Let state finances not spiral out of control

The viral of farm loan waiver is acquiring by more new states like Maharashtra, Madhya Pradesh and Uttar Pradesh. Unfortunately, broader structural changes in agriculture have eluded coherent implementation. 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. State governments are entitled to take such decisions but should strive to manage their financial consequences. Farm loan waivers are a subset of the broader issue of sustainable State finances. As the States need to address several issues.
Due to farm loan waiver, the States expenditure is higher than that of Centre.

Following the 14th Finance Commission recommendations, the total State expenditure (as a percentage of GSDP) is higher than even the Centre’s GDP. 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, a report of the Reserve Bank, State Finances: A Study of Budgets 2016-17,reveals that the combined deficit of the States reached 3.6% of GDP in 2016, significantly higher than 2.6% in the previous year. This significantly breaches the 3% fiscal deficit stipulated by the States themselves in their FRBMs.

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.

According to fiscal laws, 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, the debt ratio for the States under status quo and present FRBM scenarios is 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. 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. 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; 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.

So to curb the fiscal deficit, following steps are necessary:

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.

By Gudipati Rajendera Kumar