tax reforms; and altering the composition of spending by reducing and redirecting subsidies towards rural infrastructure and agricultural R&E—most of the poor live in rural areas. Power sector reform is also important for fiscal reasons, and to help manufacturing, the most tax-buoyant sectors in the economy.

General government grew from less than 60 percent of GDP in 1985/86 to 87 percent by 2002/03, not including debt of central public enterprises and guarantees. This risks an uncontrolled upward trajectory if interest rates rise and growth slows down. This is a good time to begin implementing a phased reform given high reserves and currently low interest rates. The Ministry of Finance’s _Economic Survey 2003-03_ (released July 7, 2004), notes the seriousness of the situation: “Growing deficits and public debt and the concomitant declining share of the private sector in total credit have been preventing the economy from realizing its growth potential. The unobserved cost of fiscal deterioration is the growth forgone.” The challenge is to implement the Fiscal Responsibility and Budget Management Act of 2003, which mandates the central government to eliminate its revenue deficit by 2008, i.e., raise public savings;<sup>2/</sup> reform the borrowing regime for states; expand center-to-state transfers linked to reform and performance; and simplify expenditure management—in short, to strengthen fiscal institutions and improve the quality of the fiscal stance.

1/ The growth rate was over 8 percent in 2003-04; but this after 4 percent growth the previous year. The trend rate of growth is closer to 6 percent—below the 8 percent target mandated for the Tenth Plan (2002-03 to 2006-07). 2/ The revenue deficit is the difference between total revenues and current spending. Eliminating it is tantamount to requiring that borrowing be used only for public investment.

_Source: World Bank (2003) and Pinto and Zahir (2004)._ The issue of causation remains. Does high public debt cause low growth, or is it a cumulative symptom of bad past decisions on spending and taxation, misuse of fiscal resources, poorly designed stabilization programs and the postponed consequences of contingent liabilities? Omitted variables can also be an explanation, e.g., a supply shock could both lead to lower growth and a higher public debt-to-GDP ratio. And weak institutions could likewise lead to low growth and high indebtedness.<sup>43</sup> A pragmatic view is that once a country crosses a certain debt-to-GDP threshold, debt could easily become a dominant factor going forward as well as the biggest constraint on policies and growth; how it was accumulated becomes secondary and dealing with the indebtedness itself becomes a primary task.<sup>44</sup> And countries which choose to generate large primary surpluses in pursuit of debt tolerance can do so convincingly only if these efforts are accompanied by institutional reform, as noted in Box 8 on Turkey’s reforms. The good news is that policies and institutions in MACs may mature over time; but the process is time consuming, and prone to setbacks. Some setbacks may be welfare-enhancing, forcing fundamental institutional, political and social reform. For example, Mexico in the early 1990s and Korea in the mid-1990s followed policies that turned out to be unsustainable. Both countries ended with a crisis and deep recessions, but experienced quick rebounds with output exhibiting a V-shaped path. This pattern of recovery has been facilitated by adopting greater exchange rate flexibility, relying on export orientation, and the beginning of major internal restructuring. The process has induced important political economy changes, reducing the ability of incumbents—political or business elites—to 43 Acemoglu, Johnson, Robinson, and Thaichoren (2003) stress the primacy of institutions by arguing that crises are caused by bad macroeconomic policies, which increase volatility and lower growth; but bad macro policies in turn are the product of weak institutions. In order to avoid problems with endogeneity and omitted variables, they develop a technique to isolate the “historically determined component of institutions” based on the colonization strategy pursed by European settlers, and show that this is the critical factor in explaining volatility, crises, and growth.

44 Fiscal dominance associated with high sovereign risk and unsustainable public debt dynamics for example becomes a severe constraint on monetary policy and the achievement of inflations targets, as argued in Blanchard (2004).

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