Chapter 6. India: Dealing with Perennial Fiscal Deficits

Hamid Faruqee, and Krishna Srinivasan
Published Date:
August 2013
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Mitali Das1

India’s fiscal imbalances have remained large despite a sustained period of high economic growth. Large budget deficits and high public debt can be traced to a political economy that exerts strong pressure on spending, a weak revenue system, and financial restrictions that permit weak fiscal balances to persist with little market stress. At the same time, high growth and favorable demographics have caused private saving to surge. The perpetuation of fiscal imbalances poses risks for macroeconomic stability, as evident from recent developments in major advanced economies. Fiscal adjustment is needed to reduce imbalances and sustain growth.

Widespread economic reforms following an external crisis in 1991 ushered in an era of impressive growth in India. Widening fiscal and external deficits came to the fore in 1991 when a rapid deterioration in public finances, coupled with an oil price shock and heightened political uncertainty, resulted in a classic balance of payments crisis. The postcrisis adjustment—which included a wide spectrum of fiscal, financial sector, and capital account reforms aimed at reducing government control, cutting back on the red tape required to operate a business, and providing a larger role for market forces—raised the potential for higher growth. Real output growth, which had averaged an annual rate of 4½ percent from 1976–91, rose to an annual average of 6 percent from 1992–99. Growth then edged higher, to an average 7.2 percent between 2000 and the run-up to the global financial crisis (Figure 6.1). The crisis only modestly slowed this momentum, as output continued to grow in excess of 6 percent each year from 2008–11.

Figure 6.1India: Real GDP Growth


Source: IMF staff calculations.

Despite highly favorable growth-interest differentials, fiscal imbalances have remained large. General government deficits averaged 7.7 percent of GDP between 1992 and 2007 (Figure 6.2). Primary deficits were lower, averaging 2.4 percent, but large enough to result in a steady increase of over 14 percentage points in the gross public debt ratio from 1995–2003, peaking at 84.3 percent in 2003. A sustained consolidation effort, including the adoption of fiscal rules in 2003, put fiscal positions on the mend in the years preceding the crisis. But fiscal imbalances deteriorated again with the onset of the crisis.

Figure 6.2India: Debt Dynamics

(In percent)

Sources: CEIC; and IMF staff calculations.

1The differential, in percentage points, is real GDP growth less real yields on 10-year government bonds (calculated using the GDP deflator).

After a modest improvement for a few years following the country’s 1991 economic crisis, fiscal positions worsened through the early 2000s. The revenue share of GDP stayed broadly flat over the 1990s, while the expenditure share was on a mild upward trend. Thereafter, despite significant improvement in revenue collection, which rose some 2.1 percentage points of GDP from 1998–2004, expenditures rose nearly in parallel, owing to rising interest payments and unrelenting increases in subsidies, wages, pension payments, and defense spending. A strong effort at fiscal tightening then helped lower deficits and the debt ratio. Following government passage of the Fiscal Responsibility and Budget Management Act (FRBMA) in 2003, public debt receded nearly 10 percentage points between 2004 and 2008 to 74.7 percent of GDP in 2008, assisted by a brief surplus in the primary balance and sizable growth-interest differentials.

Progress with deficit reduction reversed following the global financial crisis. A combination of spending measures introduced prior to the crisis, a soaring subsidy bill, a large fiscal stimulus, and a cyclical downturn in revenues widened the overall deficit from 4.2 percent of GDP in 2007 to over 9 percent in 2009 (Figure 6.3). However, a spike in the growth-interest differential, reflecting the swift recovery and low real interest rates, helped keep the growth of public debt in check. It fell to 67.3 percent in 2010, but remained highest among the G20 emerging market economies.

Figure 6.3India: General Government Finances

(Percent of GDP)

Source: IMF staff calculations.

Large public dissaving and high investment needs have kept the external position in modest deficit despite a secular increase in private saving. In particular, national saving and investment have evolved on parallel trajectories, each only modestly rising between 1985 and the late 1990s, before escalating sharply through 2009. Trends in national saving and investment have been driven overwhelmingly by private sector behavior.

