D Subbarao Exclusive Interview: India’s debt-to-GDP ratio is high; it is a concern and should be brought down, says former RBI Governor

D Subbarao

Former Reserve Bank of India governor D Subbarao said India’s high debt-to-GDP ratio is a concern and the government should make efforts to bring it down, warning that it could otherwise worry foreign investors and dent confidence as it is one of the main factors of macroeconomic stability.

Subbarao’s comments came about two weeks before finance minister Nirmala Sitharaman is set to unveil the interim budget and in the backdrop of warnings from economists about rising debt levels in Asia’s third-largest economy.

On the inflation-targeting policy of the RBI, Subbarao said while the idea is ‘largely good’ as it makes policy more predictable and stable, there are questions about inflation being driven by supply shocks and how effectively monetary policy can manage price rises in such a situation. However, Subbarao agreed that the RBI’s inflation-targeting framework is working in India.

The RBI has been fighting a hard battle against persistently high inflation in the past two years. The rate committee led by the central bank has increased the key interest rate by 250 basis points in the current cycle, but inflation is still above the RBI’s medium-term target of 4 percent.

In an exclusive interview to Moneycontrol, Subbarao also spoke about a range of issues including the US weaponising the dollar for political purposes and the impact of the inclusion of Indian bonds in the JPMorgan index.

Subbarao spoke on the sidelines of the CFA Society’s annual flagship conference in Mumbai. The theme for the 14th India Investment Conference was Shifts in Economic Influence: A New World Order. Edited excerpts:

How big a risk is India’s high public debt? In a recent report, the IMF said India’s public debt could go as high as 100 percent of GDP.

I saw the IMF report which said that India's debt-to-GDP ratio could go as high as 100 percent, but they said under adverse circumstances. They did not say that that is the base case. But still I believe that we need to focus, we need to be concerned about our debt-to-GDP ratio. The debt-to-GDP ratio today is about 81 percent. The FRBM committee said that a safe limit for debt-to-GDP for India is about 60 percent – 40 percent for the Central government, 20 percent for the states combined.

So we are very aware of that limit. In response to the IMF comment, the government of India has said that it is not likely. And they usually put up defences against this debt-to-GDP ratio. First is that we borrow in local currency, therefore it's not such a big risk. I agree that the fact that the government borrows in local currency is a safety net, but not too much of a safety net because although the government is borrowing in local currency largely, the rest of the economy, as an economy, needs a lot of capital inflows.

And therefore, we need foreigners to continue to have confidence in the economy. Foreigners, foreign investors, vote with their feet. So if the debt-to-GDP ratio is high, they get concerned because debt-to-GDP ratio of fiscal deficits is one of the main indicators of macroeconomic stability, and that's something that foreign investors and domestic investors track. Therefore, the fact that our debt is largely local currency is safety, but not too much safety.

The second difference put forward is that our debt-to-GDP ratio at 80 percent is quite low compared to other countries such as the US, the UK, many European countries, and Japan, which have debt-to-GDP of over 100 percent, over 200 percent. But I believe that those international comparisons are misleading because as much as our debt-to-GDP ratio is low, our revenue-to-GDP ratio is also low. So India can get into a debt trap or debt pressure even at a lower debt-to-GDP ratio.

Therefore, I think we should be concerned. I agree that the 80 percent debt-to-GDP ratio is high, we should bring it down and it is a concern.

Over the last year, the RBI has intervened in the forex market to keep the rupee within a narrow band. Will the RBI continue to actively manage the exchange rate?

First, I cannot speak for the RBI, okay? But I will try to answer your question, which is that I saw the IMF comment that the exchange rate last year was within a very narrow band despite global volatility. Therefore, the RBI intervened to keep it stable.

The RBI presumably is acting consistent with its policy, which is to manage volatility in the currency, but not target an exchange rate. Having said that, this is not about the RBI's current management or expected management of the currency. I think that we should be veering more towards letting the exchange rate respond to market fundamentals rather than managing it all the time.

For two reasons. Holding reserves, $600 billion… is a safety net, but it also involves cost. We're incurring a cost in maintaining a very high level of reserves. Where do we draw the line between buying insurance and incurring a cost?

