Fiscal Deficit, Public Debt and Economic Growth Relationship: An Empirical Investigation on Indian Economy

Dr. Ummed Singh¹*, Harshit Gupta², Shaifali Kumawat³

¹Assistant Professor, Department of Economics, University of Rajasthan, Jaipur.

²Central University of Rajasthan, Kishangarh (Ajmer)

³Research Scholar, IDS, Jaipur.

ABSTRACT:

This study is an empirical investigation to examine the dynamic interaction between fiscal deficit, public debt and economic growth in India for the time period 1991 to 2015, taking into account some the important macroeconomic variables, such as, interest rate, exchange rate, trade openness and internal and external debt. The analysis has been done by employing Unit Root Tests, Granger Causality Test, Vector Auto-Regression (VAR) and Johansen’s Co-Integration The findings of the paper indicate that there is negative and significant relationship between fiscal deficit and economic growth in the long run. The VAR analysis shows that fiscal deficit positively influence public debt. The paper finds that there is a one way causation running from fiscal deficit to public debt, and public debt to economic growth. However, this study does not find any co-integration relationship among public debt, fiscal deficit and economic growth.

KEY WORDS:  Fiscal deficit, Public debt, Economic growth, Trade openness, Granger Causality, Vector Auto-Regression (VAR), Johansen’s Co-Integration.

INTRODUCTION:

Persistence of high level of fiscal deficits and debt may have adverse impact on interest rate, output, inflation and trade balance in the medium to long run. Continuing high levels of fiscal deficit, even if adoption of fiscal Responsibility and Budget Management Act (FRBM), pose a serious danger to macroeconomic stability in India. According to World Bank Study made in 2004 “interest payment consumed less than 20 percent of total revenue in the pre-crisis period, compared to 30 percent during the Ninth Plan period (1997-2002). Revenue deficit doubled from less than 3 percent in the second half of the 1980s to 6 percent during the Ninth Plan period and beyond representing deterioration in the fiscal stance with spending on social and physical infrastructure crowded out by rising interest rate and other current payments.”  The adverse effect of this high fiscal deficit can be seen in rising burden of public debt. Due to fiscal consolidation between 1991 and 1996 public debt as a ratio of GDP, declined from 62% in 1991 to 56% in 1997 but because of large and increasing fiscal deficit during 1997-2002 it increased substantially up to 70% level in 2001-02. This rising fiscal deficit caused the decline

in gross domestic saving and investment and thereby contributed to slowdown in economic growth.

Some economists say that the relation between fiscal deficit and economic growth is positive and fiscal deficit helps in economic growth if the expenditures are due to productive expenditures like education, health etc., while others are of the opposite view that fiscal deficit and economic growth has negative relationship. A High level of fiscal deficit as the percentage of GDP tends to hamper the economic growth of an economy. Financing this deficit has historically being a challenge to many countries especially emerging economy like India. Therefore the fear about high fiscal deficit is justified if the government incur deficit to finance its current expenditure rather than capital expenditure.

Clearly, there is a nexus between fiscal deficit and public debt which affects the economic growth. India, being a developing country, faced a high level of both fiscal and revenue deficits in the early 1980s, which has continued up to 2014. In the above backdrop, therefore, it is important to know that how the integration of fiscal deficit and public debt affects the path of economic growth.

OBJECTIVE OF THE STUDY:

Given the importance of macroeconomic stabilization and the potential destabilizing effects of high public debt and fiscal deficits on the Indian economy, the main objective of this study is to empirically verify whether there is some relationship between fiscal deficit, public debt and economic growth in India. The paper explores this relationship. The main objective of this paper is to examine the long run relationship between fiscal deficit, public debt and economic growth in Indian economy.

REVIEW OF EMPIRICAL LITERATURE:

Persistently high deficits and public debt have generated considerable debate in the literature on the sustainability of public debt and their spillovers to other macroeconomic variables.Past research has focused on external debt and fiscal deficit for two reasons. First, while external borrowing can increases a country’s access to resources, domestic borrowings only transfer resources with in the country. Hence, only external debt generates a transfer problem. Second, since central banks in developing countries cannot print hard currency necessary to repay external debt, external borrowing is usually associated with vulnerabilities that may lead to debt crises.