Private sector investment boomed following the economic reforms of the 1990s, while public sector investment declined sharply (over 4 percentage points of GDP from 1991–2001), particularly in much-needed infrastructure investment, as a result of the government’s early efforts at deficit reduction (Figure 6.4). Public sector capital expenditures rose modestly over 2001–09, but have played a negligible role in the dramatic rise in national investment. Although private gross investment is relatively high,2 private sector participation in the critical area of infrastructure development has been disappointing in the past, owing to a combination of limited financial sector deepening, capital controls, and governance problems.3

Figure 6.4India: Investment

(Percent of GDP)

Source: IMF staff calculations.

The surge in private saving has been led by the household sector. An era of high-income growth combined with the life-cycle implications of a rising working-age population has resulted in a rapid increase in household saving rates, which rose 10 percentage points as a share of GDP between 1991 and 2009 to reach 24 percent (Figure 6.5). Corporate gross saving rose as well by about 5 percentage points in this period, reflecting improved profitability following the financial reforms of the 1990s (Figure 6.6). Corporate excess saving (gross corporate saving less corporate investment), though, remained negative, as private investment boomed. At 34 percent of GDP in 2010, India’s private saving rate was second to China among G20 economies.

Figure 6.5India: Saving

(Percent of GDP)

Source: IMF staff calculations.

Figure 6.6India: Financial Surplus by Sector

(Percent of GDP)

Sources: CEIC; and IMF staff calculations.

Risks of perpetuating imbalances over the medium term are high. With growth projected to remain robust and the government’s announced commitment toward fiscal consolidation, IMF staff’s baseline projection is for the public debt ratio to fall about 5 percentage points between 2010 and 2016 to 62 percent, in line with authorities’ targets.4 However, risks to this forecast are high, stemming from pressures for social spending and infrastructure investment, inertia in withdrawing fiscal stimulus, and continued delays in planned tax reforms. IMF staff project that high growth and favorable demographics will push private saving rates higher in the medium term, to 37 percent of GDP by 2016.

Root Causes of Imbalances

Root causes of fiscal imbalances can be traced to political economy factors that exert strong pressure on spending and resistance to raising taxes, a weak revenue system, and government regulations that permit fiscal excesses to be financed with little market stress. Rapid growth and favorable demographics underlie private saving imbalances, while missing insurance markets also play a role. The factors behind each of India’s major imbalances are described below.

Fiscal Imbalances

The rising share of expenditure in GDP through the late 1990s and early 2000s and then again in the years before the global financial crisis—without a commensurate increase in the revenue share of GDP—reflects the failure of the government to take advantage of a sustained boom to build fiscal space. On the expenditure side, major factors include large outlays on subsidies, due in part to of a high incidence of poverty, a succession of coalition governments, and federal-state fiscal arrangements. The key factor on the revenue side is a complex and outdated tax code. High private saving, capital controls, and statutory purchase of government securities by financial institutions combine to provide stable and relatively low-cost financing for public debt.

The benefits of greater economic prosperity have accrued unevenly, resulting in persistent pressure to increase government social spending. India’s social indicators compare unfavorably regionally as well as with other G20 emerging market economies. In particular, while India’s poverty rates have declined over the past two decades, the World Bank estimates that 42 percent of the population (410 million people) remained impoverished as of 2005 (Table 6.1).5 As a consequence, there is persistent political pressure to increase social spending and subsidize commodities (notably fuel and food). Subsidy spending accounted for 2.1 percent of GDP in 2009, almost as much as expenditures on all of health and rural development. Meanwhile, the expansion of safety nets in recent years has resulted in a steady increase in nonsubsidy social expenditures as well, which accounted for 3.1 percent of GDP in 2009.

TABLE 6.1India’s Social Indicators Compared with Other G20 Emerging Market Economies(Percent)
Saudi Arabian.a5.347.2
Source: World Bank.

