debt dynamics. The weak fiscal situation leaves little room for maneuver in macroeconomic policies and could entrench the cycle of decelerating growth and deteriorating fiscal balances."

The IMFis not alone in these sentiments. On September 8, 2002, Moody's Investors Service commented: "The government's rising debt service burden is consuming an overwhelming share of its limited financial resources, leaving the authorities with little fiscal room to redress the country's infrastructure and social problems, much less business cycle slowdowns. The fiscal dilemma also constrains monetary policy, dampening longer-term investment and growth prospects. Even with growth at 5%-6%, average living standards are stagnating. The dependence upon non-resident capital to finance the current account gap is also not sustainable, particularly in view of the volatile political scene."

Reflecting many of the same concerns, S&P downgraded India's ratings on September 18, 2002. Maintaining a negative outlook, the rating agency stated: "Continued large fiscal deficits, along with a languid pace of economic reform, would lead to a further ratings downgrade."

Although the government is aware of the issue, there are so many other major issues clamoring for attention. Consequently, the domestic debt problem represents a slow-moving, yet still very real, potential crisis for the government. Unable to push reforms at a faster pace, its privatization program off track, and increasing problems with its power sector (slowing prospects for growth), the BJP government will eventually be forced to return to the domestic agenda.

Prospects for a new Gulf War, with the potential for another spike in oil prices, should worry New Delhi. While it is not likely to provoke another crisis as in 1991, it will push India's finances into a much tighter situation. If unchecked, India will find itself in more dire straits as the decade continues.