The Ujwal Discom Assurance Yojana (Uday) has been the subject of much debate in the financial markets. The cost of borrowing for state governments has risen sharply since Uday was launched in November. More recently, as state governments have tried to raise funds by selling Uday bonds, they have been blamed by some (incorrectly, as we will see) for creating a shortage of funds for other borrowers.
As background, readers may recall that Uday was launched to turn around power distribution companies (discoms), which are generally inefficient state government monopolies that are struggling financially. One of its key features is the replacement of high-cost discom debt, which attracts interest rates as high as 13 per cent, with state government bonds, where the cost of borrowing was then a much-lower 8 per cent. States could not have done this unilaterally because they would have breached their fiscal targets. The Centre then dangled the carrot of providing a temporary exemption on fiscal targets in return for a commitment from the discoms to improve operating parameters and also raise power tariffs to bring them in line with costs.
Seventeen states, adding up to 77 per cent of India’s power demand and 79 per cent of outstanding discom debt, have already agreed to Uday. Of these, nine states, which together constitute 42 per cent of power demand and 55 per cent of discom debt, have also taken the next step, signing a tripartite agreement between the Centre, the state government and the discom, committing to a significant improvement in operations and thus financial performance.
The agreement commits them to replacing 50 per cent of discom debt with state government bonds (state development loans, SDLs) in the current financial year (that is, the year ending March 2016), and a further 25 per cent in the coming financial year. For these nine states, the quantum that had to be raised in the current year under Uday came to nearly Rs 1 trillion, which effectively doubled the total borrowing they were earlier scheduled for in the last three months of the year.
This seems to have surprised many in the bond markets, driving up SDL bond yields — that is, the market is now only willing to lend to state governments at a higher cost, as much as six-tenths of a percentage point more than five months back. The gap between the costs at which the Centre and the state governments borrow — “the yield gap” — has now widened to levels only seen at a time of crisis.
This seems unwarranted since we estimate that the increase in the states’ borrowing costs should have been only about half of the increase we have seen. We use a simple calculation: The quantum of high-cost discom debt that will be replaced by low-cost SDLs is about Rs 2 trillion, and this would get added to total state liabilities of Rs 31 trillion. As even discom debt was implicitly guaranteed by the respective state government, the blended borrowing costs should remain unchanged. As the market stabilises, it is possible, if not likely, that the yield gap will narrow, particularly as the market has not been differentiating between states that have large Uday-related issuances and states that don’t.
The second concern for the markets — that this sudden jump in bond issuance by states has caused a shortage of funds for others — is even less justified, in our view. This whole process is just debt replacement where the banks that had earlier lent to the discoms get their money back, and are then free to lend in the economy, or even buy SDLs from the market. Even the non-banking companies that receive the proceeds of these SDLs may deploy them in bank bonds, among others things, and these funds thus enter the market again.
So why is there tightness in liquidity currently, that is, more borrowers than funds? The main cause for the shortage in funds seems to be a pick-up in bank credit growth. After nearly 15 months of growing below seasonal trends, credit has started moving as per seasonality from October onwards, showing that economic momentum is picking up. Yet, so anchored is the prevailing consensus on negative-sounding stories that even positive data points are being “explained” negatively. Until two years ago, tight liquidity was a common feature in the months of February and March, as January to March is the strongest period for economic activity in India, partly due to amenable weather and partly because it’s the fiscal year end.
There has also been some impact from the jump in state government borrowing even without the Uday bonds. While this information should have been known to the markets, there was an element of surprise. There is an important lesson for policymakers here: Given its large borrowing needs, the Central government issues most of its bonds in the first half of the fiscal year so as not to crowd out the market towards the end of the year. State government borrowing, however, is still back-end loaded. This is despite the fact that this year, state government borrowing, even without the Uday bonds, is more than 60 per cent as much as Central borrowing. This ratio was much smaller a few years back. A better-planned borrowing calendar for the states is becoming a necessity.
So the kerfuffle over Uday bonds should settle as liquidity improves from April onwards and yields normalise once the bunched-up issuances are behind us. One hopes that the Rs 1.15 trillion of Uday-related SDL issuances in the coming financial year are better spaced out so as not to cause market distortions.
This should also bring market attention back to the near universal adoption of Uday by states; when the scheme was launched, this seemed unlikely to us. The discoms, along with the railways, are among the few generally large and inefficient government monopolies that need reform. Change in the discoms can be fur-ther complicated by the fact that these are state government controlled. Under Uday, states have committed to transformative operational improvements in the next three-four years. The political will to raise tariffs and improve billing and collection is likely to be tested. But technological improvements, like in metering and feeder line separation, should help and the merging of discom losses with fiscal deficits a few years down the line should improve the success rate.
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