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Competitive federalism in the state bond market

Markets are starting to differentiate between states based on their individual credit quality

One data point does not make a trend. Still, some data points are interesting enough to analyse and see if they represent the start of a trend.

The data point in question is this week’s auction of state government bonds (a.k.a. state development loans). The auction, usually a routine affair which gets far less attention than central government bond auctions, caught the eye of market watchers. There were two reasons for this. First, the yields being demanded by the markets for state bonds jumped considerably. Second, there was a wide difference between the yields demanded on bonds of different states, which was unusual. While both these points were noteworthy, it was the second that got people talking.

Soumyajit Niyogi of India Ratings in a note highlighted the difference in the yields from state to state and attributed this to “higher issuances by a few states and possibly differentiation on account of credit quality and liquidity issues". R. Sivakumar, head of fixed income at Axis Mutual Fund felt that the power distribution company (discom) revival scheme, which involves the conversion of discom loans into state government bonds, may be impacting the view that investors are taking on different states.

In the absence of a definitive explanation (and it may be too early for one), it may be interesting to work backwards and look at the states that were asked to shell out more to borrow.

The state that paid the highest interest rate to borrow at this week’s auction was West Bengal. It borrowed 2,500 crore for a period of 10 years at 8.88%. Uttar Pradesh paid 8.83% and Bihar paid 8.82% to borrow the same amount. The state that got the best rate was Odisha, which borrowed 1,000 crore at 8.48% (but for five years).

Data collated from a 2015 Brickwork Ratings report shows that each of the three states where yields jumped has seen a significant jump in borrowings over the last five years, although they aren’t the states that saw the biggest jump.

In the case of West Bengal, market borrowings over the last five years between fiscal 2011 and fiscal 2016 have jumped 328%; borrowings for Uttar Pradesh are up 237%; and Bihar’s market borrowings have jumped nearly 200%. Overall, state government borrowings are up about 90% over this period.

But just looking at the quantum of gross market borrowings may not fully explain the reason some states are being penalised more than others. In a presentation, Saugata Bhattacharya, chief economist at Axis Bank, highlighted an important point. Data compiled by his team shows that states at an aggregate level have frittered away most of the surplus they may have built up during the good years. This has meant that a larger proportion of the consolidated state fiscal deficit is being financed through market borrowings. So, in fiscal 2015, 78% of the 2.3% state fiscal deficit was financed through market loans compared to 71% of the 2.5% deficit in fiscal 2014.

Some states are more reliant on borrowings that others. West Bengal, for instance, saw it net market borrowings surge to 142% of its 2014-15 fiscal deficit from 89% of its fiscal 2014 deficit, showed Bhattacharya’s presentation. This is the worst among major states in this respect and also one of the biggest borrowers in absolute terms. That may explain why it paid the highest interest rate at the auction.

Another factor that is getting tacked on while assessing the credit quality of states is the discom revival package. For instance, Uttar Pradesh has agreed to take over nearly 40,000 of the debt of its power distribution utilities and convert this amount into state government bonds.

Just like West Bengal, the state is already a heavy borrower and as per fiscal 2016 budget estimates, Uttar Pradesh’s market borrowing were pegged at just under 46,000 crore.

For Bihar, the jump in interest rates may be emerging from the fact that its absolute market borrowings have increased and its net market borrowings as a percentage of fiscal deficit has gone up sharply from 32% in fiscal 2014 to 72% in fiscal 2015. At about 2,300 crore, its burden from the discom revival package is lower .

It’s important to note that the discom scheme doesn’t appear to be the only thing the market is focusing on. Rajasthan, which will take over the maximum (60,000 crore) in discom loans, managed to borrow at a relatively lower 8.65%. This may be because it is currently financing a lower proportion of deficit through borrowings.

To sum up, markets are starting to differentiate between states based on their individual credit quality. If this trend persists, states will be under greater pressure to manage their finances better. The differentiation is happening on the basis of a state’s track record and in anticipation of any future burden it may have to incur on account of liabilities such as discom debt and the impact of the 7th Pay Commission.

The government and the central bank would do well to start sensitising states towards the possibility of higher borrowing costs. They should also prepare for any spill-over of the higher interest rates from the state bond market to the corporate bond market and even the market for central government securities.

Ira Dugal is assistant managing editor, Mint.

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