Why deteriorating state finances should worry us

The increase in deficit will limit the benefits of fiscal consolidation by the central government

“I think it undermines an honest credit culture…overall government borrowing goes up, yields on government bonds also are impacted. Thereafter, it can also lead to the crowding out of private borrowers as higher government borrowing can lead to an increase in cost of borrowing for others,” said Reserve Bank of India (RBI) governor Urjit Patel when asked about farm-loan waivers in the post-monetary policy press conference last week. Patel further suggested that a consensus should be created so that loan-waiver promises are avoided, as sub-sovereign fiscal challenges can affect the national balance sheet. The comment should be seen in the context of the recent farm-loan waiver announced by the new Uttar Pradesh (UP) government. Similar demands are being raised in various other states.

Loan waivers will affect state government finances by increasing the deficit and worsening the quality of expenditure. For instance, the UP government has announced that it will issue bonds to fund the loan waiver. Even though the actual impact will be known after the state government presents the budget, its present and future liability is bound to go up. The possibility of implementation of loan waivers in other states such as Maharashtra and Punjab will have similar implications, and will have a bearing on the national balance sheet. Even though finance minister Arun Jaitley has said that the fiscal onus of loan waivers will be on states, it should worry the Central government as the chances of a credit-rating upgrade will diminish.

Since state governments at the aggregate level account for about 60% of total government expenditure, maintaining fiscal discipline and quality of spending at the state level is becoming increasingly important. The implementation of the fiscal responsibility and budget management (FRBM) rules in the last decade helped state governments improve their fiscal performance significantly. According to the numbers compiled by the Fourteenth Finance Commission (FFC), debt to gross domestic product (GDP) ratio for states at the aggregate level came down from 31.1% in 2004-05 to 21% in 2014-15. The gross fiscal deficit also came down from the level of 3.3% of GDP to 2.4% of GDP during the same period. An analysis of state government finances published by the RBI last year showed that even as revenue expenditure continues to dominate state government budgets, there has been an improvement in the quality of expenditure.

However, fiscal adjustments made over the years at the state level are now getting reversed to some extent. A new report prepared by the economists at HSBC—which analysed the budgets of 16 large states, making up about 85% of the Indian economy—shows that states at the aggregate level clocked a fiscal deficit of 2.8% of GDP in the financial year 2017 compared to the target of 2.6% set at the beginning of the year—largely because of a rise in current expenditure. The report expects the deficit to remain elevated in the current year as well. Factors such as rise in wage bill and under-provisioning of interest payment for Ujwal DISCOM Assurance Yojana (UDAY) bonds are likely to affect the final outcome. Farm-loan waivers in different states will further increase the risk of slippage.

There are at least two big reasons why state budgets deserve far more attention than they currently get.

First, even though the state deficit remains under the FRBM target, the increase in deficit will limit the benefits of fiscal consolidation by the Central government. India’s general government deficit is one of the highest among its peers and an increase in state deficit will make the overall consolidation difficult. Elevated fiscal deficit and higher borrowing affect interest rates in the financial market and crowd out private investment. The new fiscal rules recommended by the FRBM review committee aim to bring down the total debt to GDP ratio to 60% by 2023, from the present level of about 67%. This will require fiscal discipline both at the state and Central levels. The spread between state government and Central government bonds has increased in the recent period and should work as a deterrent against populist spending.

Second, since the states account for a higher share of government expenditure, deterioration in the quality of spending will affect growth prospects. Also, as the states’ share in Union tax revenues has been increased from 32% to 42% in line with the recommendations of the FFC, it has become more important for the states to spend wisely and focus on capacity creation that will augment growth in the long run.

Fiscal discipline both at the Centre and states will help strengthen the national balance sheet. It is vital that states don’t end up undoing all their hard work in terms of balancing the books over the years. For now, it is important that state governments avoid competitive populism.

Are state government finances becoming increasingly important?