Rogoff (2010) examined the relationship between public debt, inflation and growth for USA. They find out positive relation between growth, inflation and debt. They also stated that short- term loan is more vulnerable to the crisis than any other factor. Liu et al. (2005) carried out an empirical study for China. Their findings indicate that there is a positive relation between fiscal deficit and public debt. It also emphasised that high public debt is influenced bylow economic growth in China during the period. Indeed they argued that high bank debts do not affect the economy for the immediate time.

Even if one ignores the numerous technical criticisms made to such findings (for instance the IMF World Economic Outlook (2010) and Jayadev and Konczal (2010), and Irons and Bivens (2010) provided extensive critiques of Alesina-Ardagna and Reinhardt-Rogoff respectively), it is clear that studies supporting expansionary austerity neglected the possibility that economic growth is not only affected by fiscal policy, but may improve public finances and contribute to sustainability. Such dynamic interactions are crucial for determining the causes and consequences of the recent deterioration of the deficit and prospects for the future in the USA (Taylor et al., 2011).

Jorge C. Avila (2011) examined the relationship between fiscal deficit, macroeconomic uncertainty and growth of Argentina for the period 1915-2006, and found that the deficit hampered on per-capita income growth in Argentina through the volatility in relative prices.

In a recent study Folorunso et al. (2013) examined the relationship between fiscal deficit and public debt for Nigeria which showed that there is a bi-directional relationship between fiscal deficit and public debt. They also showed that domestic debt has a strong positive effect on higher fiscal deficit than external debt.

Nill Olekalns and Paul Cashin (1990) examined whether the magnitude of long running fiscal deficit involved violation of India’s inter-temporal budget constraints.  Findingno evidence of co- integration, a result that implies a violation of inter-temporal solvency, author declared that the current fiscal policies are unlikely to be sustainable in the long run. The result supported the preposition that the indefinite continuation of current stance is unsustainable and needs to be altered to prevent an adverse response from lenders. This conclusion was based on a time-series analysis of the behaviour of Indian government’s revenue and expenditure data which indicates that adherence to the inter-temporal budget constraint has not characterised Indian fiscal policy, and provide support for the moves towards fiscal consolidation which occurred since early 1990’s.

Seshan (1987) was the first to draw the attention to the possibility of domestic debt and fiscal deficit in India reaching an unacceptably high level in the too distant future. Subsequently, the Report of Comptroller and Auditor General (CAG) of India also warned against the alarming growth in domestic debt. The initial studies, based on simple trend analysis, were criticised byRangarajan, Basu and Jhadv (1989) on the ground that they lacked ‘analytical constricts’ behind the findings.  For an Indian perspective Rangarajan et al. (1989) examine the relationship between fiscal deficit and govt. debt for India. Based on their economic analysis they found out the positive relation between fiscal deficit and debt. They also argued that a much deeper framework is required to measure the fiscal deficit and public debt in India. Similarly, Pradhan (2011) has investigated the sustainability of public debt for India in which he found out that public debt in India has been sustained during the time. He also advocated the public sector solvency for dealing with the problem of high public debt.

Rangarajan and Mohanty (1997) assessed the relationship between fiscal deficit, external balance and monetary growth. Rao (2000) also assessed the fiscal impact on interest rate and inflation, limited to formalizing the links between budget deficits, money creation and debt financing.

DATA SOURCE AND METHODOLOGY:

Data for the study have been obtained from Data Base on Indian Economy from Reserve Bank of India for the time period 1991-2015 and Economic Survey, Govt. of India. This study has examined the empirical relationship between fiscal deficit and public debt and economic growth in India. The paper takes the different variables such as GDP, fiscal deficit, internal and external debt, inflation and current account deficit. All variables are converted to natural log. Natural logarithm of gross domestic product as the real value of final goods and services adjusted for inflation (GDP), natural logarithm of internal debt as government borrowings from domestic sources (ID), natural logarithm of external debt as government borrowing from foreign sources (ED), natural logarithm of Public debt in the form of total borrowings (PD), natural logarithm of fiscal deficit as government expenditure above revenue (FD), natural logarithm of interest rates (IR), natural logarithm of exchange rate (monthly average) of the Indian rupee against U.S. dollar (EXR), natural logarithm of trade openness as the summation of export and import to GDP (Open)  have been taken.