Percent of population earning less than $1.25 a day at purchasing power parity.

Percent of children malnourished, weight for age (under five years old).

Percent of population aged 15+.

Source: World Bank.

Percent of population earning less than $1.25 a day at purchasing power parity.

Percent of children malnourished, weight for age (under five years old).

Percent of population aged 15+.

Rising expenditures are partly a result of an era of coalition governments. Since the mid-1990s, as regional parties with diverse regional interests have strengthened, the central government has had to depend on coalitions of as many as 16 distinct political parties to stay in power. Catering to a wide range of ideologies and constituencies has necessitated fiscal forbearance and made it politically more difficult to withdraw or reform populist schemes such as subsidized commodities and cheap electric power, which have often been poorly targeted. Moreover, implementation of social assistance programs has been inefficient, resulting in significant leakage and the denial of benefits to eligible persons (Comptroller and Auditor General of India, 2008). This reflects the absence of a system of unique identification or national registers (that is only now being gradually implemented) and poor enforcement.

The federal-state tax and spending structure has made it difficult to enforce fiscal discipline. Under India’s fiscal federalism, about two-thirds of tax revenue is collected by the central government, while states are tasked with carrying out a similar proportion of general government expenditures—using tax-sharing and transfers from the central government—to implement government policies.6 With implicit central government guarantees on state government debt, the system offers a high degree of autonomy to states but few incentives to maintain fiscal restraint (since the mid-2000s, a majority of states have adopted their own fiscal responsibility rules).

During the 1990s, deteriorating general government balances reflected rising fiscal excesses at the state level. In particular, the trend decline in central tax collection over the 1990s led to a reduction in transfers to states. However, states not only failed to raise their own revenues, but also retained a high level of spending.7 Consequently, their contribution to the general government deficit rose from 35 percent in 1992 to nearly 50 percent in 1999 (Figure 6.7).

Figure 6.7India: Central Government and State Shares in Government Gross Deficits


Sources: CEIC; and IMF staff calculations.

Note: The gross fiscal deficit is defined here by total expenditure, inclusive of net loans, minus revenue and nondebt capital receipts.

Differences in tax collection responsibilities partially explain the varying evolutions of central and state government fiscal deficits. The central government is assigned tax collection for customs and excise duties, from which it draws its largest share of revenues, while states collect taxes on commodities and services, which constitute the preponderance of state revenues. This system has meant that both the economic cycle and structural changes (e.g., in demand for commodities) have played a role in determining the evolution of central versus state government deficits.

A narrow tax base, poor compliance, and weak collection efforts have eroded tax revenues. A comparison of general government revenues across emerging G20 economies indicates that India (with a 2010 revenue share of GDP equal to 18.5 percent) is at the bottom end in revenue collection (Figure 6.8).8 In part, this reflects the low buoyancy of the tax system, which is narrowly based on indirect taxes and manufacturing activity, with agriculture and the rapidly growing services sector largely outside the tax net. It also reflects weak enforcement, extensive loopholes, and political resistance to raising taxes in a still-poor economy.

Figure 6.8General Government Revenues among G20 Emerging Market Economies, 2010

(Percent of GDP)

Source: IMF staff calculations.

Incomplete tax reforms after the external payments crisis contributed to declining revenues over the course of the 1990s. Revenue collection dropped by 1.6 percentage points of GDP from 1992–99, even as household and corporate incomes surged. In part, this reflected the impact of trade and financial liberalization reforms, which narrowed the tax base by cutting trade tax rates and customs duties, but without (planned but not implemented) compensating hikes in direct taxes and measures to reduce exemptions and loopholes.

