While it is reasonable that unanticipated shocks, if severe enough, can derail development efforts in even the most fiscally responsible countries, it is harder to justify repeated episodes of debt distress. If volatility is a fact of life for many of these countries, these shocks cannot any longer be viewed as surprises; and the countries need to build up a buffer in terms of debt headroom for unanticipated shocks.

Public debt could also be a constraint to growth and development in countries like India. This claim may appear surprising in view of India’s stellar growth track record and the absence of macroeconomic vulnerability. But as argued in World Bank (2003), beyond a point, public debt becomes a constraint on the composition of government spending as interest payments consume a growing fraction of revenues. It could also constrain financial sector reform and development— because the government is reliant on a captive financial system to buy its debt—thereby affecting resource allocation; and reduce private investment to the extent that it exploits complementarities with public investment.

# **Box 7.  India: High Deficits, Debt and Reserves—But High Growth?**

India’s growth performance during the 1980s and 1990s was exceeded by only a handful of countries; so was the size of its fiscal deficits. But it is not vulnerable to a repeat of its 1991 fiscal and balance-ofpayments (BOP) crisis because of the build up of foreign exchange reserves, capital controls, a flexible exchange rate system and widespread public ownership of banks. Nevertheless, a fiscal adjustment is needed to bolster the chances of sustained high growth over the long-run.<sup>1/</sup> Spending composition has deteriorated as a result of an inefficient fiscal adjustment during the ten years following the 1991 BOP crisis. Table 7 presents changes in key fiscal variables for the general government over the Eighth Plan (1992/93 to 1996/97) and Ninth Plan periods to illustrate this.

**Table 7: Fiscal Adjustment Dynamics, 1985/86-2001/02 (based on period averages)**

|_% of GDP_|_8_<sup>_th_</sup>_Plan (92/93-96/97)_<br>_versus_<br>_85/86-89/90_|_9_<sup>_th_</sup>_Plan (97/98-01/02)_<br>_versus_<br>_8_<sup>_th_</sup>_Plan_|
|---|---|---|
|Revenues|-1.5|-0.9|
|Primary deficit|-3.2|+1.4|
|Debt|+8.0|+0.0|
|Interest|+1.3|+0.7|
|Capital expenditure|-2.8|-0.4|
|Fiscal deficit|-1.8|+2.1|

During the Eighth Plan period, revenues fell and interest payments rose relative to the pre-crisis period, 1985/86-1989/90, ‘compensated’ by a big reduction in capital expenditure. This happened even though growth was at its highest level over the past two decades and the primary deficit was reduced substantially. The fall in revenues and rise in interest rates both stemmed from reforms—cuts in customs and excise duty rates to stimulate efficiency, and a reduction in domestic financial repression. The net result was that capital expenditure fell by over 3 percentage points of GDP by the Ninth Plan period. And the sum of interest, administration and pensions rose by 3 percentage points of GDP and a huge 22 percentage points of revenue while developmental spending on health and education stagnated and that on irrigation, power and transport declined (not shown in table).

Crisis proofing by accumulating foreign exchange reserves and switching towards long-term rupee debt for deficit funding in this milieu meant high real interest rates for the private sector for much of the second half of the 1990s. The key to reversing the fiscal slide and eventually raising public savings to a level <u>consistent with Tenth Plan macroeconomic targets is to mobilize revenue by completing direct and indirect</u> 30