To determine the relationship between fiscal deficit, public debt and economic growth Co- integration technique, VAR, Unit Root Test, Augmented Dickey-Fuller (ADF) Test, Granger Causality test have been used. In order to analysis the dynamic relationship between fiscal deficit, public debt and economic growth, this study used a vector auto-regression (VAR) approach.

The basic p- lag VAR model in its general form may be defined as:

Yt = c + Φ1 Yt-1 + Φ2 Yt-2 +…… + Φp Yt-p + ε_t;         t=1,2,3…….T          (1)

Where,  

Yt= (Y_1t, Y _2t ……… Y _nt) is a vector of (n x 1) times series variables; c is a k- vector of intercepts; Φi are (n x n) coefficient matrices with all eigenvalues of Φ having less than 1 to satisfy the stationaryproperty of time series; and ε_{t is} an (n x1) zero mean white noise error vector process with time invariant covariance matrices ∑.

With the stochastic exogenous variables, the general form of VAR (p) model can be defined as:

Yt = c + Φ1 Yt-1 + Φ2 Yt-2 +…….+ Φp Yt-p + ΨXt+ εt; t=1,2,3…….T               (2)

Where,

Xt represents (m x 1) matrices of exogenous variables; and Φ and Ψ are the parameters matrices. The selection of VAR lag length is based on the lag selection criteria using the Schwarz Bayesian Criterion (SBC).

RESULTS AND INTERPRETATION:

The descriptive statistics for all variables in study, namely, consumer price index (CPI), as proxy for inflation, fiscal deficit, public debt, internal and external debt, trade openness, gross domestic product (GDP), exchange rate and interest rate are presented in Table 1 given below. From perusal of the table it is obvious that the frequency distributions of underlying variables are not normal. The significant coefficient of Jarque-Bera statistics also indicates that the frequency distributions of considered series are not normal. The value of standard deviation indicates that the interest rate, trade openness, fiscal deficit and public debt are relatively more volatile as compare to exchange rate.

It can be seen from the table that mean value of economic growth in terms of GDP is 36229.93 million rupees from 1991 to 2015 with maximum of 113550.7 million rupees and minimum 6738.750 million rupees during the period. Similarly, fiscal deficit and public debt also have high mean values with 2123.203 million rupees and 318555.7 million rupees respectively.

Table 1:Descriptive Statistics

	GDP	CPI	FD	PD	EXRATE	GDPGR	INTDEBT	INTRATE	OPEN	EXDEBT
Mean	36229.93	6.450	2123.203	318555.7	42.821	6.402	338208.6	8.309	8064.982	8572.764
Median	23558.45	6.310	1257.940	326444.0	44.940	6.680	321456.0	7.830	2972.170	4954.590
Maximum	113550.7	13.913	5556.490	857094.1	62.930	9.570	854565.0	19.570	27370.87	29746.36
Minimum	6738.750	-0.326	363.250	12629.24	22.680	1.430	62348.00	3.290	432.010	1630.010
Std. Dev.	30994.37	3.403	1834.434	220479.9	10.679	2.058	219923.7	3.758	9291.591	7859.743
Skewness	1.196	0.178	0.822	0.778	-0.175	-0.269	0.701	1.761	1.127	1.524
Kurtosis	3.280	2.658	1.985	2.838	2.637	2.597	2.532	5.763	2.815	4.182
Jarque-Bera	6.042	0.533	3.893	2.552	0.265	0.470	2.279	20.888	5.335	11.136
Probability	0.048	0.881	0.142	0.279	0.875	0.790	0.319	0.029	0.069	0.003
Observations	25	25	25	25	25	25	25	25	25	25

Note: 1. Mean, median, maximum and minimum values are in million rupees

2. EXDEB= External Debt; EXRATE= Exchange Rate; CPI= Consumer Price Index; FD= Fiscal Deficit; GDP= Gross Domestic Product; GDPGR= Growth Rate of Gross Domestic Product; INTDEBT= Internal Debt.

From the correlation matrix given below, it can be concluded that most of the variables are highly correlated as the values coefficients are more than 0.80 implying the presence of multi-collinearity. GDP and fiscal deficit are closely correlated while fiscal deficit and public debt are also positively correlated. It is also evident from the table that open trade policy has positively associated with economic growth. The use of VAR model, therefore, can capture the endogeneity.

