Personal Website of R.Kannan
Students Corner - A Decade of Economic
Reforms in India - A Review

Government consumption and investment spending constitute an important part of aggregate demand in the economy. It influences growth through several channels. An increase in public spending on physical capital could positively influence the long-term growth. The impact of such spending in human capital formation could be larger but benefits require longer gestation period. So is the case with Government spending on research and development (R&D). As such, any programme of stabilisation-cum-adjustment, has to give considerable attention to the expenditure side of fiscal restructuring. It is important to plan expenditure reduction while improving quality of public spending to aim simultaneously at supporting growth with equity and improving fiscal balances. In India, expenditure/GDP ratio of the Centre had risen from about 12.3 per cent in 1970-71 to around 20 per cent in the latter half of the 1980s. This had placed a difficult burden on budgetary balances. With a view to narrowing down the fiscal gap, particularly by bridging the revenue deficit, a cut in current expenditure was considered essential.

The steps taken to compress expenditure led to a reduction in the size of overall public expenditure as a ratio to GDP in the initial years of the 1990s. The combined expenditure of Centre and State Governments as a ratio to GDP declined from 28.8 per cent in 1990-91 to 25.1 per cent in 1996-97. However, the trend reversed and the expenditure to GDP ratio once again began to follow an upward movement after 1996-97 and reached 29.5 per cent in 2001-02. Furthermore, the efforts to augment investment expenditure by cutting consumption expenditure did not materialise. This was due to the fact that at, both, the national and sub-national levels of Government, expenditure correction was brought about mainly through cut in capital expenditure. Between 1990-91 to 1996-97, although combined revenue expenditure fell by 1.2 percentage points, it increased again by about 3.6 percentage points between 1996-97 and 2001-02. On the other hand, there was a steep fall of 2.5 percentage points in the capital expenditure to GDP ratio between 1990-91 and 1996-97, though it rose marginally by 0.8 percentage point between 1996-97 to 2001-02. Thus, since the beginning of the 1990s upto 2001-02, while the revenue expenditure to GDP ratio increased from 22.8 per cent to 25.2 per cent, the capital expenditure to GDP ratio declined from 6.0 per cent to 4.4 per cent. The deterioration in capital expenditure contributed to the decline in the share of public investment from 9.3 per cent of GDP in 1990-91 to 6.3 per cent in 2001-02.

The major contributing factor imparting a downward rigidity to the revenue expenditure relates to items of committed expenditure, of which, interest payments and expenditure on wages and salaries are prominent. Interest payments as a ratio to GDP increased from 3.8 per cent in 1990-91 to 4.7 per cent in 2001-02 for the Central Government, while for the States, the corresponding rise was steeper from 1.5 per cent to 2.8 per cent (Chart IV.9). During the phase of fiscal consolidation, even though the debt to GDP ratio for the Central and State Governments fell from 61.7 per cent in 1990-91 to 56.5 per cent in 1996-97, the rise in the weighted average interest rate on Central Government and State Governments market borrowings, following the progressive alignment of coupon rates with market interest rates, led to the rise in interest payments. On the other hand, in the latter half of the 1990s, though the cost of borrowings declined consistently due to fall in market interest rates, interest payments continued to rise unabated. This essentially reflects the impact of sizeable outstanding liabilities contracted at higher interest rates during the first half of the 1990s, and also the return to rising deficit, and consequent, increase in public debt to GDP ratio to 71.1 per cent by 2001-02.

The rising wage bill has been considered as an important element in fiscal deterioration in recent years. One view is that the rise in spending on wages and salaries and pension was the prime factor for the abnormal rise in revenue expenditure during the 1990s (Acharya, 2001; Rao, 2000). The Eleventh Finance Commission (EFC), on the other hand, notes that the surge in revenue expenditure towards the late 1990s cannot be attributed only to salary and pension revision, though it led to immediate and acute fiscal stress all round (Government of India, 2000c). A similar view is expressed by Mohan (2000) who notes that, for the Central Government, spending on salaries and pension as a proportion to GDP during the 1990s was much lower than that in the 1980s.

The growth in Central Government spending on wages and salaries and pension was restrained during the period from 1990-91 to 1996-97. As a proportion to GDP, it dropped by around 0.8 percentage point. With the implementation of the Fifth Pay Commission award towards the late 1990s, the wage bill could not be kept constricted. Though the present expenditure on salaries and pensions for the Central Government employees as a percentage to GDP is still lower than it was at the end of the 1980s, the sharp rising trend is worrisome. It may be added that with downsizing of the Government as part of the reform process, the share of its wage bill in GDP should decline substantially. As liberalisation of the economy puts upward pressure on wage rates in competitive sectors that attract fresh domestic and foreign capital, preferred strategy would be to redeploy the surplus labour from the public sector to more productive sectors. This will reduce the wage bill burden in a much more meaningful way.

