Even as markets obsess about the Union budget every year, what has slipped under the radar is the increasing importance of state finances. Last year, total expenditure at the state level (17.1 per cent of the GDP) was much higher than the Centre’s expenditure (13.3 per cent), and state capital expenditure (capex) was almost double the Centre’s. The relative importance of state finances is only going to grow. On the one hand, the Centre has already begun transferring a much higher share of the divisible pool of resources to the states. On the other, several states will likely have to absorb substantial chunks of state electricity board (SEB) debt explicitly on to their books. As state revenues grow, so will their explicit liabilities.
So, it’s natural to ask what market signals state bonds are getting. Much is made of the ebbs and flows of yields of Central government securities (G-Secs) because they reflect the cost of government borrowing, help determine the sustainability of Central government debt and create market-based incentives to remain fiscally prudent at a time when the FRBM Act has occasionally been “relaxed” and fiscal roadmaps changed.
Against this backdrop, what are state bond yields telling us? For starters, they typically trade 40 basis points (bps) above Central government yields. This could either reflect a credit spread — showing higher credit risk because there’s no explicit sovereign guarantee for these bonds — or a liquidity premium, given that the market for state bonds is much less liquid than that for G-Secs.
To test which of these it is, we look at the cross-sectional variation across states. If, in fact, it’s a credit spread, we should expect to find substantial cross-sectional variation, reflecting the widely different underlying fiscal positions of the states. But instead, we find exactly the opposite. West Bengal’s debt-to-GDP ratio is almost twice that of Maharashtra, but its bond yields trade only 1 bps above Maharashtra’s. Similarly, Rajasthan’s fiscal deficit last year was twice that of Gujarat. Yet, its bond yields trade 1 bps below Gujarat’s. Why is Gujarat not being rewarded and Rajasthan not facing a higher cost of borrowing? More generally, why are bond yields so closely clustered around each other — with only a 6 bps difference between the highest and lowest among the 14 states that participated in the October 13 auction? Or just a 2 bps difference among the eight states that participated in the October 27 auction? Why this distortionary pricing across states?
One could argue that markets take into account both explicit and implicit (SEB) liabilities to have a broader definition of debt. But it’s hard to imagine that when both are added up, debt levels are exactly identical across states, so as to warrant such little price differentiation. There isn’t even comprehensive data available on this broader definition of debt across all states. So it’s hard to imagine that this is driving market behaviour.
Instead, there seem to be two other fundamental issues driving the distortionary pricing. First, while there are no explicit sovereign guarantees, markets are likely assuming and pricing in an implicit guarantee by the Central government. On the back of this implicit guarantee, it doesn’t matter what states’ individual vulnerabilities are because, if things go pear-shaped, the Centre will step in. These perceptions are likely reinforced by the fact that the risk-weights assigned to state loans for the purposes of capital adequacy are zero. To be sure, there is also a Consolidated Sinking Fund (CSF) that is managed by the RBI, to which states have contributed, and which can be used to repay investors. But the size of the CSF is 0.4 per cent of the GDP, versus an outstanding stock of state bonds of 9.5 per cent of the GDP. So, the perception is largely of an implicit guarantee by the Centre — thereby suggesting that the spread above G-Secs largely reflects a liquidity premium.
Second, there’s no real market for state bonds, with virtually no secondary market trading. The current pool of investors largely comprises of public-sector banks, and state insurance and pension companies (the latter are mandated to hold state bonds), which can be thought of as captive buyers and ones, given their vantage point, that are likely less sensitive to credit risk across states. Expanding the investor base is therefore important for creating more market depth and liquidity. On this front, policymakers need to be commended. Last month, they allowed FPIs to invest in state bonds, albeit to a limited extent (they can only hold 2 per cent of the outstanding stock by March 2018). But this is an important first step and the interest was large: $500 million in bonds was lapped up by FPIs in less than a week.
But while expanding the investor base is a necessary condition for price discovery, it’s not a sufficient condition. As long as the perception of implicit guarantees remains, efficient price discovery will be impeded and price distortions will continue, no matter what the investor base expands to. States will not be rewarded by markets for prudence, nor punished for profligacy. And market signals are important because the 14th Finance Commission doesn’t provide incentives for states to reduce deficits below 3 per cent of the GDP. We, therefore, need to rely on market signals to shape incentives. For example, it’s only when state borrowing costs rise upon taking on SEB debt that states will be incentivised to reform them. But none of this will happen, as long as there’s an implicit sovereign guarantee from the Centre.
Institutional and market development that leads to better price discovery has underpinned India’s reforms over the last 25 years. Now, we must extend that to the market for state debt, because in a couple of years, state deficits will account for almost half of the consolidated deficit. The landmark 1997 agreement between the RBI and the finance ministry, ending the automatic monetisation of deficits, was a key moment in reforming the market for Central government bonds and led to better price discovery. We must now reform the market for state bonds by rolling back distortionary implicit sovereign guarantees. Only then will price differentiation across states occur. And only then will the conditions emerge for true competitive fiscal federalism.
The writer is chief India economist, JP Morgan. Views are personal