Table 2:Correlation Matrix

	LNEXDEBT	LNEXRATE	LNFD	LNGDP	INTRATE	CPI	LNOPEN	LNPD
LNEXDEBT	1
LNEXRATE	0.835	1
LNFD	0.958	0.837	1
LNGDP	0.987	0.860	0.971	1
INTRATE	-0.458	-0.621	-0.485	-0.506	1
CPI	0.364	-0.052	0.383	0.371	-0.070	1
LNOPEN	0.971	0.839	0.971	0.993	-0.535	0.426	1
LNPD	-0.364	-0.408	-0.310	-0.361	0.413	0.006	-0.343	1

The Unit Root Analysis

The stationarity of the data series has been established by the standard procedure of unit root testing by employing the Augmented Dickey Fuller (ADF) test. However, the ADF test is often criticized for low power. Hence, it has been supplemented with the Phillips-Perron (PP) test and the Kwiatkowski-Phillips-Schmidt-Shin (KPSS) tests. The results are presented in Table 3. All the three stationary tests indicate that fiscal deficit, GDP, trade Openness, Exchange rate and external debt are integrated of the order I(1) while, interest rate and public debt are integrated of the order I(0). The non-stationary data has been converted to first difference in order to use the VAR model.

Vector Auto-regression (VAR) Analysis

Snce the degree of association is more among the variables, they may cause series indigeneity.  Simple OLS won’t work so we need to use advance version of statistics like; Vector Auto-regression (VAR). Further the detailed Vector Auto-Regression analysis in depicted in Table 4. The results from this table indicate that fiscal deficit is statistically significant at its second lags. This means in simply that the past two years fiscal deficits positively affect the level of public debt. It is evident from the table that public debt and trade openness may be positively related to each other. This is because more open economy has higher resource for external debt to finance the deficit. Trade openness shows positive relation with economic growth. Thirdly, the level of public debt is negatively related to economic growth at its first lag. However, exchange rate has significantly related to the economic growth.

Granger Causality Analysis:

The results from the causality tests are reported in table 5. Each panel of the table  represents onedependent variable and othertwo variables. From the first panel it is evident that there exist a one-way causality from fiscal deficit to public debt. GDP is not statistically significant in causing public debt. It also evident that fiscal deficit and GDP jointly do not case public debt. Thesecond panel also show not significant causation from either way. However, the third panel indicates that there exist a one way causation between public debt and GDP. Moreover, it can also be observed that both fiscal deficit and public debt are jointly cause GDP.

Table 3: Result of Unit Root Tests

Variables	ADF H0: Variable is non-stationary	PP H0:Variable is non-stationary	KPSS H0:Variable is stationary	Order of Integration
Int rate lnFD ∆(lnFD) lnGDP ∆(lnGDP) lnOpen ∆(lnOpen) lnPD lnexrate ∆(ln exrate) lnexdebt ∆(lnexdebt)	-4.272** -0.468 -5.532** 0.573 -4.717** -0.751 -3.804** -4.276** -1.589 -7.208** 0.645 -5.216**	-4.408** -0.208 -8.423** 0.602 -4.717** 0.732 -3.786** -4.23** -1.972 -8.085** 0.584 -4.997**	0.587 0.702** 0.500 0.734** 0.159 0.727** 0.107 0.358 0.661** 0.196 0.715** 0.216	I(0) I(1) I(1) I(1) I(0) I(1) I(1)