Income tax revenues have been stagnant due to constant adaptation of exemption levels and income brackets. Despite a highly progressive income tax code, and private nominal incomes that escalated sevenfold from 1991–2008, the share of personal income tax revenues in GDP remained very low, exceeding no more than 3.6 percent of GDP.9 While any explanation must include low compliance, political economy played a significant role. In particular, the tax schedule was changed repeatedly, with continuous increases in exemption thresholds and income brackets (Piketty and Qian, 2009). Notably, the rise in thresholds was almost as large as the rise in nominal income growth itself. As a result, the population subject to income tax rose modestly, from about 1 percent in 1991 to 3 percent in 2008 (Piketty and Qian, 2009). This is a reflection of strong political resistance to taxation given the still-high incidence of poverty, and the ineffectiveness of tax policy given the very large share of informal workers.

Financial Controls

High levels of private saving, capital controls, and statutory requirements for investing in government securities have allowed for financing fiscal deficits without discernible market stress. Despite major financial sector reforms starting in the 1990s, the government’s statutory liquidity ratio (SLR) currently requires banks to hold one-fourth of their deposits in the form of government or other approved securities,10 while insurance and provident funds are also subject to similar investment regulations. In combination with capital controls and an increasingly large pool of household saving, this system has provided a stable and relatively low-cost source of funds for financing government debt. Indeed, from 2001–07, on average, 50 percent of household saving was used to finance fiscal deficits (Figure 6.9). Moreover, regulatory requirements that direct private sector resources toward the purchase of government securities have hindered development of the corporate debt market.

Figure 6.9India: Use of Household Financial Saving

(Percent of household financial saving)

Sources: CEIC; and IMF staff calculations.

Note: Public and private investment are in net terms (investment less saving). “Foreign” is the current account balance.

High administered interest rates on small saving schemes have reinforced the effects of statutory requirements on banks. Small saving schemes are government-operated deposits in post offices and provident funds that are used exclusively to finance government debt (Figure 6.10).11 The need to ensure adequate resources to finance the government’s large borrowing has kept (administratively set) interest rates on these schemes high.12

Figure 6.10India: Financing of Government Debt

(Average percent share over 2000–08)

Source: CEIC.

These high interest rates on small saving schemes have also distorted lending and borrowing behavior in the banking sector. In effect, they force banks to keep their deposit rates high and, thus, lending rates high as well (Figure 6.11). For borrowers, this has served to dampen credit demand, particularly for small and medium-sized enterprises (SMEs), which have few financing options beyond bank credit.

Figure 6.11India: Lending and Deposit Rates in Commercial Banks and Small Saving Schemes


Sources: CEIC; Reserve Bank of India; and IMF staff calculations.

Finally, SLRs and high administered rates on small saving schemes, in conjunction with inadequate improvement in the financial sector’s risk assessment framework, have resulted in perpetuating distortive financial restrictions. In particular, while economic reforms in the 1990s improved competitiveness, they also raised the risks of lending, without an accompanying increase in banks’ capacity to evaluate or handle these risks (Banerjee and Duflo, 2002; Singh and Srinivasan, 2005). As a result, in periods of high administered rates (and consequently high bank lending and deposit rates), investment in government securities has provided a relatively attractive and less-risky alternative than providing credit to the private sector, given the lack of opportunities for investing in corporate bonds and external capital controls that limit investment abroad (Table 6.2).13 This confluence of distortions created by the SLR and high administered rates, along with very gradual improvement in banks’ regulatory framework, has contributed to sustained periods of “lazy banking,” reducing banks’ role in financial intermediation.14 In addition, it has raised interest rate risk due to a significant maturity mismatch in banks’ balance sheets.

TABLE 6.2India: Commercial Banks’ Holdings of Securities(Percent of deposits)
Goverment securitiesOther securities
Source: CEIC.
Source: CEIC.

Private Saving Imbalances

The surge in household saving reflects the dramatic rise in disposable incomes and a rise in the working-age ratio. Household saving rates in India have been on the rise for over four decades, increasing steadily from 9 percent of GDP in 1970 to nearly 24 percent in 2009.15 High growth has boosted household incomes beyond subsistence consumption levels. Indeed, personal disposable income nearly tripled in real terms over 1991–2008. As many households’ incomes surpassed their sub-sistence levels of consumption, household saving ratios increased (Figure 6.12). As a result, the real private consumption share of real GDP has been in steady decline, falling from 69 percent in 1991 to 59 percent in 2010. Even so, real private consumption grew at a robust annual rate of 6 percent during this period.

