Are state government finances out of control?
The problem of lack of parity between states has arisen because the flexibility in the setting of state fiscal deficits prescribed by the 14th Finance Commission was not accompanied by a transparency requirement
For quite some years now, there has been anxiety about the fiscal situation of states spinning out of control. There was the debt accumulation of loss-making state-owned power distribution companies (discoms) happening outside the explicit debt of state governments. Then when that debt was (partially) transferred to the debt of (opting) states under the Ujwal Discom Assurance Yojana (UDAY) scheme, there was renewed anxiety on account of the additional issue of state bonds over two fiscal years, FY16 and FY17, to enable that transfer.
This year’s annual report by the Reserve Bank of India (RBI) on state finances was issued in July. All fiscal analysts depend critically on this annual publication, the only source of processed data on the finances of all states in a single place. The data lag has been dramatically shortened this year, with state budgets for FY19 (variously presented over January-February) assembled and published in July, just a few months later.
That said, the report in several passages erroneously assigns discretionary latitude to states on deficits and borrowing. An example is paragraph 2.1: “…states targeted to lower the [aggregate] gross fiscal deficit to 2.7% of GDP (gross domestic product) in 2017-18, hoping to undershoot the 3.0% norm.” The paragraph goes on to lament the fact that the revised estimates for the year show the aggregate at 3.1%, but adds approvingly that the budgeted aggregate for 2018-19 is set at 2.6% of GDP.
By constitutional mandate, state borrowing has to have had the formal approval of the central government. Subject to conditions which still hold good, it is the ministry of finance at the centre that approves the borrowing limits for state governments. So, it was not as though states “targeted to lower” their fiscal deficit in FY18. It is just that in the previous two years, FY16 and FY17, they had been given special permission to borrow additionally under the UDAY scheme (on which more later). States in India are not free fiscal warriors, with or without the UDAY scheme, to borrow on financial markets as they choose. It is very important to note this.
The “3% norm” referred to in the quoted sentence is what states have been held to as a target ever since 2005, under the recommendations of successive Finance Commissions. If that is so, why was the aggregate state deficit budgeted at a mere 2.7% of GDP for FY18? State domestic product (SDP) estimates in India are estimates of value added within the boundaries of the state, excluding indirect taxes (net of subsidies), which enter into the countrywide GDP at market prices, an expenditure aggregate. This GDP is a larger denominator than the sum across all states of SDP at value added, by roughly 10%. So, even if all states had budgeted borrowing at 3% of their respective SDP, the sum of state borrowings works out to 2.7% of GDP. The important point is that it was not the states “hoping to undershoot the 3.0% norm”.
What the RBI report very usefully points out however (para 2.9) is that not all states were budgeted for FY18 at the 3% (of SDP) norm. Of 29 states, 12 had budgeted fiscal deficits above 3% of their respected SDP in FY18, but these states are not listed. There could be a perfectly legitimate reason for this. Since 2015, the Centre has been empowered by the 14th Finance Commission to permit states to borrow up to 3.25% of GDP, if they qualified under one of two conditions, and up to 3.5% if they satisfied both. A further flexibility has been granted to states to carry forward unutilized borrowing from one year to the next.
By the revised estimates (RE) for FY18, 19 states actually crossed the 3% mark, and these are listed in the report. Deficit percentages are a problem because they bring into play a moving denominator—the budgets use projected SDP, but the RE percentages are worked out with respect to provisional estimates of SDP (as distinct from the projected number). Absolute bond borrowings are a surer indicator of change during the year. These show 10 states with higher absolute borrowing in the RE figures than budgeted.
Now, that becomes a matter of keen significance. It means that at some point during the year, either the absolute borrowing limit was enhanced by the Centre, or the state had initially budgeted less than its full-year entitlement, but asked for more during the year. The key issue to remember is that the RBI, which is still in charge of issuance of all government bonds, requires prior approval from the centre for all state bonds issued. This then requires that the ministry of finance be far more transparent in the manner in which state borrowing entitlements are set. In particular, it has to make public the projected SDP used to set the borrowing limits, and the justification for approval of any deficit percentage set above 3%. If the bond borrowing is enhanced in absolutes during the year, that has to be justified too.