** indicates statistical significance at the 5% level, Δ represents first difference

Table 4: Vector Auto-regression Analysis

	LNPD	D(LNFD)	D(LNGDP)
LNPD(-1)	-0.002 (0.217) [-0.009]	0.003 (0.065) [ 0.059]	-0.022 (0.008) [-2.591]
LNPD(-2)	0.254 (0.441) [ 0.575]	-0.174 (0.133) [-1.302]	0.009 (0.017) [ 0.568]
D(LNFD(-1))	0.055 (0.957) [ 0.058]	-0.126 (0.290) [-0.435]	-0.027 (0.037) [-0.729]
D(LNFD(-2))	2.601 (1.009) [ 2.576]	-0.564 (0.305) [-1.846]	0.040 (0.039) [ 1.031]
D(LNGDP(-1))	-0.607 (4.595) [-0.132]	0.527 (1.391) [ 0.378]	0.721 (0.180) [3.999]
D(LNGDP(-2))	-2.144 (3.245) [-0.660]	-0.505 (0.983) [-0.514]	0.041 (0.127) [ 0.325]
C	7.404 (6.508) [1.137]	2.518 (1.971) [ 1.277]	0.132 (0.255) [ 0.518]
D(LNOPEN)	5.477 (2.938) [1.864]	-1.273 (0.889) [-1.431]	0.221 (0.115) [ 1.920]
D(LNEXRATE)	0.861 (2.556) [0.336]	0.725 (0.774) [ 0.936]	0.490 (0.100) [ 4.882]
INTRATE	0.102 (0.076) 1.332]	0.000 (0.023) [ 0.013]	-0.001 (0.003) [-0.507]
D (CPI)	0.056 (0.115) [ 0.492]	0.021 (0.034) [ 0.621]	0.002 (0.004) [ 0.462]
R- squared	0.541	0.396	0.855
Adj. R-squared	0.124	-0.151	0.724
F- statistics	1.299	0.723	6.528
Log likelihood	-20.479	5.798	50.741

Note: t- values are in [ ] and standard errors are in ( ).

Table 5: Granger Causality Analysis

Dependent variable: D(LNPD) H0: D(LNFD) does not affect D(LNPD)
Excluded	Chi-sq.	Degree of freedom	Probability Value
D(LNFD)	6.786	2	0.0336
D(LNGDP)	0.478	2	0.787
All	7.095	4	0.131
Dependent variable: D(LNFD) H0: LNPD does not affect D(LNFD)
Excluded	Chi-sq.	Degree of freedom	Probability Value
LNPD	1.702	2	0.427
D(LNGDP)	0.369	2	0.831
All	2.822	4	0.588
Dependent variable: D(LNGDP) H0: LNPD does not affect D(LNGDP)
Excluded	Chi-sq.	Degree of freedom	Probability Value
LNPD	7.067	2	0.029
D(LNFD)	1.908	2	0.385
All	8.284	4	0.081

Multivariate (Johansan) Co-integrated Analysis

The Johansen test approaches the testing for co-integration by examining the number of independent linear combinations (k) for an m time series variables set that yields a stationary process. Table 6 represents both the trace test as well as max-eigen statistics. The result estimated that there is no co-integrating equation at the 5% significance level.

SUMMARY AND CONCLUSION:

The article has looked at the impact of fiscal deficits and public debt on economic growth in the light of the theoretical literature on the subject. Keynesians argue that deficits may stimulate savings and investment even if interest rate rises, primarily because of the employment of hitherto unutilized resources.

Table 6 Multivariate (Johansan) Co-integrated Tests Results

Hypothesized No. of CE(s)	Trace Statistics	0.05 Critical Values	Probability**	Max-eigen Statistics	0.05 Critical Values	Probability**
None	20.392	29.797	0.396	12.170	21.131	0.530
At most 1	8.222	15.494	0.441	6.704	14.264	0.525
At most 2	1.518	3.841	0.217	1.519	3.841	0.218

Note: **MacKinnon-Haug-Michelis (1999) p-values

However, it does not mean that any amount of fiscal deficit or government borrowing is good for economic growth and employment generation in the economy. Higher fiscal deficit, that is, borrowing by the government involves payment of interest and raises the burden of public debt. The large increase in public debt involving large interest payments year after year will not only make the process unsustainable but adversely affect economic growth through reducing investible resources for spending on infrastructure and social sectors. Revenue deficits amount to a reduction in government savings, which may not be fully offset by a corresponding rise in private savings, leading to a fall in the overall saving rate. The impact of the fiscal deficit on investment arises both from its impact on private investment and government investment. The adverse effects on private investment occur if fiscal deficits put pressure on interest rates since private investment is sensitive to the interest rate. Fiscal deficit and associated borrowing is good as long as it is used for increasing public investment on physical infrastructure, education and health.