Figure 6.12India: Private Disposable Income and Consumption

(Billions of 2005 rupees)

Sources: CEIC; and IMF staff calculations.

At the same time, a significant rise in the working-age dependency ratio has contributed to high saving rates. India is in the midst of a demographic transition that has lifted the share of the working-age population from 58 to 64 percent over the last two decades. The observed rise in household saving thus conforms to the predictions of the life-cycle hypothesis.

Inadequate insurance vehicles and limited access to credit have played a role in the accumulation of household saving. Households and SMEs face barriers to obtaining credit, which has contributed to the high rate of saving. Moreover, a poorly developed and state-dominated system of life insurance and a nascent private health insurance industry, combined with little scope for provident saving for informal workers, forces households to save. However, as these factors have been in place for decades, they are not an explanation for the escalation in household saving rates.

Corporate saving has also played a role in rising private saving rates. Corporate saving rates languished between 1½ and 2½ percent of GDP from 1970–90, and then rose modestly in the 1990s. It was only in the early 2000s that corporate saving rose much more sharply, from 4.5 percent in 2003 to a peak of 9.5 percent prior to the global financial crisis. This occurred primarily due to significant restructuring of corporate balance sheets in the early 2000s.

Are India’s Imbalances a Problem?

Large fiscal imbalances pose risks to macroeconomic stability and domestic growth objectives, perpetuate financial restrictions that create distortions, and restrain development of the financial sector. The primary effects of fiscal imbalances fall on India itself, although a collapse in the country’s growth would slow the global economy, and a sudden stop in capital inflows could create financial disruptions for other economies. Key problem areas are examined below.

Financial Sector and Growth Implications

The perpetuation of financial sector investment restrictions will likely pose a significant constraint on India’s ability to realize its development potential. Subjecting domestic financial institutions (banks, insurance, and provident funds) to punitive regulatory requirements, and distorting credit markets by setting deposit rates that do not necessarily reflect market conditions, distorts the allocation of private saving, crowds out private investment, and potentially lowers growth.16

Financial restrictions on asset purchases, for example, limit financial deepening and restrain much-needed infrastructure investment. Mandated purchase of government securities has curtailed the availability of domestic credit for the private sector and restrained development of a corporate bond market. Although caps on foreign purchases of domestic bonds have been raised substantially in recent years, foreign participation has not increased significantly—held back by other impediments such as minimum maturity requirements, unfavorable tax treatment, and lock-in periods.

Meanwhile, firms have been forced to borrow from commercial banks at adjustable rates, or borrow long term in foreign currency, to fund investment projects, which has raised exposure to currency and interest rate risk. Given segmentation in credit markets, credit constraints have been particularly acute for SMEs. Aside from the usual crowding out of private investment due to large public dissaving, policy-induced distortions in lending and borrowing rates have also served to reduce credit for the private sector. Capital controls, instituted with a view toward minimizing exchange rate risk and preserving macroeconomic stability, have hindered firms’ access to foreign saving at competitive prices. If capital account restrictions were gradually eased, there could be further efficiency gains in financial intermediation and greater availability of credit for domestic entities.17

With large infrastructure needs and limited fiscal space, India’s Eleventh Five-Year Plan (2007–12) called for higher private sector involvement in much-needed infrastructure investment. The long-term nature of these projects has, however, laid bare the impediments to meeting these goals. A particular concern for the bank-dominated financial system is the risk of large maturity mismatches, while capital controls have limited foreign financing. Coupled with deep structural rigidities, including governance problems and implementation risks, envisaged private sector participation in this critical sphere of development could again fall short of targets.

