Context

• The fiscal health of a government can significantly impacts its ability to function, fund essential services, and maintain investor confidence.
• In 1975, New York City found itself on the brink of financial collapse, facing a monumental fiscal crisis that threatened to destabilise the entire city.
• This situation, in which New York City was essentially locked out of the financial markets, echoes concern that India faces today regarding the borrowing practices of its state governments.

The Case of New York City

• New York City's 1975 fiscal crisis was marked by a severe cash shortage, inability to pay bills, and eventual exclusion from the credit markets.
• At first, President Gerald Ford categorically refused to provide federal assistance, infamously declaring that he would veto any bill aimed at bailing out the city.
• Ford's refusal was based on a widely held belief that a bailout would encourage fiscal irresponsibility and that New York City needed to reform its financial practices.
• However, despite this initial stance, Ford eventually relented and helped in the form of $2.3 billion in loans.
• This intervention highlighted the delicate balance between encouraging fiscal discipline and recognising when external assistance is essential to prevent further economic and social fallout.

An Analysis of India's Fiscal Stress: Implicit Guarantees and Market Distortions

• The Nature of Implicit Guarantees in India
  • Implicit guarantees refer to the assumption that the Union government will ultimately backstop the debt of state governments, even though such guarantees are not officially provided.
  • In India, this implicit guarantee is effectively operationalised through an auto debit mechanism, managed by CAS Nagpur, which ensures that state governments’ loan repayments are deducted automatically from their bank accounts.
  • This mechanism virtually eliminates the risk of default, as it assures creditors that payments will be made on time, regardless of the state’s fiscal condition.
  • The result of this system is that creditors, including both domestic and foreign investors, perceive state government bonds as being risk-free, akin to central government securities.
  • Even states facing severe fiscal difficulties can borrow at relatively low interest rates, as the market does not price in the credit risk that would typically accompany such borrowing.
• The Distorted Pricing of Risk in Bond Markets
  • One of the most significant consequences of the implicit guarantee is the distortion it creates in the bond market.
  • Normally, the bond market is a critical tool for ensuring fiscal discipline, as it differentiates borrowers based on their financial health.
  • In a well-functioning market, fiscally sound states would enjoy lower interest rates, while states with higher debt levels or fiscal imbalances would face higher borrowing costs to compensate lenders for the increased risk of default.
  • This mechanism incentivises governments to maintain sound fiscal practices, as higher borrowing costs would make profligate spending unsustainable.
  • However, in India, this mechanism is absent due to the implicit guarantee.
  • For instance, Gujarat, a state with a robust fiscal position, and Punjab or Himachal Pradesh, both of which are struggling with fiscal imbalances, all access credit at nearly the same interest rates.
  • Gujarat’s strong fiscal fundamentals including a low debt-to-GSDP ratio, a revenue surplus, and a manageable fiscal deficit should ideally translate into lower borrowing costs.

Consequences of Implicit Guarantees on State Behaviour

• Lack of Accountability
  • The presence of implicit guarantees creates moral hazard, as states have little incentive to maintain fiscal discipline if they know that the Union government will ultimately step in to prevent a default.
  • The auto debit mechanism further reinforces this lack of accountability, ensuring that creditors are paid regardless of the state’s financial management.
  • This has led to a situation where many states engage in borrowing not for productive investment (capital expenditure or capex) but for day-to-day operational expenses, including subsidies, salaries, and pension payments.
• Increased Dependency on the Union Government
  • This borrowing for consumption, rather than investment, is unsustainable in the long run.
  • A significant portion of state revenues is being diverted to service debt and meet operational expenses, leaving little room for investment in infrastructure or other growth-enhancing sectors.
  • The over-reliance on borrowing also means that states are becoming increasingly dependent on the Union government to meet their financial obligations, further entrenching the cycle of debt and fiscal stress.
• Lack of Market Discipline and Political Dynamics
  • In addition to the structural distortions caused by implicit guarantees, political dynamics play a significant role in how states manage their finances.
  • Politically influential constituencies, such as farmers, are often prioritised in state budgets, leading to a misallocation of resources.
  • For instance, in some states, subsidies for electricity and free power for farmers take precedence over essential expenditures such as paying government salaries on time.
  • These politically motivated spending patterns further exacerbate the fiscal stress faced by states.
• Complicated Foreign Investment
  • The lack of market discipline also deters foreign investors from fully embracing state debt.
  • Investors are wary of the opaque nature of state finances and the political uncertainty that often influences state-level fiscal decisions.
  • The absence of clear risk-based pricing in the bond market further complicates investment decisions, as investors are unable to accurately assess the fiscal health of individual states.
  • This lack of transparency and market differentiation limits the growth of a robust and competitive market for state government bonds.

Potential Solutions to Address the Fiscal Challenges at the State Level

• Adherence to Market Discipline
  • To address the distortions caused by implicit guarantees and encourage fiscal discipline, many have advocated for a shift toward market-based pricing of state debt.
  • Under such a system, states with stronger fiscal fundamentals would benefit from lower interest rates, while those with weaker financial positions would face higher borrowing costs.
  • This market-based approach would incentivise states to maintain fiscal prudence, as failure to do so would result in higher debt-servicing costs.
  • In theory, market discipline could help impose fiscal responsibility on state governments, much like it does in the private sector.
• Implementation of Differentiated Fiscal Rules
  • To strike a balance between encouraging fiscal discipline and avoiding economic instability, India needs a nuanced approach to managing state debt.
  • One potential solution is the implementation of differentiated fiscal rules that consider the unique financial positions of individual states.
  • For example, states with strong fiscal fundamentals could be subject to less stringent borrowing limits, while those in a more precarious position could face tighter constraints.
  • This would allow for greater flexibility in managing state debt while still promoting fiscal responsibility.
• Gradual Withdrawal of Implicit Guarantee
  • Another option is the gradual withdrawal of the implicit guarantee that currently underpins state borrowing.
  • By phasing out this guarantee over time, the Union government could encourage states to take greater ownership of their financial management and reduce their reliance on external support.
  • However, such a shift would need to be carefully managed to avoid creating instability in the bond market or exacerbating fiscal stress in weaker states.

Conclusion

• India's implicit guarantee system has created significant distortions in the bond market, allowing fiscally irresponsible states to borrow at favourable rates while avoiding the consequences of poor financial management.
• To address these issues, India must consider a range of solutions, including market-based pricing of state debt, differentiated fiscal rules, and the gradual withdrawal of implicit guarantees.
• By doing so, the country can promote greater fiscal discipline at the state level while safeguarding its broader economic stability.