The viral of farm loan waivers is acquiring epidemic proportions. In some ways it is a competitive race to the bottom. This is notwithstanding serious concerns that this can scarcely address the distress of the farming community. Unfortunately, broader structural changes in agriculture have eluded coherent implementation. Loan waivers in the past failed to address intended outcomes. We know that the loan waivers of February 1990 by the National Front government led to sharp fiscal deterioration and the subsequent balance of payments crisis. Subsequent loan waivers had similar results.
The Finance Minister has spoken wisely that the Central government has no role to play. State governments are entitled to take such decisions but manage their financial consequences. Farm loan waivers are a subset of the broader issue of sustainable State finances. We need to address several issues.
A growing concern
Following the 14th Finance Commission recommendations, the total State expenditure (as a percentage of GSDP) is higher than even the Centre’s. State finances have increasingly become a crucial lynchpin of India’s fiscal framework. Many State governments have adopted State-level fiscal laws and adhered to the 3% fiscal target under the State-level FRBMs (Fiscal Responsibility and Budget Management Act). However the recent report of the Reserve Bank, State Finances: A Study of Budgets 2016-17 , has some worrying conclusions. The combined deficit of the States reached 3.6% of GDP in FY16, significantly higher than 2.6% in the previous year. This significantly breaches the 3% fiscal deficit stipulated by the States themselves in their FRBMs. As a consequence, the consolidated fiscal deficit of the Central government (Centre and States combined) will increase from 6.7% in FY15 to 7.5% in FY16. The fiscal consolidation of the Centre is more than offset by expansion of the States. This is partly explained by the State power distribution companies (DISCOM) debt, 75% of which will be explicitly accounted in States’ balance sheets, and treated as capital spending in fiscal accounts. The quality of compliance by States has also deteriorated. These go beyond UDAY (Ujwal DISCOM Assurance Yojana) to include irregularities in food credit accounts of State governments with commercial banks, off-balance sheet expenditures, and creative accounting engineering to evade stipulated targets.
Debt is considered sustainable if debt-GDP ratio is stable or on a declining path. This is a necessary condition for solvency of any government’s finances. While debt ratios for the Central government are projected to decline under plausible assumptions, the behaviour of the States is strikingly different. The debt ratio for the States under status quo and present FRBM scenarios is actually projected to increase! This is mainly because the primary deficit (total deficit excluding the interest payments), a driving variable in debt dynamics, is much higher for the States compared to the Centre. The Centre’s primary deficit according to the RBI report is 0.7% of GDP while that of the States is close to 2% of GDP. A significant part of the Central government’s deficit is mainly towards interest payments on existing borrowings, unlike the States which spend significantly less on interest payments. Nonetheless, if this picture persists, State debts will increase from close to 20% of GDP to 35% of GDP over the next 10 years. A significant consolidation by the States would be needed to keep the debt ratio stable for the States, let alone decline.
Given the increased foreign holdings of Indian government bonds, a worsening of State finances will dent India’s credibility among foreign institutional investors (FIIs). The rise in government bond yield of State government securities would increase the interest burden on new debt and also for the old debt which are re-priced. Such a scenario could make State debt more explosive. Indeed, the yields of State government debt have increased, remaining higher than the Central government securities and with the spread showing a rising trend.
Composition of the deficit
An ameliorating factor for the States is that the revenue deficit for the Centre is 2.5% of GDP compared to 0.2% for the States. Thus while the Centre borrows largely for revenue spending and current consumption like wages, salaries, the States do so for capital expenditure like infrastructure. This is despite the fact that delivering public services which are growth enhancing, such as health and education, is the prime responsibility of the States. Overall, however, this is a compositional issue and matters less for solvency or debt sustainability.
Although composite State finances are useful to analyse, there are marked variations across States. States like Tamil Nadu, Gujarat, and Maharashtra have significantly lower fiscal deficit, with more intensive tax efforts, than States like Uttar Pradesh and Jharkhand, which collect lower tax and are fiscally less prudent.
Despite significant variations across States in the degree of fiscal prudence, there is little correlation between State government yields (measured as spread over Central government securities) and fiscal deficits. Yields have no relationship to State fiscal prudence. Perhaps this is on account of the implicit guarantee by the sovereign. The implicit sovereign guarantee, however, cannot explain why State bonds consistently trade above Central government Gsecs, and the spread may, in fact, suggest the additional credit risk associated with State bonds. Or perhaps the latter spread could reflect the liquidity risk.
Borrowings by States are likely to increase sharply due to interest of UDAY bonds, and more importantly, the viral of farm loans waivers. With little compensatory action, this will seriously undercut the hard-won battle to secure fiscal prudence for the country as a whole.
What can be done
We must recognise that macroeconomic stability is contingent on the fiscal position of the general government. The Central government has pursued fiscal prudence against many odds. Unchecked profligacy by States can undermine the overall macro stability.
There are three short-term steps. First, we must improve the due diligence by the Central government in giving consent to borrowings by States under Article 293 of the Constitution. Unfortunately, there is some lack of coordination within the Ministry of Finance itself. Approvals for State government borrowings are accorded by the State Plan Division with little coordination with the Budget Division, which monitors implementation of FRBM obligations. A more stringent criteria in approving borrowings for States which deviate from stipulated fiscal norms is urgently needed. The criteria must be transparent and apolitical in character.
Second, whenever the Central government breaches the fiscal norms, it secures parliamentary approval. State governments must be encouraged to adopt a similar practice by securing the approval of the State Legislature.
Third, regulatory measures can be devised to enable bond yields to be responsive to market signals and bridge the information asymmetry between markets and State finances of the concerned State governments.
Finally the 15th Finance Commission must address the broader issue of adherence by States to fiscal obligations. It must restore adherence to fiscal norms as an important ingredient in the devolution formula. This also implies inter se distributional burden among the States themselves.
Investors recognise and reward macro stability. Fiscal prudence exercised by the Central government has been widely acclaimed. The management of State finances must not undercut this important achievement which is central to investor confidence and enhanced credit rating. A lot is at stake. We must not undo the gains.
N.K. Singh is a former Member of Parliament & Chairman, FRBM Review Committee. Prachi Mishra was recently with the Reserve Bank of India, Strategic Research Unit