Macroeconomic Stability Implications

Fiscal consolidation should help maintain macroeconomic stability, create policy space for contingent needs, and limit vulnerability to external shocks. As evident from recent developments in major advanced economies, market sentiment toward sovereigns with large fiscal imbalances can shift abruptly, resulting in higher risk premiums and adverse debt dynamics. The following are the key elements of fiscal consolidation:

  • Narrowing of the growth-interest differential. Public debt has grown even as growth-interest differentials have been large and positive. In part, this is because a number of factors have kept the cost of government borrowing low, including the captive base for government securities and capital controls. But the large differential is unlikely to persist, especially if integration with global financial markets continues to increase and SLR requirements on domestic financial institutions ease. Independently, a protracted growth shock could set public debt on a potentially unstable path.

  • Reconstituting fiscal space. A perpetuation of fiscal imbalances limits the space for countercyclical policies when needed, and raises the risk of a higher risk premium on debt over the medium term. Interest payments currently absorb 25 percent of total revenues, and could become explosive if yields were to rise.

  • External balance. Higher public and private sector investment, notably in infrastructure projects, and lower private saving (to the extent that household saving reflects the lack of social insurance) are both desirable. To minimize pressure on the current account, these shifts in national investment and private saving must be offset by smaller government budget deficits.

How to Address Imbalances

To address imbalances and sustain high growth, India should embark on durable fiscal consolidation, while increasing public investment in much-needed infrastructure projects. The plan to bring the general government deficit down by 2015, anchored by a broad-based consumption tax, is an appropriate objective. The key will be implementation. Relaxing investment restrictions on financial institutions would create a favorable environment for increasing private sector participation in infrastructure development. To the extent that high private saving reflects the lack of social insurance, safety nets could be strengthened. The key domestic policy priorities are elaborated in turn below.

Tax Reforms

Given the projected and necessary increase in public infrastructure investment, and pressing social needs, tax reforms are critical for fiscal adjustment. Overperformance of public finances during the current expansion will help reconstitute fiscal space. Although revenue growth has been relatively strong in the recovery, there is further scope to widen the tax base, streamline collection, and improve compliance. A key challenge of current tax proposals is to overcome the political economy of shifting tax collections from the center to the state, given the increasing relative power of the states.

A nationwide Goods and Services Tax (GST) would simplify the tax system, widen the tax base, and increase revenues in the long run. The government has recommended implementing a GST as a value-added tax.18 This tax would replace India’s web of state- and national-level excise, sales, and value-added taxes with a unified consumption-tax framework, and draw in the entire consumption base by taxing imports while excluding exports. Although this reform has been designed to be revenue-neutral, the replacement of India’s current system with the more streamlined GST is likely to raise compliance and hence revenues.

Reform of the personal and corporate income tax code is long overdue. The scope of the government’s proposal for a new Direct Tax Code (DTC), which has provisions to limit deductions and widen the tax base, could be expanded. Although the DTC is planned as revenue-neutral, implementation of it in combination with the GST will likely enhance growth by reducing distortions.

Improving tax compliance and enforcement could significantly raise tax revenues. That less than 5 percent of the population pays income tax even as the ranks of the middle class have swelled is indicative of room to raise income tax revenues by increasing compliance. Accelerating the development of a National Population Register, thus far discussed in the context of better targeting subsidies to the poor (see below), could vastly improve tax collections.

Finally, more ambitious revenue-raising reforms should also be considered. For example, rates on the top income brackets (currently 30.9 percent) could be increased, possibly by reversing the recent reduction of the highest income tax bracket. Given the scope for tax arbitrage if personal income tax rates are raised and corporate tax rates are reduced, any reform of the tax code must take into account the full impact of a tax revision on raising revenue.

Spending Reforms

Greater spending efficiency of government programs is key to square the stated consolidation objectives with significant social and infrastructure needs. Policy priorities are to shift government funds from nonessential expenditure toward infrastructure development, better allocate funds for subsidies, improve targeting, and increase the use of performance-based incentives to improve spending efficiency. Other reforms, such as land reform and reducing red tape, would improve governance and policy predictability but are also critical for infrastructure development.

