Public Finance
Indian debt

In recent years the Indian public sector financial deficit and the primary, or non-interest, deficit, have been rising in real terms and as a proportion of GNP. The real values of the public debt and the public debt/GNP ratio are rising sharply, and even the present value of public debt is increasing. This pattern of debt and deficits may not be sustainable for four reasons.
First, if there is no debt neutrality, borrowing instead of taxing current labour income will tend to raise private consumption, which will either displace private investment and other interest-sensitive forms of private spending or raise the deficit on the current account of the balance of payments. Second, the absence of `first-order' debt neutrality rules out the option of `tax smoothing' by running budget deficits or surpluses when there are no lump-sum, non-distortionary, tax-transfer schemes available. Third, the eventual monetization of persistent deficits potentially involves serious inflationary consequences. Fourth, a prolonged debt crisis may lead to the insolvency or bankruptcy of the national Exchequer.
In Discussion Paper No. 408, Research Fellow Willem H Buiter and Urjit R Patel focus on the third and fourth of these by reviewing briefly some of the key facts concerning recent budgetary developments in India and analysing whether the current and recent behaviour of key budgetary and related time series is sustainable. They evaluate the eventual inflationary implications of recourse to monetary financing by estimating a demand function for base money, in order to calculate the long-run inflation rate associated with different real revenues raised by running the printing presses. Their estimated base money demand function has very sharply diminishing real revenue returns from higher inflation.
The results of their statistical and informal solvency tests and the estimated demand function for base money indicate two main conclusions. First, the continuation of recent patterns of behaviour would eventually lead to the insolvency of the Exchequer. Second, the option of using the inflation tax to close part of the budgetary gap is limited: small increases in the share of seigniorage in GNP would have a high cost in terms of additional long-run inflation, and even maximal use of the inflation tax would not suffice to close the solvency gap.
Buiter and Patel also consider alternative policy options for dealing with India's debt crisis. These fall into three categories: policies aimed at ensuring larger primary surpluses or smaller primary deficits; policies to reduce the interest cost of borrowing; and increased recourse to seigniorage or the inflation tax.

Willem H Buiter and Urjit R Patel
Debt, Deficits and Inflation: An Application to the Public Finances of India

Discussion Paper No. 408, April 1990 (IM)