The result from the VAR estimation suggests that excess public debt is positively related to fiscal deficit although at its second lag. Secondly we find that public debt and trade openness is positively related to each other. Thirdly, the level of public debt is negatively related to economic growth at its first lag.  The effect on government capital expenditure is through committed interest payments, which rise if the debt-GDP ratio rises and/or interest rate rises. In the context of debt accumulation in India, the main findings are summarised below:

In the context of the present policy options, there is a need to bring down the debt-GDP ratio from its present level, which is in excess of 80 per cent of GDP. The process of adjustment may be considered in two phases: adjustment phase and stabilisation phase. In the adjustment phase, the fiscal deficit will have to be reduced in each successive year to a level, which is less than the level of the fiscal deficit relative to GDP that will stabilise the debt-GDP ratio at the previous year's level. This phase should be continued until the revenue deficit is eliminated. In the second phase, the fiscal deficit could be stabilised at 4 to 6 per cent of GDP. In this phase, the debt- GDP ratio would fall for some more years and eventually stabilise at 56 per cent. At this level of the debt-GDP ratio, it is estimated that the interest payment to revenue receipts ratio, under given assumptions, would fall to 17 per cent. As the reasonable trade openness also has significant role in determining the growth level and meeting the fiscal target. 

REFERENCES:

1.      Alfredo S., (2004) "Debt and Economic Growth in Developing and Industrial Countries", Working Papers 2005:34, Department of Economics, Lund University, available at http://www.nek.lu.se/publications/workpap/Papers/WP05_34.pdf.

2.      Bandiera (2008) “Public Debt and its Determinants in Low Income Countries: Results from 7 Country Case Studies”. World Bank Working Paper Series, World Bank, 47(12), 368-385.

3.      Bardhan, P. (1984) The Political Economy of Development in India, New Delhi:   Oxford University Press.

4.      Brahmananda, P. R. (1980) Growth less inflation by means of stockless money, Himalaya Publishing House, Bombay.

5.      Charan, S. (1999) “Domestic debt and economic growth in India” Economic and Political Weekly, 34(23), 1445-1453.

6.      Chakraborty (2002) “Fiscal Deficit and Rate of Interest: An Econometric Analysis of the Deregulated Financial Regime”, Economic and Political Weekly, 37 (19).

7.      Dickey and Fuller (1979) “Distribution of the Estimators for Autoregressive Time Series with a Unit Root”, Journal of the American Statistical Association, 74 (1), 427

8.      Easterly and Schmidt-Hebbel (1993) “Fiscal Deficits and Macroeconomic Performance in Developing Countries”. World Bank Research Observer, 8(2), 211-237.

9.      Ferguson, J.M.(ed) (1964) Public debt and future generations. University of North Carolina Press, Chapel Hill.

10.    Gupta, S. et al. (2005) “Fiscal policy, expenditure composition, and growth in low-income countries”, Journal of International Money and Finance, Vol.24, No.3, pp 441

11.    Hauner, and Kumar (2009). “Fiscal Policy and Interest Rates: How Sustainable is the New Economy?” Economic Policy Review, 24(2), 348-351

12.    Johansen, S. and K. Juselius, (1990), “Maximum likelihood estimation and inference on cointegration with application to the demand for money”, Oxford Bulletin of Economics and Statistics, Vol.52, No.2, pp: 169-210.

13.    Jacob and Butler (1989) “The Ricardian Approach to Budget Deficit”, Journal of Economic Perspectives, 3(2), 37-54.

14.    Lahiri, A. and Kannan, R. (2001) ‘India’s Fiscal Deficit and Their Sustainability in Perspective’, World Bank NIPFP Seminar of Fiscal Policies for Growth: New Delhi.

15.    Mohanty, M.S and Joshi, H. (1992) ‘The Dynamic Interrelationship Between Fiscal and Trade Deficits in India: 1970-71 to 1990-91, Reserve Bank of India Occasional Papers

16.    Rangarajan and Srivastava. (2005). “Fiscal Deficits and Government Debt: Implications for Growth and Stabilisation”. Economic and Political Weekly, 40(27), 2919-2934.

17.    Rajaraman, I. and Mukhopadhyay, A. (2000) 'Sustainability of Public Domestic Debt in India' in D.K. Srivastava (ed.) Fiscal Federalism in India- Contemporary Challenges,National Institute of Public Finance and Policy, New Delhi.

Received on 22.02.2017

Modified on 06.03.2017

Accepted on 24.03.2017

© A&V Publications all right reserved

Research J. Humanities and Social Sciences. 8(1): January - March, 2017, 21-26.

DOI: 10.5958/2321-5828.2017.00003.1