State governments driving fiscal expansion in India

The rising concerns over the growing deficits of states are reflected in the widening spread between state development loans (SDLs) and Central government bonds

Ever since the Fiscal Responsibility and Budget Management Act (FRBM) was introduced in India, state governments have largely been conservative spenders, limiting their spending far more effectively than the Union government. This trend seems to be reversing in recent years, with the aggregate fiscal deficit of states rising at a time when the aggregate fiscal deficit of the Union government has been declining.

Overturning years of fiscal conservatism, Indian states have become much more profligate than before, a Mint analysis of major state budgets show. These states, accounting for 86% of India’s gross domestic product (GDP) and 76% of the country’s population, have witnessed their aggregate gross fiscal deficit rising sharply to around 3.2% of India’s GDP in 2016-17, significantly higher than the budget estimates of 2.8%. The analysis uses final (actual) budget figures where available, and relies on revised estimates where such actuals are not available.

As the chart below shows, the aggregate fiscal deficit of states has been trending upwards over the past few years. At a time when the Union government has been bringing down its fiscal deficit-GDP ratio, state governments seem to be on an expansionary mode.

The sharp deterioration in state finances over the past couple of years is partly because of the restructuring of state-run power utilities under the Ujwal Discom Assurance Yojana (UDAY).

For instance, one of the states which posted a sharp increase in its fiscal deficit in the just-ended fiscal year was Madhya Pradesh, which saw its deficit rising from 2.5% of gross state domestic product (GSDP) in 2015-16 to 4.7% in 2016-17. A recent analysis by PRS Legislative Research shows that Madhya Pradesh had to borrow Rs7,361 crore from the market last year on account of the UDAY scheme. This means that in the absence of UDAY, the deficit would have only risen from 2.5% of the GSDP in 2015-16 to 3.5% of the GSDP in 2016-17, instead of the actual 4.7% deficit. Similarly, Rajasthan’s huge deficit in 2015-16, amounting to more than 9% of GSDP, could be attributed in large part to the UDAY scheme.

While the UDAY scheme might have led to the sharp downturn in state finances, state government deficits would have worsened even without UDAY in 2016-17, as JP Morgan economists Sajjid Chinoy and Toshi Jain pointed out in a 22 February note on state finances.

While the debt created on account of UDAY is a one-time cost, the resultant increase in interest burden would persist in the coming years. States have as yet provisioned for only around 60 of the new interest liabilities arising out of UDAY in their budgets which means further fiscal slippages are likely, a recent report on state finances by the HSBC economists Pranjul Bhandari and Dhiraj Nim said. Besides, the HSBC report estimates that states’ increased wages and pension bill on account of their respective Pay Commission revisions could inflate their total deficit by another 0.2% of the GDP this year (2017-18).

The rising concerns over the growing deficits of states are reflected in the widening spread between state development loans (SDLs) and Central government bonds. As state government borrowings have increased, spreads have moved up. While markets may not be very selective when it comes to punishing state governments, treating fiscally responsible state governments and less responsible ones in similar fashion, market participants seem to be taking note of the rising risk profile of state governments as a whole.

Ironically, the deterioration in state finances has coincided with the implementation of the 14th Finance Commission recommendations, which have led to an increase in aggregate transfers from the Centre to the states.

Indeed the Centre to states transfers were more than expected (or budgeted) in 2016-17. However, they were offset by lower-than-expected own tax collections by the states (mainly indirect taxes) and higher-than-expected expenditure, leading to deficits exceeding the initial budget estimates for the year.

The excessive spending by states is not just on account of schemes such as UDAY or linked to pay and pension expenses. Aggregate deficits have gone up also because states have stepped in to invest in social infrastructure such as health and education. With the Centre is curtailing expenditure on these areas over the past few years, states have had to step in to fill the gap, raising spending on these sectors (more on this issue in the next part of this series).

The states which exceeded their deficit targets by the biggest margins of error were also generally the states with high deficits such as Bihar, Madhya Pradesh, Rajasthan and Tamil Nadu. The pattern in these states was more or less similar—less-than-expected tax collections and more-than-budgeted expenditure led to higher deficits.

Although state deficits or the net addition by states to public debt has been rising, states account for only a third of the overall public debt in the country. As the recent report of the FRBM review committee led by N.K. Singh pointed out, states not only have a much lower level of aggregate debt compared to the Centre, they also collectively run a revenue surplus (i.e., their aggregate current expenditure has been less than their aggregate revenue receipts) unlike in the case of the Centre. This is partly because of limited borrowing powers of the states (they often need approval from the Central government to undertake additional market borrowings).

The Singh committee recommends that the states “be allowed to maintain their debt GDP ratios at FY17 levels (i.e. 21% of GDP)” in the near future. However, states may contest this cap, given that their stock of debt is far lower than the Centre and their responsibilities have been rising over the years. It is also not clear how the cap on debt will apply to different states, with different levels of debt, and with different developmental needs. The 15th Finance Commission will likely grapple with these issues to find a debt path for states that is fair, equitable and sustainable.

Meanwhile, it will be important to keep a close watch on the deficit levels of states as the health of public finances in India will in great measure depend upon the performance of states. The upcoming pay commission hikes and the growing clamour for farm loan waivers across several states are likely to strain the already stressed finances of states.