help with SMEs, which at present suffer from very high real lending rates owing to the perception of high risk, as noted in Mohan (2003). One topic that is relevant at present is interest rate risk. Financial institutions which have invested in long-term government paper have been making large trading profits as interest rates continued to fall, but now face risks from the possibility of rising interest rates. In an attempt to counteract this, RBI has issued a directive on creating an Investment Fluctuation Reserve. While banking regulation has improved, some of this has been offset by easing regulations to encourage restructurings and lending for housing and infrastructure, which is beset by a weak framework for user charges.

Insurance and provident funds are heavily invested in government debt, and will face losses as interest rates rise. Moreover, state provident funds have also invested in special purpose vehicles (SPVs) guaranteed by the state. Many of these assets are no longer earning interest, making the performance of the state provident funds even more dependent on debt servicing by cash starved States, now that the guarantees are beginning to be called. The ability of these provident funds to meet their obligations is likely to affect public confidence in government debt issues more broadly. Finally, the administratively set returns on the provident funds are significantly above market rates, which encourage the management to engage in risky investments in the non-regulated portion of their portfolio and, more generally, create a potential contingent liability for the central and state governments along the lines of UTI. Linking rates on the provident fund more closely to the market, and reducing the role of administratively fixed rates, would help control the continued build-up of these problems. A similar link to rates on small savings would save interest costs for states.

A last point is on institutions for fiscal management. The Fiscal Responsibility and Budget Management Act passed by the Parliament in 2003 mandates the central government to eliminate its revenue deficit by March 31, 2008. A few states<sup>53</sup> have passed similar acts and others are in the process of formulating these. In addition to revenue mobilization and subsidy reform, making this mandate credible would require strengthening the institutional framework, such as reforming the borrowing regime for states, expanding the volume of center-to-state transfers linked to reform and performance (such as the Fiscal Reforms Facility and the Accelerated Power Development Reform Program) and measures to simplify expenditure management, including addressing what is widely regarded as an unhelpful division of budgetary resources into “plan” and “non-plan”, and rationalizing the management of Centrally Sponsored Schemes.<sup>54</sup>

# **6. Debt and Deficit Projections to 2006/07**

General government debt and deficits are projected to the end of the Tenth Plan period, 2006/07, under two scenarios: a base case with no reform; and a reform case. The reform case is driven by priorities emerging from the above analysis and centers around revenue mobilization, the re-focusing of a part of food and fertilizer subsidies toward rural infrastructure and the elimination of power sector losses.<sup>55</sup> Box 2 summarizes the assumptions underpinning the two scenarios. The reform scenario also assumes that the fiscal reforms are supplemented with structural reforms to spur growth.<sup>56</sup> Debt projections are based on Annex 2, equation (1).

> 53 States like Karnataka, Tamil Nadu, Kerala and Punjab.

> 54 For details, see World Bank (2003) pages 27-28.

> 55 As Mihir Rakshit has noted in comments, these reforms do not derive from an optimal fiscal program.  In particular, no change in monetary policy is assumed, for example, a discontinuation of the sterilization of capital inflows which could increase seignorage by enlarging the monetary base.  See also Rakshit (2000).  Nevertheless, the projections here show that a small set of well-defined reforms can have a major positive impact by the end of the Tenth Plan period. 56 For a detailed discussion of structural reforms, see World Bank (2003).

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