Opinion Should states that spend irresponsibly be penalised?

All states are given credit at the same rate, irrespective of fiscal status. Finance Commission needs to find an arrangement that pushes states to spend prudently

October 5, 2024 09:23 AM IST First published on: Oct 5, 2024 at 01:40 AM IST

In 1975, New York City was facing a fiscal crisis. With the precarious state of its finances, the city was also locked out of the markets. Initially, Gerald Ford, the then US president, vehemently opposed providing assistance. Ford went on to say that he would “veto any bill that has as its purpose a federal bailout of New York City to prevent a default”. The rationale was straightforward — denying a bailout would force the city to put its house in order. This explicit dismissal of the possibility of a bailout by the federal government was succinctly captured by the headline in the New York Daily News: “Ford to City: Drop Dead”. Ford, however, did help later on, extending loans worth $2.3 billion.

The issue of a federal bailout or backstop for sub-national debt, or the extension of a guarantee, either implicit or explicit, or the lack thereof, is worth revisiting in light of the fiscal stress facing many states in India.

State government borrowings in India are perceived to be backed by an implicit guarantee of the Union government. In practice, the implicit guarantee seems to be exercised through an auto debit mechanism on the states’ bank accounts (CAS Nagpur). This guarantee, which essentially implies that the probability of a default is near zero, eliminates the credit risk of states. Thus, unlike in the private market where interest rates differ depending on the financial position of the borrower, yields on state bonds hardly vary despite a difference in their fiscal position. Higher interest rates are not charged to compensate for the credit risk.

For instance, take Gujarat, Himachal Pradesh and Punjab. Not only is Gujarat an economic powerhouse, but it also has a lower debt-to-GSDP ratio, a lower fiscal deficit and a revenue surplus. Both Punjab and Himachal Pradesh are under severe fiscal strain. In fact, Himachal Pradesh was recently unable to pay salaries on time. Yet, this difference in the fiscal position of these states does not reflect to a similar degree in their bond yields. The market does not differentiate. Fiscally stressed states do not have to worry about the wrath of bond markets. And so they can continue borrowing at a rate that does not reflect their precarious financial position.

It has often been argued that India needs to move towards pricing of state debt that is market-determined. In Himachal Pradesh’s case, for example, it would force the state government to tighten its belt, and take the necessary measures to improve its fiscal position as it would have to pay a much higher interest rate on its borrowings. Put differently, the market would ensure fiscal discipline. But is it really that straightforward? Would market pricing lead to states in a stressed financial position — such as Bihar, Kerala, Punjab, Rajasthan, and West Bengal (as per an RBI study), as well as some of the special category hill and Northeastern states — being simply priced out of the market? This is not just a problem for the government’s bankers, but an economic and political problem. Perhaps this lack of clarity is one of the reasons holding back foreign investors from fully embracing state debt.

The peculiarity of the situation often manifests in ironic ways. For instance, in one northern state, a power corporation is said to have inserted the auto debit mechanism in its contracts — perhaps in an attempt to get a higher rating. Another fiscally stressed state is more punctual in paying its power suppliers than in paying salaries of government employees. Farmers, who are the primary beneficiaries of free power in the state are, after all, a more powerful political lobby. State bond yields though don’t reflect this stress.

State government finances are plagued by the problem of TIPS: Tariffs on electricity and water that do not reflect the true cost of provision, and are minimal in large parts of the country; interest payments on state debt which are eating away a large share of states revenues; pension obligations that may rise further as states opt for the old or the unified pension scheme; and allocations for the increasingly long list of subsidies that are being announced with greater frequency. While there is considerable variation across states, in the case of a large number of states, just the allocations for interest payments, pension and power account for more than 70 per cent of their own tax revenue. A large number of states are now borrowing not for capex, but just to fund their consumption.

States also respond in different ways. As per reports, the Himachal Pradesh government is looking into the myriad subsidies that have been extended, perhaps looking for ways to reduce its obligations. On the other hand, the Punjab government reportedly sought a bailout from the 16th Finance Commission. But the question is whether another bailout will fix the underlying problem. After all, what is the position of the power discoms after the Uday bailout?

As the taxation power of states is limited, and considering their reluctance to increase collections through the non-tax route, the route to adjust their debt deficits will be through expenditure control. Perhaps the imposition of austerity or the mere threat of it will change the incentives of politicians. As long as fiscally imprudent behaviour is not penalised, there will be no incentive to behave responsibly.

How long will the implicit guarantee be extended to state borrowings? It cannot be anyone’s case that this arrangement should continue forever. Is there a way out? Will a new set of fiscal rules, which vary depending on a state’s fiscal position be appropriate, or will market discipline be more effective? The 16th Finance Commission should offer a way out.

ishan.bakshi@expressindia.com