BackOpinion | India’s fiscal responsibility rules for states might need a relook
States are at the frontline of our development efforts and may need greater flexibility in borrowing to achieve their goals
PremiumState governments are at the frontline of the battle against the covid pandemic. A lack of funds for them can have profound human consequences. States also bear a heavy burden in more normal times. The combined spending by states is now much more than spending by the Union government. It is thus unfortunate that not enough attention is given to state finances. The International Monetary Fund has shown that the Indian ratio of sub-national government expenditure as a proportion of total government expenditure is almost twice the global average.
Borrowing costs is a good place to look. The past few months have seen a lot of interesting action. Financial markets were demanding very high interest rates from state governments in the early weeks of the pandemic. Borrowing costs surged. Kerala had to pay a premium of more than 200 basis points on long-term bonds over what the Union government was being charged.
The recent auction of state development loans have thus been a relief. Borrowing costs have crashed. So have premiums. Maharashtra could borrow three-year money at 4.76%, a modest premium of 26 basis points. The state also borrowed two-year money at 4.45%, only slightly above the cost at which the Union government borrows for this tenure. To be sure, the narrowing of premiums is more evident for state government bonds with shorter tenures. But even the interest rates on longer-term bonds have come down by around 100 basis points since March for many states.
A look at the data over the past 20 years is instructive. The weighted average of the borrowing costs of states have generally been higher than the comparable cost of central government borrowing. The average premium has been 33 basis points, though the range was higher. For example, the premium was a wafer-thin 4 basis points in fiscal year 2000-01. Fiscal year 2014-15 also saw a premium in the single digits.
On the other hand, the premium was a high 88 basis points in fiscal year 2009-10. Fiscal years 2013-14 and 2017-18 were also tough years for the states in terms of how much more on average they had to pay, compared to the borrowing costs of the Union government. Fiscal year 2001-02 is the odd year out, when the average borrowing costs of state governments were actually lower than those of the Union government by 22 basis points. This is in all probability because of the special debt swap scheme announced by the Atal Bihari Vajpayee government to bring down the interest burden in state government budgets.
The reasons why the difference between the interest rates paid by New Delhi and the states fluctuates every year are complex, but there could be some link to the borrowing programme of the Union government. The fiscal years 2009-10, 2013-14 and 2017-18 saw sharp increases in borrowings by the Centre, either through the Union budget or outside it. The liquidity stance of the Reserve Bank of India (RBI) also matters, with the central bank either pouring in or sucking out liquidity from the money market.
There is another puzzle as far as state government borrowing costs go. State governments have varying fiscal numbers. Consider the 17 non-special-category states. In the past four years, for example, Maharashtra’s highest fiscal deficit as a percentage of its state gross domestic product (SGDP) has been 2.1%. The lowest for even a well managed state like Andhra Pradesh has been 2.6% of SGDP. Gujarat has been another fiscally conservative state. Madhya Pradesh has run relatively high fiscal deficits.
The divergence in state finances is not reflected in borrowing costs. In other words, fiscally conservative states do not have meaningfully lower borrowing costs than the more profligate states, largely because investors know that all state government borrowings are implicitly backed by the Union government. An economist friend of mine has described this as India’s Greece problem, alluding to the European situation where Germany and Greece had similar borrowing costs before the financial meltdown in the latter country.
A new RBI working paper by Sangita Misra, Kirti Gupta and Pushpa Trivedi casts light on some of the emerging issues in sub-national fiscal policy. State governments have generally tried to keep their fiscal deficits within the limits imposed by their fiscal responsibility laws (FRL), often by cutting essential expenditure. Yet, state debt burdens have been rising because of contingent liabilities. States have also been exposed to fiscal shocks. The authors have highlighted an important policy issue: “It may be pertinent to review the FRL adopted by the states in the 2000s, much the same way the Centre revised their [Fiscal Responsibility and Budget Management rules] in the 2018-19 Union Budget, whereby debt was explicitly added as a target variable along with fiscal deficit. This is particularly desirable considering the fact that while the fiscal deficit of states remains well within their FRL threshold of 3% for [gross fiscal deficit] to [gross domestic product] ratio, as adopted during the early 2000s, the debt is rising at a high pace, crossing corresponding implicit thresholds." Is it time to relook at our state fiscal responsibility laws?
Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics
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