How much public debt is too little?

It is generally agreed that a secularly declining public debt-to-GDP (gross domestic product) ratio was unambiguously a good thing, and indeed recommended fiscal rules which led to precisely such an outcome. Intuitively I find this view seriously problematic…

My discomfort primarily stems from the fact that government debt is the only interest-yielding risk-free asset in any country, and is therefore central to a wide range of key economic variables and decisions in a modern economy. Unless these aspects are explicitly taken into account while assessing the ‘optimal’ level of public debt, any fiscal rule would be seriously flawed, and indeed perhaps dangerous.

The purpose of this article is to outline some of the considerations which should be taken into account while determining the desirable stock of public debt and of its flow counterpart the fiscal deficit.

Monetary considerations

In all modern economies, national currencies are backed by some form of sovereign debt. Central banks, such as the Reserve Bank of India (RBI), issue currency on the basis of their holdings of sovereign bonds and sometimes of gold.

In an autarchy, therefore, the minimum level of public debt held by the central bank would be equal to the value of the national currency in circulation minus the value of gold holdings. In India this would amount to roughly 14% of GDP.

In an open economy, however, this tight relationship between currency and public debt can be loosened by the central bank holding sovereign assets of other countries that is, foreign exchange reserves…

Fiduciary considerations

In any country, a large part of household wealth is held for precautionary purposes and for meeting post-work-life consumption needs. For such investments, the return is less important than the security of the principal.

By and large, countries with low risk thresholds and with poor or non-existent social security systems, such as India, will tend to place much more importance on and have a higher share of such assets in the total household financial wealth.

All countries recognise this imperative and impose fiduciary status on institutions offering specific forms of assets. The common forms are life insurance, pension/provident funds, and certain types of mutual funds and asset management company products.

In India, there is an additional asset class called small savings instruments for which the government itself is the fiduciary, that is, bears 100% of the liability. This amounts to about 11.5 percentage points in the total public debt stock of 68% of GDP.

The other assets which bear fiduciary protection comprise another 25% of GDP… Therefore, just for compliance with the law, the stock of public debt must be a minimum of around 12.5% of GDP on this count alone.

Although legally commercial banks are not fiduciaries, the perception of the depositors is usually quite different, and they tend to view bank deposits as a form of low-yield secure assets. Therefore, even if banks don’t have legal fiduciary status, they certainly bear a moral fiduciary responsibility.

Most governments recognise this tension between the legal and the moral/perceptual status of banks, and address it through “prudential regulations”. In India, prudential regulations stipulate that 20% of the total net liabilities of banks (called the statutory liquidity ratio (SLR)) must be held in government bonds; this works out to 18% of GDP.

Therefore, if we add up the minimum amount of public debt required by law to meet fiduciary responsibilities in India, it comes to 42% of GDP; comprising 11.5% for small savings instruments, 12.5% for insurance/provident funds/ etc., and 18% for commercial banks…

Sovereign debt instruments provide the anchor for all interest rates, since they are the only financial instrument with zero default risk. Theoretically, the interest rate on private debt of a particular maturity should be the interest rate on government bonds of the same maturity with a premium reflecting the default risk of the private borrower.

For it to effectively play this role, however, government bonds must be freely and actively traded so that their yield (which is the effective interest rate) accurately reflects the market risk and liquidity premia14. It is, therefore, necessary that an active market should exist for government bonds…

In order to judge whether the voluntary holdings of government securities are too high, the actual market-determined yield should be compared to the desired rate.

If the yields are higher, it implies that there is an excess of government securities in the market. If, on the other hand, the yields are lower, it means that there is an excess demand for government bonds, and any reduction in their supply will lower interest rates even further, thereby distorting the various decisions that are contingent on the interest rate.

At present, the yields on 10-year treasury bills are marginally below the coupon rate of 7%. Therefore, the voluntary holdings of public debt amounting to 12% of GDP are by no means excessive, and may even be too low.

Minimum public debt

Coming back to the main inquiry, if the voluntary holdings of public debt are added to RBI’s holdings and the mandated holdings, the minimum public debt stock comes to at least 58% of GDP. However, this is only the current position.

In view of the government’s push towards greater ‘financial inclusion’ in the form of bank deposits and insurance coverage, it is likely that this ratio will trend upwards in the foreseeable future. Therefore, a certain amount of cushion needs to be provided for contingencies. Seen in this light, the FRBM Committee’s recommendation of a target public debt ratio of 60% seems eminently sensible, but as a floor and not a ceiling.

Fiscal deficits and composition of public debt

The stock of public debt is only one part of the story. Consideration must also be given to the fiscal deficit, which is the annual rate of generation of public debt. There is little point in having a desired level of public debt to GDP ratio if the addition to this stock is not consistent with maintaining the ratio over time.

If the nominal GDP grows at 11.5% per year, the debt ratio will decline by 6.2 percentage points annually if there is no addition to the debt stock. Therefore, consistency demands that the fiscal deficit should be maintained as 6.2% per annum in order to stabilise the public debt ratio at the desired level.

Also, the steady-state relationship between the fiscal deficit and the debt stock ratio assumes that the composition of the debt does not matter. However, the fact of the matter is that it does, and any analysis which ignores this is seriously flawed… Government securities must account for at least 5% of GDP in the total financing of the consolidated fiscal deficit for the immediate future.

Unless this condition is met, the gap between the actual and desired stock of government securities will continue to widen to a point where fiduciary institutions will be under stress both from being unable to meet their legal requirements and from reduced income flows from their holdings of public debt instruments.

The Ministry of Finance needs to assess these considerations, and perhaps so should many other countries. (Excerpts from an article; Reprinted with permission from Ideas for India - www.ideasforindia.in)

By Pronab Sen