average minus one standard deviation.<sup>28</sup> The standard deviation and the averages are computed based on historical data for Tamil Nadu.

The first sensitivity test sets the real effective interest rate, the real growth rate and the primary balance after 2006/07 at their historic averages for the period 1990/1991-2000/01. Strong economic performance in the 1990s<sup>29</sup> and low real interest rates<sup>30</sup> – a result of government controlled interest rates in the first part of the 1990s before economic liberalization – allow the government to run a primary deficit that is more than twice the deficit assumed in the baseline without increasing significantly its debt burden. The debt to GSDP ratio grows from 27.8 percent in 2003/04 to around 34.6 percent in 2026/27. This debt burden is however twice the size of the debt burden in 2026/27 in the baseline implying that the fiscal adjustment program of the state government is ambitious by historical standards.

Since the government of India liberalized interest rates in the second part of the 1990s, the historic average for the real interest rates is no longer relevant. Therefore, the second sensitivity test sets the real interest rate at 5 percent after 2007/08 as in the baseline, while leaving the real growth rate and the primary balance after 2006 at their historic averages for the period 1990/91-2000/01. Comparing the paths of the debt to GSDP ratio in Table 3 and Table 4, one clearly sees the costs of loose fiscal policy. Persistent primary deficits of 1.3 percent of GSDP imply that Tamil Nadu’s debt burden will rise to 50.4 percent as a share of GSDP by 2026/27 - a debt burden that is more than 3 times the one in the baseline, while its debt service will be 20 percent of revenue – a threshold which the central government considers an indicator of fiscal stress.<sup>31</sup> Unexpected, adverse shocks of nonpermanent nature do not threaten long-run fiscal sustainability. For instance, a negative shock of two standard deviations from the historic mean, in either, the real interest rate, the real growth rate or the primary balance, which occurs in two consecutive years (2005/06 and 2006/07), will not increase the debt burden of the state. However, a combined negative shock of one standard deviation from the historic means in the real effective interest rate ( μ _r_ + σ _r_ =6 percent),<sup>32</sup> the real growth rate ( μ _g_ −σ _g_ =1.3 percent), and the primary deficit ( μ _x_ −σ _x_ =-2.2 percent) that occurs in two consecutive years (2005/06 and 2006/07) will nearly double the debt burden expected in

> 28 It is difficult to determine the likelihood of a one standard deviation shock without knowing the probability distribution. Assuming a normal distribution, the probability of a one-standard deviation, combined shock to the primary balance, real interest and growth rate is 15.9 percent if the shocks are perfectly correlated. If the shocks are perfectly uncorrelated, the probability declines to 0.4 percent.

> 29 The average, annual real GSDP growth in Tamil Nadu in the 1990s was 6.4 percent.

> 30 The average, real interest rate in Tamil Nadu in the period 1991-2001 was 2.3 percent.

> 31 We assume that revenue will grow so that its share of GSDP remains at 12.5 percent, its projected value for 2008/09 in the MTFP.

> 32 The implied standard deviation from the historical mean of the real interest rate is 3.76 percentage points. It is large as it reflects the impact of interest rate liberalization in India in the 1990s.

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