The second is if every time the exchange rate moves and the RBI tries to stabilise the exchange rate, the message that will go to the market is that the RBI will take care of exchange rate fluctuation, we can play around with whatever. They will outsource exchange rate risk management to the RBI, they will not hedge. That's not a good thing because the cost is then passed on to the entire economy. So I believe that the RBI should veer more towards keeping away from the market than playing in the market.

What are the implications of Indian government securities being included in the JPMorgan Bond Index?

That is a very positive thing. But it also comes with challenges. First, let me talk about the positives. The biggest positive, of course, is confidence. The signal about confidence that India is sending out that we are an open economy. It is a signal of confidence and I think that's a big deal. Second, it's expected that about $25 billion to $30 billion will flow in. That will reduce the yields on G-Sec bonds, so it will reduce the cost of borrowing for the government. It reduces the cost of borrowing for corporates, because their borrowing rates are benchmarked to G-Sec rates. So, we will be able to finance – the government will be able to finance the fiscal deficit, and the economy will be able to finance the current account deficit more easily.

But the challenges are that we will be more vulnerable to global shifts in sentiment. So anything that happens outside is affecting us today as much as we're integrated.

But we will be even more integrated, because once we enter the bond index, the government's fiscal stance and the economy's current account position will be under great scrutiny and capital will flow out, flow in and there will be much greater volatility, so we should be more stable.

Going forward, there's a risk that capital flows will dictate the current account rather than the current account dictating capital flows. We should not let that happen. Our current account should be an independent variable and capital flow should come in according to that. It's not as if so much capital will come in and we import more in order to get more capital. That should not happen.

So we should continue to see that the current account deficit is an independent variable and capital flows are a dependent variable.

There is resentment among emerging markets against the US weaponising the dollar for political purposes. There was talk of a BRICS currency. Will these efforts cause a shift away from dollar dominance?

Yeah. As you said, there is resentment against the dollar, first, because America is weaponising the dollar. There is resentment also because the dollar being the dominant reserve currency in the world is a threat to global stability. We saw that during the 2008 global financial crisis. We saw that during the taper tantrums. We saw that during the pandemic.

So, one large dominant reserve currency is a threat to global stability. The resentment is also because… as we trade in dollars, we invoice in dollars, we hold dollar reserves, we are incurring a cost. So diversification is good, and BRICS, among others, is trying to de-dollarise. There was much speculation that the BRICS Summit would come out with the BRICS common currency… that did not happen, but they agreed on trading in local currencies.

The BRICS common currency might eventually come, but…  I think it's politics that will come in the way, geopolitics. Do we want to move into a China-controlled system by trying to move away from an America-controlled system? It's a difficult choice. And I don't believe that other BRICS countries, most notably India, will be inclined towards that.

Inflation was above the RBI's band for quite some time last year. Even today, it is above the midpoint of the target band and is expected to remain above the midpoint this year too. Is inflation-targeting working in India?

My short answer is yes. But let me give you a more considered answer, which is that, as you said, today headline inflation is above the midpoint, it is within the tolerance band, but above the midpoint, in fact, closer to the top end of the band, and is expected to remain there.

Two things are happening in the inflation picture today. One is core inflation is below 4 percent, below the midpoint of the target, but headline inflation is high… largely because of food prices. And food prices are responding more to supply shocks than demand.

So the question about inflation-targeting the reservation that most people have about inflation-targeting is this: Can monetary policy, which tries to control inflation by controlling demand, by calibrating the interest rate, can it control inflation, which is driven by supply shocks? The stock response that governors give, which I gave too when I was governor, is that yes, even if inflation is driven by supply shocks, the monetary policy has to be the first line of defence because if inflation is high for too long a time, inflation expectations get de-anchored. So, monetary policy has to act to manage inflation expectations. There is some substance to that argument, but we can't carry it too far.

So, the answer to the question about India embracing an inflation-targeting framework is that largely it is good, it gives an anchor, it makes RBI policy more predictable, it gives more stability, but still we have the concern about inflation being driven by supply shocks and to what extent monetary policy is an effective instrument for managing inflation in such a situation.