India’s sovereign debt reached unprecedented levels in 2020, partly driven by the policy response to Covid-19, but also by low growth and high interest rates.

Some have argued that high levels of debt may be less concerning in an environment of low interest rates. But there is also a significant body of evidence that points to several mechanisms through which high levels of sovereign debt can have negative effects on the economy.

Against this background, we document stylised facts on the recent evolution of sovereign debt and fiscal deficits in India and ask the following questions: what are the costs of high debt levels in India? Are there any silver linings? What lies ahead?

We analyse macroeconomic outcomes during and after debt “surges”, “stabilisation”, and “reduction” periods in India and other countries and ask whether past experiences with surges and reductions shed light on different policy options and the tradeoffs for India during the post-pandemic recovery.

The Covid-induced surge in debt in India was unique compared to its own history, but also bigger than that for the average emerging market economy.​ The drivers of the debt surge were different too.

Both fiscal expansion and the collapse in growth played a proportionately larger role in India compared with the average emerging market, even as higher inflation played a greater role in reducing debt in India​.

Notwithstanding the high level of sovereign debt, there are a few silver linings for India. The share of sovereign debt held by foreigners – an important predictor of crises in the literature – is low.

Moreover, although global waves of debt surges have been followed by restructuring or default, India has not had any such episode so far. Furthermore, long-term real rates remain low in India, comparable to the median emerging market. That said, we find substantial heterogeneity across countries. While India was closer to the 25th percentile during the last decade, it has now caught up with the median.

We document substantial costs of high debt. A major one is foregone resources on account of strikingly high interest payments, which at almost 30% of overall revenues during Covid-19, are close to three times higher for India than the typical emerging market.

High expenditures on interest payments reduce the resources available for countercyclical fiscal policies in the event of negative shocks such as Covid-19, as well as for social spending in critical areas such as health and education, where India’s public spending remains markedly below peers.

Indeed, our analysis suggests that business cycle fluctuations explain a smaller fraction of the variation in debt in India compared with peers, reaffirming the limits to countercyclical fiscal policy on account of high debt levels.

Simple calculations suggest that reducing India’s interest payments to revenue to the emerging market average of 10% would release resources of close to Rs 6-8 trillion, a figure comparable to India’s pre-Covid general government education expenditure, and about three times its health expenditure.

Another cost of high public debt in India is its impact on borrowing costs. Although real rates in India are low and in line with the median emerging market, we find that they have increased over time, and that the elasticity of borrowing costs to a unit increase in debt is higher for India than the typical emerging market.

For example, on average, an increase in debt to gross domestic product by 1 percentage point, or pp, increases long-term borrowing costs by 0.19 pp in India, while for a median emerging market, it increases by only 0.01 pp.

Finally, public debt exemplifies an important factor in the assessments of rating agencies too, where India’s debt and deficits stand out as being markedly higher than similarly rated peers.

In order to understand where to go from here, we look at India’s own history and also draw on cross-country experiences​. Since 1913, India has had nine episodes of debt surges, five episodes of reduction and six episodes of debt stabilisations.

Surges have typically ended in stabilisations in India, whereas in an average emerging market, 75% of surges end in reductions. In other words, India has been able to sustain debt at high levels without default or restructuring. Across reduction episodes, India reduced debt ratios by 2 pp per year, compared to more than double the figure for the average emerging market.

We also find that debt surge episodes are associated with worse macroeconomic outcomes – low economic growth and public investment – compared with debt reduction episodes. Moreover, cross-country evidence suggests that the greater the magnitude of the rise in debt, and longer lasting the episode, the greater the associated reduction in growth around the surge.

How much debt could India reduce? One way to approach this question is to look at interest payments and additional budgetary resources that could be generated by lower sovereign borrowing. For example, getting interest payments down to 22% – still much higher than the emerging market average of 10% – would require reducing the debt ratio to 70%, bringing it closer to the median for similarly rated peers.

What is a possible path and how long would it take to get there? The higher the growth rate and the lower the borrowing costs, the lower the need for fiscal adjustment.

​Simulation exercises suggest that if we assume constant values for real GDP growth rate at 7% and real rate at 2% in line with the International Monetary Fund World Economic Outlook assumptions, a general government primary and fiscal deficit of lower than 1.7% and 5.9% of GDP, respectively, would be needed every year to reduce debt ratios to 70% in the next 10 years (and interest payments to 22% of revenues).

This would require a sharp adjustment when compared with the financial year 2022-’23 primary and fiscal deficit at a projection of 4.5% and 9.9%, respectively, according to the World Economic Outlook.

Importantly, the higher the growth rate and the lower the interest rate, the less the required adjustment. For example, a growth rate of 9% or a real rate of 0% would open up more space with a primary deficit of more than 3% of GDP instead of 1.7%, still ensuring the same debt reduction.

While the calculations above assume constant primary and fiscal deficits, allowing for some transitional dynamics and smoothing the adjustment path, we report in Figure 5 illustrative scenarios for debt and fiscal consolidation for India over the next five years.

Indeed, evidence across emerging economies suggests that primary balance consolidations outside of recessions could, in fact, be successful in reducing debt, and do not tend to be detrimental to growth​ as multiplier effects roughly balance the positive impulse from other channels such as higher confidence.

Prachi Mishra is Chief of the Systemic Issues Division in the Research Department at the International Monetary Fund, Washington DC. Nikhil Patel is an Economist at the International Monetary Fund, Washington DC.

The article was first published on India in Transition, a publication of the Center for the Advanced Study of India, University of Pennsylvania.