crisis itself. India is not immune to a Sargent-Wallace (1981) outcome, where rising interest payments compel the government to resort to inflationary finance, damaging macroeconomic credibility and raising real interest rates. If the high reserves are used to preserve exchange rate stability, that country could have a situation of appreciating real exchange rates and high real interest rates, hurting the real sector and lowering growth prospects. Thus at a minimum, failure to address the fiscal imbalance will hurt growth prospects and set poverty alleviation back.

An alternative viewpoint argues that with excess capacity in industry and record levels of reserves and food stocks, this is the right time for a fiscal expansion to stimulate growth.<sup>7</sup> As is shown below, the two main arguments against this reasoning are first, that government debt and interest payments have already reached extremely high levels, constraining counter-cyclical fiscal policy. Second, the build up in reserves has not been a fortuitous accident but driven by a macroeconomic policy mix designed to keep inflation low and minimize external vulnerability in spite of the fiscal deterioration.

The need for “fiscal adjustment now” arises not because a crisis is imminent but because postponing reform is likely to result in an unmanageable debt and interest burden by the end of the Tenth Plan period notwithstanding the current low interest rates and burgeoning reserves. In contrast, a phased adjustment beginning now and focusing on a relatively small set of reforms is likely to yield substantial, positive benefits over the same horizon and be more conducive to longrun growth and poverty reduction. By “adjustment” is not meant an immediate, drastic cut in the fiscal deficit. The only way to do so given the extraordinarily high level of interest payments would be to cut capital expenditure even more, which would be undesirable. Instead, the advocated focus is on revenue mobilization and redirecting “non-merit subsidies” toward capital and development expenditure. The paper makes its case first by showing that a key factor in the fiscal deterioration during the Ninth Plan period (1997/98-2001/02) has been the significant reform-induced losses in revenue (both indirect tax revenue and financial-repression revenue), and also the government's inability to adjust public spending (as interest payments take up an increasing share of the budget). Debt dynamics worsened over 2002/03 despite the record lows in interest rates. The reason for this and the inadvisability of gambling on the persistence of low interest rates are spelled out. Second, it demonstrates that government debt dynamics are showing signs of being unsustainable. The primary deficit (non-interest fiscal deficit) is large and real interest rates have converged to growth rates. Third, the Reserve Bank of India’s (RBI) policy of building up reserves and sterilizing them (to cushion against external shocks and keep inflation low, respectively), coupled with constraints on government spending (because of fiscal deficits and public debt) has resulted in low public and private investment, putting long-run growth in jeopardy relative to the levels needed for rapid poverty alleviation. Moreover, while higher reserves have increased liquidity, the joint balance sheet of the general government and the RBI has weakened. Fourth, projections show that postponing fiscal adjustment will push the debt burden to unmanageable levels by the end of the Tenth Plan period; but a phased adjustment that begins immediately will lower deficits and greatly improve spending composition.

Before proceeding, two points are worth noting. First, structural reforms to underpin faster growth are crucial to any fiscal reform scenario. These are not discussed here; World Bank (2003a) contains a detailed discussion. Second, the Government of India (GoI) and the RBI are cognizant of the need for a fiscal adjustment, as evidenced by numerous initiatives and policy pronouncements. The key is to find the momentum for implementation in the present environment of high reserves and low interest rates, a momentum this paper hopes to advance.

> 7 Chandrasekhar (2000).

3