under control. And (v) as emphasized by Acharya (2001) there was a conscious post-crisis decision to build up FX reserves and minimize dependence on external debt in financing the deficit as part of a crisis-proofing strategy.

# **Debt Sustainability through the 1990s**

<u>Sustainability</u> means the fiscal policy is feasible, i.e., no problems are seen in relation to debt servicing in the foreseeable future under prevailing fiscal policies.<sup>66</sup> The idea of solvency is simply that the present discounted value of future fiscal primary surpluses (revenues minus noninterest expenditure) plus seignorage exceed the initial level of debt.<sup>67</sup> This condition applies when the real interest rate exceeds the growth rate, which, in the absence of financial repression, is typically the case. Discussions of sustainability and solvency can be conducted at various levels of technical complexity. Be that as it may, tests throughout the 1990s of the solvency condition -- based on examining the stationarity of the time series of the nominal debt stock discounted back to some historical point in time -- were unable to reject the hypothesis that India’s public debt was on an explosive path under prevailing fiscal policies. The operative phrase is “under prevailing policies”. For example, in a seminal paper, Buiter and Patel (1992) found, using data from 1970/71 to 1987/88, that the discounted public debt was nonstationary. They warned, in the first draft of the same paper which was completed before the 1991 BoP crisis, that without a reduction in the primary fiscal deficit, India was heading for a fiscal crisis that could exhaust reserves and lead to emergency IMF funding. While this came to pass, the 1991 crisis led to well-documented fiscal and structural reforms, which led to an acceleration of growth and a decline in the debt/GDP ratio during the Eighth Plan period (1992/93-1996/97). Thus, the “prevailing fiscal policies” changed after the 1991 crisis, but not for long.

Serven (1996) re-examined the solvency of the Indian public sector motivated by the observation that by 1996, the fiscal adjustment occasioned by the 1991 crisis appeared to be losing steam. The paper concluded along the lines of Buiter and Patel that debt was on an explosive path. An additional concern was that, with the introduction of the auction system for Treasury Bills and dated securities in 1992/93, interest rates would rise with the growing volume of public debt, placing it on an even faster upward trajectory. Serven presented evidence showing that the average interest rate on government debt was rising, which meant that at the margin, interest rates were rising even faster, i.e., newly-issued debt was carrying a higher interest rate than the inherited debt stock, pushing up the average rate of interest paid. Serven argued that it was only a matter of time before the marginal and average interest rates converged, with a sizable impact on deficits and debt. In addition, the elimination or reduction in financial repression as a result of lowering the cash reserve ratio and statutory liquidity ratio for banks combined with a move to market-determined prices for government securities would boost interest rates.<sup>68</sup> All this would mean three things: (i) interest payments would consume a growing share of revenues and reduce the resources available for public spending on infrastructure and the social sectors; (ii) a growing burden would fall on monetary policy to keep inflation within target levels. In other words, there was the danger that a “loose fiscal-tight money” policy would emerge; and (iii) as debt and interest payments rose, the fiscal latitude to deal with unanticipated shocks, e.g., a bad monsoon, would be severely curtailed.

> 66 See Reynolds (2001), which discusses various notions of sustainability and solvency.

> 67 Debt, primary fiscal surpluses and seignorage are all expressed as fractions of GDP and the appropriate discount rate is the real (nominal) interest rate minus the real (nominal) growth rate.

> 68 Revenues from financial repression were estimated by Giovannini and de Melo (1993) as close to 3% of GDP per year over 1980-85.  Kletzer and Kohli (2001) come up with higher numbers using the same methodology.

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