Downward rigidity has also been discernible in expenditure on subsidies, which is another major constituent of the revenue expenditure. Subsidies are an important policy instrument. Apart from impacting the expenditure side of the fisc, these affect domestic resource allocation, income distribution and expenditure efficiency. Subsidies can also affect international competitiveness by introducing distortions in international trade. Apart from providing implicit subsidies through under-pricing of public goods and services, Governments also extend subsidies explicitly on items such as exports, interest on loans, food and fertilisers. Owing to the conscious efforts made by the Government, total explicit subsidies of the Central Government, which constituted 2.14 per cent of GDP in 1990-91 were reduced to nearly 1 per cent by 1995-96. Cut in subsidies in the beginning of the reform period was brought about largely through the phasing out of export subsidies (cash compensatory support) which amounted to nearly Rs. 2,750 crore (0.5 per cent of GDP) in the year 1990-91. During the second half of the 1990s, the size of subsidies again started rising and increased to 1.36 per cent of GDP by 2001-02.

Details on State Government subsidies are not available in their budget documents but the indications are that the trend is similar to that of the Central Government, as reflected from the quantum of subsidies extended to some of the SEBs by the respective State Governments.

The downward inflexibility in the subsidies was essentially on account of the growing size of food subsidy, which recorded nearly a six-fold rise over the reform period. It has been observed that a sizeable proportion of food subsidy is due to the carrying cost of the food stock (Balakrishnan and Ramaswami, 2000). Thus, a significant part of subsidies goes to make up for the inefficiencies embedded in institutional arrangements meant for providing subsidy rather than benefiting the targeted group. Although subsidies are extended by the Government on the grounds that the poor are benefited, evidence shows that impact on poverty and nutritional status of the population is very limited (Srinivasan, 2000; Government of India, 1997). Expressing similar concerns, it has been stated that the argument that subsidies are meant for the poor has little basis in actual practice. The better-off sections of the society consume most of such services (Mohan, 2000). It has been shown that during 1986-87, the public distribution system (PDS) and other consumer subsidy programmes accounted for less than 2.7 per cent of per capita expenditure of the poor in rural areas and 3.2 per cent in urban areas (Radhakrishna and Subbarao, 1997). This indicates that phasing out of subsidies would have a very limited impact on the poor and less so in rural areas. However, there is a need for ensuring safety-net for the poor segment of population, whose ability to adjust to areas of work in the face of restructuring is rather limited. In order to ensure availability of food to the poor, the Government launched the Targeted Public Distribution System (TPDS) in June 1997. The Scheme was targeted to families Below Poverty Line (BPL)/ Antyodaya Anna Yojana (AAY) families in a transparent and accountable manner. The ability of the scheme to make a lasting dent on poverty would depend on the ability to create adequate entitlements through employment opportunities for the poor. Such policies would support income improvement without the burden of large fiscal subsidies.

In sum, it seems that the reversal in expenditure correction followed from the downward rigidity in consumption expenditure, particularly, in the interest payments for both the Central and the State Governments. The pay revision in the late 1990s further compounded the problem, while provision of subsidies continued to remain inefficient. In the event, capital expenditure had to bear the brunt of restraint placed on expenditure.

As stated earlier, the growing fiscal deficit during the pre-reform period was increasingly financed through the pre-emption of institutional resources at sub-market rates by progressive increase in SLR and monetisation by the Reserve Bank. These developments eventually resulted in crowding out of private investment, growing financial repression and imposed constraints on the conduct of monetary policy. Thus, the efforts towards better monetary-fiscal coordination were aimed at elimination of automatic monetisation by the Reserve Bank and movement away from financial repression through the reduction in statutory pre-emption of banks and long-term resources to allow a level-playing field to private investors. With these underlying objectives, a series of structural and institutional reforms were initiated during the 1990s which, inter alia, included aligning coupon rates on Government securities with market interest rates, introduction of auction system, introduction of system of primary dealers and setting up of D vP system. These measures resulted in the emergence of an active, wide and deep Government securities market and paved the way for complete elimination of automatic monetisation and substantial lowering of statutory pre-emption of institutional resources by the Government.

These developments were also reflected in the structural change in the financing pattern of fiscal deficit during the reform period - with a marked shift towards market borrowings. Accordingly, the share of market borrowings, which constituted 26.9 per cent of gross fiscal deficit (GFD) in the 1980s rose sharply to 59.1 per cent in the latter half of the 1990s and financed about 70 per cent of the GFD by 2001-02. On the other hand, ad hoc Treasury Bills which financed a sizeable proportion of GFD, both in the 1980s and in the 1990s upto 1996-97, no longer exist as a financing item with their replacement by WMA in 1997-98. Similarly, the share of external finance which was around 10 per cent in the 1980s also came down sharply to an average of 2.9 per cent during 1997-98 to 2001-02. The share of other liabilities has been relatively stable and averaged around 40.0 per cent, both, in the 1980s as well as in the 1990s .

