sector has performed well, infrastructure-dependent sectors such as heavy and light industries have been constrained by the poor state of infrastructure (World Bank and Confederation of Indian Industry 2002, 2005; World Bank 2004b).

Numerous authors have argued the positive impact of infrastructure investment on economic growth in developed and developing counties (Aschauer 2000, Estache and Liu 2003, Canning and Bennathan 2000; Briceno _et al_ . 2004, Easterly and Serven, 2003). In this paper, we are interested in knowing to what extent Tamil Nadu can accelerate infrastructure investment without increasing its debt service payments above the debt stress threshold of 20 percent of revenue and its debt burden above its level in 2006/07.

Public infrastructure investment by Indian states has stayed below 3 percent of their GSDP since the 1990s. In Tamil Nadu capital expenditure was lower than 3 percent varying between 1.5 and 2 percent of GSDP over the same period. We therefore simulate the impact of an increase in Tamil Nadu’s capital expenditure to 3 percent of GSDP starting in 2008/09. We assume that real economic growth and interest rates will remain as in the baseline, and there will be no effect on the state’s revenue. We abstract from questions about the efficiency and effectiveness of public expenditure on infrastructure investment that are critical to economic growth.<sup>34</sup> We find that under these assumptions, the debt to GSDP ratio will gradually climb from 27 percent in 2008/09 to 39 percent by 2026/27, but its debt service payments will increase to only 15.9 percent of revenue over same period – an indicator that is below the debt stress ratio of 20 percent (Figure 11). This suggests that there is “fiscal space” for Tamil Nadu to increase capital investment through additional borrowing without jeopardizing its debt service capacity.

Tamil Nadu may even avoid the increase in the debt burden,<sup>35</sup> if its annual real economic growth accelerates to 7.6 percent – an increase of 1.6 percentage points from its expected growth rate in 2008/09.<sup>36</sup> Evidence suggests that such an increase in real economic growth is possible. Estimates indicate that states such as Tamil Nadu could gain as much as 1.5 percentage points per annum in real growth from improving investment climate, particularly infrastructure (World Bank and Confederation of Indian Industry 2002). This implies that there may be “macroeconomic space” for Tamil Nadu to increase capital investment without jeopardizing its fiscal sustainability.

# **_4.4 Key fiscal risks to sustainability_**

Although the baseline points to a sustainable debt path for Tamil Nadu, there are significant risks that may derail the state’s progress along this path. Key risks are potential increases in real interest rates, constraints to primary balance adjustment, and sudden realization of contingent liabilities.

> 34 Public infrastructure investment is increasingly perceived as a complement, rather than a substitute to private sector infrastructure investment.

> 35 In other words, it may manage to keep its debt burden at its 2006/07 value of 27.5 percent of GSDP. 36 This simulation does not take into account any positive effects on state revenue. If these effects are taken into account, the required increase in growth will be smaller than 1.6 percentage points.

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