If, as for the current year FY19, 10 states were budgeted at above 3% of SDP deficit, it is not because they are “planning to remain above” the norm, as the RBI report states, but because they have been permitted to do so. Of the rest, several are well below the norm, although these may well be a state-level decision because of the carry-forward provision the 14th Finance Commission.
The problem of lack of parity between states has arisen because the flexibility in the setting of state fiscal deficits prescribed by the 14th Finance Commission was not accompanied by a transparency requirement. Inflexible may be inefficient, but flexibility can degenerate into caprice. It is important in the Indian federal structure that rules governing the constitutionally sanctioned control of state borrowing by the centre should be implemented as statutorily provided.
Now about UDAY. This scheme for partial transfer of the debt stock of state-owned power distribution companies (discoms) on to the explicit debt of state governments was initiated in November 2015. The debt overhang of discoms had accumulated with capitalized interest to an estimated total of ₹4.3 trillion at the start of UDAY, amounting to 3.1% of GDP that year. Rajasthan alone had discom debt at a whopping ₹1 trillion. Discoms in deficit were unable to honour power purchase agreements signed with independent power producers, which then led to further knock-on defaults to the banking sector by those producers.
The debt swap window closed at the end of FY17. Only 15 states actually opted for the debt swap, that permitted them to float bonds above their routine entitlement, at going rates, with which to pay off three-fourths of discom debt. These were the states with the largest discom debt overhang. The big five states among the 15 opting into the debt swap scheme were Rajasthan, Uttar Pradesh, Tamil Nadu, Punjab, Haryana. These five alone accounted for 66% of total transferable debt.
The five states include the major food bowl states where free power to farmers was one of the contributors to the fiscal losses of discoms. They opted for the debt swap despite the additional interest bill it carried, because they saw it as preferable to the greater disaster of having to bail out the discoms at some future date. But the immediate fiscal cost was also the reason why all states did not opt for the swap. For the lending banks involved, there was a clear gain, against which they were required to restructure the residual debt of the discoms at concessional rates.
Participating states were further mandated to cover stated percentages of the losses of discoms going forward, to incentivize them to notify cost-covering tariffs. Of the 14 states not opting for the debt swap, 11 participated in this operational feature of the scheme. The incentive for doing so was that if targets set for narrowing losses were achieved, the state could access central funding for upgrading the transmission and distribution network.
Of the three parties involved in the scheme, the incentives for states and banks are clear. For discoms, there was an immediate lifting of the debt burden, but because the scheme imposed a prior improvement in their parameters of functioning as a pre-condition for accessing the Central schemes, the prospects of immediate efficiency improvements are not promising.
The summary position by the data for FY18 in respect of discom losses, which is what built up debt over the years, does not look too good. Across the 26 states participating in some version of the scheme, average cost still exceeded revenue by 22 paise per unit. This is the present loss to discoms for every kilowatt-hour (kwh) supplied, on average.
Underlying the average, there is wide variation across states, even within the big five. Punjab, the biggest worry of them all, still reports a mind-boggling loss of 68 paise per kwh supplied. Uttar Pradesh and Tamil Nadu are at 27-28 paise loss per unit. Only Rajasthan and Haryana seem to have crossed over into positive territory (data sourced from www.uday.gov.in).
However, it is not as though Rajasthan has stopped having to subsidize discom losses (fractionally mandated under the UDAY scheme). The Jaipur and Jodhpur discoms earn average revenue above average cost, but the Ajmer discom still makes a loss of 39 paise per Kwh supplied. This means the state still has to cover the losses of the Ajmer discom, since there is no cross-subsidization across discoms within states.
Fiscal haemorrhaging on account of the power sector, therefore, continues. It is imperative that both the centre and states follow through on what was an excellent scheme for resolution of the problem. Progress on that front will be watched keenly by credit rating agencies and bond traders.
Indira Rajaraman is an economist.
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