There is significant potential for reforms of subsidies to reduce costs and improve social outcomes. Major subsidies, notably on fuel products, impose a high cost on the government budget, are poorly targeted (and mostly regressive), and present opportunities for arbitrage. Recent subsidy reforms, including liberalization of petrol prices, are a step in the right direction. Additional reforms include replacement of some subsidies with targeted support (e.g., cash vouchers) and accelerating development of the National Population Register and Unique Identification Number (UID) to help target subsidies more effectively.

The planned expansion of social spending must be undertaken with a view toward increased efficiency of implementation. Given the country’s pressing social needs, expanding education and employment programs are necessary to achieve inclusive growth. Furthermore, steps could be taken to ensure that the food security bill currently being discussed, which proposes to provide subsidized rice or wheat to eligible households, is affordable and well-targeted. To reconcile expansion of social programs with planned fiscal consolidation, it is critical to improve spending efficiency (e.g., by making greater use of performance-based incentives). Without such efficiency gains, targets in the FRBMA could only be met by tightly constraining public investment, which would undermine growth.

The commitment to fiscal consolidation in the 2011/12 budget as well as in the Government Debt Report has improved transparency and strengthened India’s medium-term budget framework. Authorities could also provide details quantifying how they envisage fitting rising capital and social expenditures into a budget envelope that declines as a share of GDP. To minimize the risk of reversals in consolidation, it is crucial to amend the FRBMA, as recommended by the Thirteenth Finance Commission, including by tightening escape clauses and introducing a fiscal oversight committee.

Financial Sector Reforms

Ensuring more efficient intermediation of domestic savings will require a concerted effort toward financial sector reform. Gradually reducing the SLR will not only free up funds for private borrowing but will also allow government bond interest rates to become truly market-determined. That would allow government rates to become true benchmarks, paving the way for the development of the corporate bond market. At the same time, steps should be taken to boost bond market liquidity and develop securitization and hedging instruments both to ensure sufficient long-term rupee debt resources for domestic investment needs, and to help banks manage their liquidity and concentration risks.19 Meanwhile, continued reduction of the SLR and opening of the financial sector would provide government the incentive to adjust by narrowing its base of captive finance.

Development of a health insurance industry will aid in reducing households’ precautionary saving. Studies indicate that the financial burden on Indian households from health spending is significant (Balarajan, Selvaraj, and Subramanian, 2011). Over 70 percent of all health spending is out of pocket (USAID, 2008), and the 2004 National Sample Survey revealed that about 6 percent of families became impoverished due to health expenses. A slowly growing private health care industry is largely unregulated and costly for most, and only 20 percent of the population has any form of health insurance. Steps must be taken to expand hospitalization insurance, including through partnerships between the government and nongovernmental organizations, in order to improve access to health care, minimize out-of-pocket expenses, and reduce the precautionary basis for household saving.

Toward Global Action

Strengthened policy actions in India should consider fiscal consolidation along with the removal of distortive financial restrictions as part of global rebalancing efforts across major economies. Fiscal adjustment—improving the government’s budget deficit after five years—would be in accordance with the Thirteenth Finance Commission’s medium-term plans. Fiscal adjustment should rely primarily on revenue-raising measures. Reduced SLR requirements on banks would free resources for the private sector, reducing their real cost of capital and thereby boosting investment. For the government, liberalizing financial controls would entail higher interest rates (larger debt service), which would be offset by higher value-added tax and labor income tax revenues. Specific reforms would include an increase in the consumption tax (GST), which would minimize tax distortions and which at present is very low by international comparison, as well as an increase in labor income taxes. Raising the GST may not suffice to reduce the budget deficit to target levels, in which case remaining revenues would come from the increase in labor income taxes.


