As September rolled into October, the Reserve Bank of India (RBI) released two interesting reports that offer some insights into the central bank’s thinking about the entrenched economic slowdown. While RBI staff has stopped short of prescribing a solution to overcome the near-stagnation in economic growth, both reports leave enough clues around. Combine these with a recent rating action and there are ample lessons on how not to aggravate the slowdown.

The first report, the central bank’s annual publication on state finances, was released on 30 September. The study provides an interesting counterpoint to popular perceptions of state profligacy: the combined gross fiscal deficit (GFD) of all states is within the limits prescribed by the Fiscal Responsibility and Budget Management Act (FRBM). Revised estimates for 2018-19 put the combined GFD at 2.9%, within the stipulated 3% of gross domestic product (GDP) threshold. In fact, the combined GFD over the past five years (2014-2019) has averaged 2.5%, excluding liabilities under the Ujwal Discom Assurance Yojana.

But these numbers are deceptive and hide a rather unfortunate trend. States have managed to stay within the FRBM cap by deferring critical development expenditure, especially capital expenditure. At the same time, most states have increased their indebtedness with the cumulative debt-to-GDP ratio rising to 25% over the past five years, indicating that the bulk of the spending is focused on revenue expenditure. In fact, the rise in revenue expenditure over the past two years, and particularly during 2018-19, is due to various state governments announcing farm-loan waiver schemes and income support schemes. This points to a rather regrettable situation: caught between a fiscal responsibility limit, growing political-economy demands, and a slowing economy, most states have opted to cut down on critical spending in favour of revenue expenditure.

This has serious long-term consequences. The RBI report estimates that states employ five times more people and spend about one-and-a-half times more than the Centre. Revenue buoyancy might have helped states restore the balance, but the persisting economic slowdown has affected their revenue-generating capacity. For example, stamp duties and registration fees contribute 11-12% of state revenues and the property market’s stagnation has already squeezed that source. At a broader level, the slowdown has affected consumption demand, leading to a slowdown in goods and services tax (GST) collections, a part of which belong to the states.

Time to bring in the second RBI report. The central bank’s Monetary Policy Report of October 2019 says, “States have reduced their capital spending in order to adhere to fiscal deficit targets in the last few years. This seems to have, in turn, affected investment adversely. Going forward, a pick-up in capital spending by both the centre and states is desirable given the growth augmenting property of the capital expenditure multiplier."

The term “capital expenditure multiplier" is significant here. RBI’s Monetary Policy Report of April 2019 had a special sidebar on “Estimable Fiscal Multiplier for India", in which it estimated that capital expenditure by states doubles the overall output: one rupee invested by states in capital expenditure results in 2 worth of output by crowding in private sector investment. For the Centre, the multiple is three times. It would seem that the central bank, after maintaining surplus systemic liquidity for some time and having cut its interest rate by 135 basis points over five successive monetary policy meetings, is now asking the government to do its bit.

The government’s capital expenditure is off to a slow start this year because the general election froze spending during April-June. But, even if the government does heed RBI’s advice on multipliers and focuses its energies on capital expenditure, its plans could be dented by of one of its allies: Y.S. Jaganmohan Reddy, the chief minister of Andhra Pradesh.

Reddy has been trying to rescind existing power purchase agreements. This has disrupted not only the utilities, but also banks and other financial agents that have provided loans and equity support on the basis of existing contracts. Delayed payments from Andhra state power distribution companies have upset renewable energy providers’ repayment record and adversely affected their credit rating, which not only has a rub-on effect on the entire renewables sector, but is also resulting in new sticky assets for the financial sector.

The system is also responding in its own way.

One, a recent story in The Economic Times detailed how State Bank of India, the country’s largest commercial bank, is already questioning the validity of the Andhra government’s guarantee for a 3,000-crore loan that Andhra Pradesh Power Finance Corporation is trying to raise. Two, rating agency Crisil (and perhaps some others as well) has lowered the rating or outlook of numerous old and new bond issuances from various Andhra Pradesh state corporations.

The two RBI reports and the rating agency’s actions make one thing clear: while the government can no longer delay capital expenditure as part of its economic stimulus programme, it also has to ensure that existing contracts are honoured over time, because that’s at the heart of improving the ease of doing business in India.

Rajrishi Singhal is consulting editor of Mint. His Twitter handle is @rajrishisinghal

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