India’s state finances have done an about-face. From 2009-13, state fiscal deficits contracted sharply but they have ballooned since. As a result, the spreads on state bonds (SDLs)—in effect the interest premium the states have to pay for borrowing—have skyrocketed. Today, India’s states account for 60% of overall government spending, thus more than the Centre. This means it is going to be increasingly important to understand the states, and state discipline is essential if the official recommendation that India’s public debt be lowered to 60% of GDP by 2023 (from 66% now) is to be met.
Over the last month, the states have released their budget documents. We have looked closely at those of 16 major states that make up about 85% of India’s economy and outline here what we believe is driving the excesses.
We find that the Centre’s revenue transfer to the states increased more than budgeted in FY17—from 6.5% of gross domestic product (GDP) revised estimate (RE) compared with 6.1% of budget estimate (BE). And there were changes in the composition. The proportion of “untied” funds, which the states can spend as they like, has risen vis-à-vis “tied” funds, where use is strictly defined.
Yet India’s states, on aggregate, overshot the fiscal deficit target (2.8% of GDP RE versus 2.6% of BE). The slippage was not about revenue. Luckily, all the shortfall from lower than expected stamp duty collections and oil value added tax (VAT) was made up for by higher transfers from the Centre. Instead, the entire slippage came from higher current spending (0.3% of GDP more than budgeted), while capex fell (0.1% of GDP less than budgeted).
Furthermore, we find that the states have not chosen to spend the “untied” funds wisely. The quality of state spending (proxied by the ratio of capital to current spending) has been gradually worsening over the past few years, even as the quality of the Centre’s spending (thanks to a lower subsidy bill and higher capex) has improved over the same time.
That was the past. For FY18, the states, on aggregate, have budgeted for a fiscal deficit of 2.6% of GDP. But we are not convinced by these estimates. A close look revealed that there are up to five different developments that the states may not have accounted for completely. Some of these threaten to worsen the aggregate state fiscal deficit, while others threaten to lower it.
Our analysis of the Central government’s budget shows that the Seventh Pay Commission wage proposal is expected to run up a bill of 0.6% of GDP. Experience shows that the states’ pay commission wage bill roughly equals the Centre’s. We estimate that so far the states have only budgeted for 0.4%, and the balance is likely to contribute to the slippage. Next, we estimate that the states have not fully accounted for the interest bill arising from the Uday (Ujwal DISCOM Assurance Yojana) bonds issued over the last two years (and to be issued next year). Finally, seven states will go into election mode over the next few years, and given past experience, could bump up expenditure in the run-up. These three things threaten to widen the deficit.
But there are offsetting factors as well. As the housing market stabilizes, stamp duty collections by states may rise more than budgeted. As oil prices begin to rise gradually, oil VAT revenue is likely to be higher than what the states are currently expecting. Considering everything, we find that the state deficit, on aggregate, could come in at an elevated 2.8% of GDP in FY18—the same as the revised estimate for FY17. And in this piece, we are not even incorporating the potential impact of farm loan waivers that Uttar Pradesh is likely to implement. There are risks of a wind of competitive populism spreading across states, endangering both national debt and deficit.
What does this mean for bond issuances, capex, the general government deficit and growth?
Despite an elevated state deficit, we find reasons to breathe easy, at least for now. The consolidated public sector borrowing ratios are likely to fall in FY18, thanks to the Centre’s fiscal discipline, as well as estimates of lower Uday and public sector enterprise (PSE) bond issuances over the year (see chart). Overall borrowing is likely to grow at a lower clip than nominal GDP, which is a different way of saying that the supply of bonds will grow more slowly than their demand. It is fair to conclude here that the Centre is likely to compensate for the states’ excesses.
However, the Centre may not come to the states’ rescue ad infinitum. A simple regression suggests that SDL spreads are sensitive to overall borrowing and the SDLs’ share in that borrowing. If the states do not gradually lower their deficits over time, the benefits of falling Central borrowings can be easily offset by the rising share of SDLs. And higher spreads could keep the state interest bill elevated, even threatening to put states in a vicious cycle of high borrowings today leading to a high deficit tomorrow. In short, there is no getting away from lowering state deficits over time.
Thanks to the Centre’s continued discipline, the general government deficit is expected to inch lower over FY18 (from 7% of GDP to 6.7%). Our fiscal impulse model suggests a marginally negative impact on growth. We also estimate that the combined capex thrust of the state, Centre and PSEs (public sector enterprises) is budgeted to moderate over the next year. All this reinforces the view that economic growth over FY18 will be flat at best, lower than the V-shaped recovery that markets are expecting.
But there is a clear silver lining here. A lower general government deficit is good news for macro-stability, which, in turn, is critical during periods of global volatility, especially given that India is infamous for running a higher consolidated fiscal deficit and having a public debt ratio that is much higher than the emerging markets average. The Centre is making it come down for now. Will the states do their bit in the future?
Pranjul Bhandari is chief India economist at HSBC Securities and Capital Markets (India).