Context

• The rise in the debt of Indian states, the fast-approaching June 30 deadline – after which the central government will not compensate them for any shortfall in Goods and Services Tax (GST) collections and pre-state election freebie promises made by political parties fuelled reports this year that bureaucrats were concerned, some states could go the Sri Lankan way if they didn't get a handle on their finances.
• Recently, the Centre has urged chief secretaries of all states to keep a check on the increasing debt burden and fiscal deficit.

RBI findings

• Debt-to-GSDP ratio: RBI also highlighted that the debt-to-GSDP ratio for 18 states and UTs has grown to 2%
• Definition: Debt-to-GSDP (Gross State Domestic Product) ratio signifies how healthy a state is in terms of funding its expenditure without accumulating future debt.
• Data: The states with the highest debt-to-GSDP ratio in 2021-22 include Punjab with 53.3%, Rajasthan with 39.8%, West Bengal with 38.8%, and Kerala with 38.3% and Andhra Pradesh with 32.4%.
• Market borrowing : According to the RBI report, market borrowing has reached 6% of the GDP of states by March 2022, which is a loan that governments raise by issuing market securities such as bonds.
• Largest share: Market borrowing forms the largest component of the total outstanding debt of states and union territories.
• Fiscal Responsibility and Budget Management (FRBM) Act: FRBM Act recommended a debt-to-GDP ratio of 20% for state governments (40% for the Centre) by the financial year 2022-23.

Reasons for fiscal folly

• Market borrowings: Most States increased their market borrowing during the pandemic as their fiscal deficits expanded.
• Electoral gains: The obvious motivation for States in expanding freebies is to use the exchequer to build vote banks. For instance, in campaign ahead of the Punjab Assembly election, the Aam Aadmi Party (AAP) promised a sum of ₹1,000 per month to every woman in the State.
• Discretionary expenditure: The transfer payments to provide safety nets to the most vulnerable segments of the population has become the main plank of discretionary expenditure where the spending is financed by debt, and the debt is concealed to circumvent the FRBM targets.
• Pandemic: The Covid-19 pandemic generated a long lockdown is seen as the primary reason for a surge in debt levels of Indian states.
• Subsidies: A large proportion of committed expenditure and subsidies are not matched by their revenues as majority of the States’ spending went into populist schemes with slow growth in revenues.
• Absence of strong revenue sources: States like Gujarat and Maharashtra managed to maintain their debt below 20 percent of their GSDPs, mainly due to their strong industrialised economies resulting in strong revenue streams while other states couldn’t do so.
• Longer maturity debts: States have been taking longer maturity debt unlike the norm of 10 years followed around five years back. This in turn keeps their debt levels higher for an extended period of time as they will be redeemed later.
• Losses of DISCOMs: Discoms’ revenues have significantly dropped in FY21 with demand from high-paying industrial and commercial consumer segments getting disrupted amid the lockdowns.
• Schemes: Moreover, Centre’s Ujwal DISCOM Assurance Yojana (UDAY) scheme, allowed the state governments that own power distribution companies to take over 75 percent of these companies’ debt till September 2015 and pay back the lenders by selling bonds. This also burdened the state exchequer.

Consequences of freebie culture

• No fresh revenue generation: If governments spend the loan money on populist giveaways that generate no additional revenue, the growing debt burden will eventually implode and end in tears.
• No new assets creation: The more States spend on transfer payments, the less they have for spending on physical infrastructure such as, for example, power and roads, and on social infrastructure such as education and health, which can potentially improve growth and generate jobs.
• Unsustainable practices: The electoral calculations tempt political parties to place short-term gains ahead of long-term sustainability.

Ideal scenario

• Ideally, governments should use borrowed money to invest in physical and social infrastructure that will generate higher growth, and thereby higher revenues in the future so that the debt pays for itself.

Significance of State’s financial health in economy

• Macroeconomic stability: The amount States borrow collectively every year is comparable in size to the Centre’s borrowing which implies that their fiscal stance has as much impact on our macroeconomic stability as does that of the Centre. Hence, the costs of fiscal profligacy at the State level can be huge.
• Capital expenditure: About two-thirds of India’s public CAPEX comes from states.
• Employment: States employ five times more people than Centre.
• No new asset creation: Rising debt could start a vicious cycle wherein states end up paying more and more towards interest payments instead of spending their revenues on creating new assets.
• Financial health: Huge bearing on Nation’s economy as some states’ economies are as big as India’s neighbours like Pakistan and Sri Lanka.

Ambiguous portrayal

• Healthy economic state: By observing the State Budget analysis by the Reserve Bank of India, the inference that is drawn is that State finances are in good, if indeed robust, health, and that all of them are scrupulously conforming to the Fiscal Responsibility and Budget Management (FRBM) targets.
• No FRBM tracking: However this is a misleading picture. Much of the borrowing that funds these freebies happens off budget, beyond the pale of FRBM tracking.
• Modus operandi: The States borrow on the books of their public enterprises, by pledging future revenues of the State as guarantee. Effectively, the burden of debt is on the State exchequer, albeit well concealed.
• CAG finding: The Comptroller and Auditor General of India (CAG) had pointed out that in respect of some States ‘if extra-budgetary borrowings are taken into account, the liabilities of the government are way above what is acknowledged in the official books.

Institutional checks, balances

• House check: The first line of defence has to be the legislature, in particular the Opposition, whose responsibility is to keep the Government in line. But the Opposition does not speak up for fear of forfeiting vote banks that are at the end of these freebies.
• Auditing: Another constitutional check is the CAG audit which should enforce transparency and accountability. But since audit reports necessarily come with a lag , by when political interest has typically shifted to other hot button issues.
• Market scenario: The market is another potential check that can signal the health of State finances by pricing the loans floated by different State governments differently, reflecting their debt sustainability. However, this too fails since the market perceives all State borrowing as implicitly guaranteed by the Centre even if there is no such guarantee in reality.

Way forward

• Amend FRBM Act: The FRBM Acts of the Centre as well as States need to be amended to enforce a more complete disclosure of the liabilities on their exchequers.
• The current FRBM provisions, governments are mandated to disclose their contingent liabilities, but that disclosure is restricted to liabilities for which they have extended an explicit guarantee.
• The provision should be expanded to cover all liabilities whose servicing obligation falls on the Budget, or could potentially fall on the Budget, regardless of any guarantee.
• Set pre conditions: Under the Constitution, States are required to take the Centre’s permission when they borrow. The Centre should not hesitate to impose conditionalities on wayward States when it accords such permission in accordance with well-defined, objective and contestable criteria.
• Invoke Emergency provisions: The draconian provision in the Constitution of India allows the President to declare financial emergency in any State if s/he is satisfied that financial stability is threatened.
• This provision though has never been invoked so far for fear that this will turn into a political weapon of mass destruction. But the root cause of fiscal irresponsibility is the lure of electoral profits. It will stop only if the political leadership fears punishment.
• It is therefore important to ensure that the prospect of a financial emergency in case of gross and continuing fiscal irresponsibility is not just an abstract threat but a realistic one.