The hidden public debt

The inability of MSEB to pay Enron, in recent weeks, means that the guarantees of the state or central governments will now be invoked. To use the vocabulary of options, the guarantees provided constituted gifts of options. These options are now likely to be exercised.

It is common to measure the fiscal crisis in India using measures such as the gross fiscal deficit as percent of GDP, or of the stock of public debt as percent of GDP. However, it is likely that the apparent stock of public debt is significantly understated.

At the simplest, the government has made unconditional promises about payments in the future. It is fair to reduce these into a present value and treat this as an additional debt of the state. In addition, the government has made certain conditional promises (e.g. "if the Maharashtra government is unable to pay Enron, the Central government will do so"). These promises are options. They should be valued as options, and the price of the options should be treated as an additional debt of the state.

There are two large components of the hidden public debt where some crude estimates are now available: in the pension system and in the banking system.

Implied public debt in pensions. The civil servants pension in India is a unfunded system; i.e. the payments to pensioners this year are funded out of taxes this year. It is possible to measure the stock of pension assets which would pay pensions in the future to the civil servants where pensions have been promised. In addition, the Employee Pension Scheme (EPS) which is run by the Employee Provident Fund Organisation (EPFO) is likely to feature promises of benefits which are out of line with the assets in hand. In a recent report titled India: The challenge of old age income security (October 2000), the World Bank has estimated that the implied public debt owing to these two programs amounts to roughly 33% of GDP. In my judgement, this estimate is a lower bound of what the implied public debt owing to pensions could prove to be.

Implied public debt in banking. The government today underwrites all banks. According to the best estimates available today, a large fraction of India's banks are insolvent. When these banks fail, they will make claims on the State, which has publicly promised that no banks would be allowed to fail. Further, it is essential to infuse equity capital into banks to bring their leverage down to normal levels by international standards. As long as the government controls public sector banks, it is extremely hard to attract private capital into them. In a recent paper Measuring systemic fragility in Indian banking: Harnessing information from the equity market, Susan Thomas and I estimate that it would cost roughly 8% of GDP to bring the leverage in Indian banking down to international standards. In my judgement, this estimate is a lower bound of what the implied public debt owing to banking could prove to be.

These two numbers -- Rs.7 trillion and Rs.1.7 trillion -- are extremely large and worth worrying about. The stock of public debt would go up by 41% of GDP if these implicit liabilities are added in. There are many other hidden liabilities of the Indian state, such as Enron, US-64, or the currency risk on IMD, which are ignored above. This estimate of 41% of GDP is obtained by examining exactly two fields: pensions and banking.

These values make India's fiscal situation a lot more troublesome as compared with the picture obtained while ignoring these hidden liabilities. The large stock of public debt is one factor weighing down India's credit rating, and the international rating agencies have developed a heightened consciousness about these off--balance--sheet liabilities.

In the area of pensions, the OASIS project, created by the Ministry of Social Justice, offers one blueprint for reforms. The World Bank report mentioned above offers a competing vision for pension sector reforms. In either case, it is clear that moving away from the unfunded civil servants pension and the underfunded EPS program can improve matters.

In the area of banking, the key goal for government should be to distance itself from banks. Banks should be viewed as normal firms, where birth and death are normal and healthy events. A formal deposit insurance framework should be established, to protect small depositors and avoid bank runs; but for the rest it is essential to have a normal and routine process of bank failure. Roughly 1% of the securities firms of India fail every year. There is no reason why insolvent banks should not routinely fail. If an institutional mechanism exists, through which banks can be closed down without imposing liabilities upon the State, then the implied banking debt would shrink from 8% of GDP to 0.

Similarly, the implied public debt owing to the Enron counter-guarantee would have been zero, if policy makers had dealt with the insolvency of MSEB at a structural level, by dealing with the twin diseases of gifts and theft of electricity.

The implied public debt owing to US-64 would be zero if UTI were converted into a limited liability company, as is the case with every other mutual fund in India, and all the shares in UTI were sold off by the government. Once this is done, there is no possibility that an assured returns scheme run by UTI could generate a liability for the State. As a side effect, selling off UTI could raise between Rs.3,000 and Rs.5,000 crore for the government, which could be used to retire public debt.

In summary, we face a mixed picture. The bad news is that the fiscal problem in India is much worse than meets the eye, since the stock of public debt as percent of GDP is sharply understated. Two areas alone -- pensions and banking -- involve a giant hidden public debt of atleast 41% of GDP. At the same time, there is some hope. By setting up an institutional mechanism for bank failure, and forcing weak banks to die, we can get rid of implied public debt worth atleast 8% of GDP. Some of the implied pension debt can be eliminated by better policies, the rest of it will become explicit public debt.

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