The Indian state governments’ market borrowings, which is the chief source of funding of their gross fiscal deficits, have risen sharply in recent years, in contrast to the stagnation displayed by the government’s dated market borrowings. Not only does the rapid rise in state government borrowings warrant a closer monitoring of fiscal performance at the state level, but also holds implications for the trend in bond yields going forward.

During April-October, the state governments issued gross state development loans (SDLs) of Rs2.1 trillion. Moreover, the pace of year-on-year (YoY) growth of SDL issuance ramped up from 18.6% in Q1 FY18 to an alarming 42.7% in Q2 FY18. With this, the spread between the 10-year SDLs raised in Q2 FY18 (weighted average) and the 10-year government security (G-sec) yield widened in that quarter. In our view, the migration to the goods and services tax (GST) generated transitional cash flow issues and a temporary mismatch of revenue and expenditure of the state governments, which is likely to be the key factor that bloated SDL issuance in Q2 FY18.

Encouragingly, the liquidity situation of the state governments is set to ease in H2 FY18. The Centre has collected considerable funds as integrated GST (IGST) in August-September, which would eventually get converted into the Central GST (CGST) and the state GST (SGST), after setting of refunds to the taxpayers. Moreover, the release of compensation for loss of revenue on account of the shift to the GST, from the government to the state governments, would improve the liquidity condition of the latter. News reports suggest that the first tranche of compensation was released to the states in October. Benefitting from this, the SDL issuance recorded a YoY contraction of 10.3% in that month.

Nevertheless, there are some factors that would push up SDL issuance in the remainder of FY18.

Given the back-ended redemption of SDLs and the possible funding of crop loan waivers by some states in H2 FY18, ICRA expects the gross SDL issuance to rise to Rs3.0-3.2 trillion in H2 FY18, which is likely to push up yields further. Moreover, the total SDL borrowing in FY18 could be in the range of Rs4.8–5 trillion in FY18, equivalent to over 80% of the government’s announced market borrowing programme of Rs5.8 trillion, up from 50% in FY16.

While the SDL issuance has risen rapidly, the market remains beset by issues such as low secondary market liquidity and inadequate inter-state differentiation in yields, limiting the interest of some investors like FIIs in purchasing such debt.

The Reserve Bank of India (RBI) in the “Statement of Development and Regulatory Policies" issued on 4 October, indicated that it would announce measures to develop the SDL market. These proposals are related to consolidation of state government debt, through reissuance and buybacks of SDLs, and improving the availability of high frequency data on state finances to market participants, which are keenly awaited.

The low outstanding stock of multiple SDLs is one of the key reasons for the illiquid nature of this market. Data on G-sec outstanding published by the RBI on 16 October, indicates that only five G-sec are to be redeemed in FY27. This is in sharp contrast to the 294, 10-year SDLs issued in FY17, which would accordingly be redeemed in FY27.

A healthy trend of reissuing SDLs was observed in Q2 FY18, in contrast to the prevailing practice generally followed by state governments of issuing fresh SDLs each time they approach the market. We expect the RBI’s recent proposal to reissue and buy back SDLs to reduce fragmentation and improve liquidity in this market going forward.

Notably, the government routinely reissues several G-secs, until the size of each of those securities outstanding reaches a substantial volume. Additionally, as part of the active debt management strategy, the RBI in consultation with government has been buying back G-secs to utilize the surplus cash balances of the latter from FY14 onwards.

Following the recommendations of the 12th Finance Commission, government disintermediated from the borrowings of state governments from FY06 onwards. It was expected that a rise in the volume of market borrowings would enhance the scrutiny on the states’ fiscal health, and that superior fiscal management would be incentivized through lower interest rates.

However, the cut-off yields of SDLs issued by states in any given auction remain narrowly clustered, in spite of large variations in the state governments’ fiscal performance. Since the debt servicing of SDLs is carried out by RBI through an “automatic intercept", it creates a perception that the SDLs are backed by a quasi-sovereign guarantee, leading market participants to disregard the differences between the credit-worthiness of the states.

We await the measures that the RBI may announce to improve the reflection of credit risk across the states.

However, if the existing mechanism of debt servicing of SDLs through automatic intercept by the RBI is continued, the SDL yields are unlikely to adequately reflect the true fiscal position of the states, in our view.

Jayanta Roy and Aditi Nayar are respectively, group head—corporate sector rating, and principal economist, ICRA Ltd.

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