In case of State Governments, the fiscal gap is financed by way of loans from the Centre, small savings and market borrowings. Like the Central Government, the share of market borrowings in financing GFD of States has steadily increased. The financing pattern of the GFD indicates that, on an average, the share of loans from the Centre and small savings declined from 51.9 per cent and 37.1 per cent, respectively, in the 1980s to 47.5 per cent and 36.6 per cent, respectively, during the 1990s. 7 The share of market borrowings rose from 11.0 per cent to 15.8 per cent between these two periods.

The growing reliance on market borrowing for financing the fiscal deficit has been accompanied by restraint on reserve money growth and moderation of inflationary pressure. This has also had the effect of raising interest payments. In order for the strategy to finance fiscal deficit through borrowings at market related rates to have a favourable macroeconomic impact, some discipline on growth of the fiscal deficit is necessary.

In addition to borrowings to finance the fiscal deficit, Governments, both at the Centre and State levels, also avail WMA from the Reserve Bank to bridge short-term mismatches in revenue and expenditure. While WMA is envisaged to be a short-term funding, in many States, it is continuously rolled over. In this context, the Report of the Advisory Committee on WMA to State Governments (Chairman: C. Ramachandran) has noted that WMA has assumed the form of a long-term financing facility in many States with the progressive deterioration in their fiscal balances over the years (RBI, 2003). The Committee has recommended that States need to use the facility of WMA only for meeting the temporary liquidity mismatches rather than as a near budgetary resource.

The objective of fiscal reforms to prevent further accumulation of public debt is intimately linked to the objective of reining in the fiscal deficit. Since the public debt of the Government is broadly the accumulation of liabilities created by the Government to finance its deficit over the years, debt parameters in general move in tandem with the trends in fiscal deficit. Thus, reflecting the downward rigidity in the fiscal deficit, the objective to curtail growth of public debt was also not achieved, particularly since the mid-1990s. The outstanding debt of the Government sector as a proportion to GDP after witnessing improvement from 61.7 per cent in 1990-91 to 56.5 per cent in 1996-97 rose once again, and by the year 2000-01, the debt-GDP ratio at 66.4 per cent exceeded the level at the beginning of the reform process.

Although the primary deficit declined in the 1990s as compared to that in the 1980s, the growth in debt-service burden as a result of growing reliance on high cost market borrowings largely contributed to the downward inflexibility in the debt-GDP ratio. The weighted average interest rate on Central Government securities almost doubled from 7.03 per cent in 1980-81 to a peak level of 13.75 per cent in 1995-96. Since then the interest rates have declined gradually to 11.77 per cent in 1999-2000 and further to 9.44 per cent in 2001-02. Moreover, the higher implicit cost of borrowings through small savings and provident funds, owing to tax concessions, also placed additional burden on Government resources.

In addition to the size of debt appearing on the budget/balance sheets of the Governments, there has been a steep rise in the off-budget liabilities arising on account of guarantees extended by the Governments. The guarantees given by the combined Government rose in nominal terms from Rs.1,00,603 crore as at end-March 1993 to Rs.2,61,975 crore as at end-March 2002, though as a ratio to GDP they declined from 13.4 per cent to 11.4 per cent during the same period. The Central Government outstanding guarantees increased from Rs.58,088 crore in 1993 to Rs.95,859 crore in 2002. As a percentage of GDP, these guarantees dropped from 7.8 per cent to 4.2 per cent over the same period. Thus, in terms of contingent liabilities, there are clear signs of fiscal prudence by the Centre in the reform period. In contrast, State Governments’ (17 major States) outstanding guarantees increased sharply from Rs.42,515 crore in 1993, comprising 5.7 per cent of GDP, to Rs.1,66,116 crore in 2002, comprising 7.2 per cent of GDP.

A rise in contingent liabilities, particularly in case of State Governments, essentially reflects the practice followed by the State Governments to set up corporations to borrow from the market to undertake departmental jobs. In view of low user charges and inefficient operations of PSUs, these contingent liabilities are a potential threat to the stability and sustainability of the fiscal system.

To overcome such disquieting trends in State Governments’ finances, many States in their budgets have initiated fiscal measures such as setting up of consolidated sinking fund, guarantee redemption fund, statutory and administrative limits on guarantees and restructuring of PSUs. This follows the recommendation of the Technical Committee on State Government Guarantees (1999). Besides, some States have also taken decision to charge guarantee commission on outstanding guaranteed amount.