Mitali Das is a Senior Economist in the IMF Research Department. This chapter was written with guidance from Josh Felman, input from Michal Andrle, and support from Eric Bang, David Reichsfeld, and Anne Lalramnghakhleli Moses.

India’s private investment rate is the highest among emerging G20 economies (and other economies at a similar level of per capita income). Among emerging G20 economies, India’s national investment rate is second to that of China.

However, during the first half of the Eleventh Five-Year Plan (2007–12), private sector participation in infrastructure investment exceeded plan projections.

See India Article IV Staff Report (IMF, 2012).

Using the World Bank indicator of poverty based on the headcount of persons (percent of population) earning less than $1.25 a day at purchasing power parity.

The share of central government revenues transferred to states changes over time. It is set by the Finance Commission, a constitutional body that meets every five years with the primary purpose of determining the sharing of centrally collected tax proceeds between the central and state governments, and the distribution of grants-in-aid of revenue across states.

Both central and state budget deficits rose in part due to the large wage increases recommended by the Fifth Pay Commission.

India’s revenue share of GDP fell in the lower third of the distribution each year from 2007–10 among economies whose nominal U.S. dollar GDP per capita was between $648 and $1,488 in those years.

IMF staff estimates using data from the World Economic Outlook and CEIC databases, calculated as the ratio of direct taxes paid by households and miscellaneous receipts of government to GDP.

As part of financial sector reforms in the 1990s, the SLR was progressively reduced from 38.5 percent in 1991 to 25 percent in 1995. In December 2010 it was lowered to 24 percent.

These schemes drew about 21 percent of aggregate bank deposits from 2000–08 and provided an average of 16 percent of funding for government debt in this period. Meanwhile, public sector debt to foreign creditors peaked at 37 percent of GDP during the external payments crisis, declined thereafter, and is virtually absent presently. The only external debt the public sector has currently is to multilateral institutions.

In Figure 6.10, market borrowing refers to bank bond purchases under the SLR.

Investment in government securities has the added advantage of having a low risk rating in meeting capital adequacy requirements.

While the 1990s reforms reduced the SLR from nearly 40 percent to 25 percent, banks’ investment in government securities has since systematically surpassed these requirements, notably in long-maturity government bonds. In part, some excess holding of government securities could be due to banks’ liquidity needs, given that the SLR cannot be used to obtain liquidity from the Reserve Bank of India. More recently, holdings above the SLRs could be due to an upward shift in the yield curve, which may have discouraged banks from unwinding such holdings as that would have resulted in losses being crystallized. However, these are unlikely to be a complete explanation, given that banks have held as much as 40 percent of deposits in government securities, including in periods (e.g., 2003) when bond yields remained largely flat.

IMF staff analysis suggests that demographic, socioeconomic, and macroeconomic variables partially explain India’s high private saving rate (IMF, 2010). These empirical estimates do not explicitly take into account whether the lack of insurance affects private saving.

The positive effects on growth from unwinding investment restrictions could potentially involve some trade-offs. In particular, such unwinding could affect fiscal dynamics by raising the growth-adjusted effective interest rate paid on government debt.

Since the 1990s, capital controls have been gradually liberalized, and remaining restrictions are focused on areas such as foreign purchases of Indian bonds and resident outflows. The full removal of capital controls must, however, be mindful of the risks involved, including a possible increase in domestic interest rates (if Indian financial intermediaries decide to move assets abroad), as well as higher volatility of interest rates, which could be damaging for growth. Furthermore, as capital controls strengthened India’s resilience to potentially destabilizing outflows during the recent crisis, authorities must retain sufficient flexibility to put them in place if circumstances dictate doing so.

The proposal is that the central government would tax goods at 10 percent, services at 8 percent, and essentials at 6 percent, with the recommendation that states add identical rates. That is, the total rate on goods would be 20 percent.

Steps taken to reduce statutory requirements on the purchase of government securities must be mindful that banks continue to abide by international best practice (i.e., Basel liquidity standards).

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