Are regulators behind the curve?

The Union govt can only enforce fiscal deficit targets for states as long as states owe it money

Are regulators behind the curve on state governments’ bond issuances? In the past seven years, even as the absolute fiscal deficit of the Union government has been largely unchanged, that of the state governments has increased two-and-a-half times. As a result, whereas they borrowed only about a third as much as the centre from the bond market just six years ago, in the year that just ended they borrowed 76 per cent as much. These numbers are after adjusting for the distortion introduced by UDAY, a scheme that allowed for refinancing of state distribution company debts through state government bonds: More than Rs 2 lakh crore of bonds were issued under it in the past two years.

If we group claimants on financial savings in the Indian economy into three groups: Borrowers from banks and non-banking finance companies (NBFCs), the Union government, and the state governments, the state governments seem to be the fastest growing group, having reached 27 per cent of total borrowings in the last fiscal year. Their scope to borrow and spend more keeps rising, as the fiscal deficit cap is defined at 3 per cent of GDP, and nominal GDP continues to grow in double digits. These issuances should therefore continue to rise. 

And yet, they are the least understood. Their growth has already been causing uncertainty and turbulence in the bond markets and there need to be corrections made on several fronts.

The first is the seasonality of borrowing. The Union government front-loads its borrowing, with about 60 per cent of the bonds issued in the first half and 40 per cent in the second half of the financial year. This is done most likely to counteract the natural seasonality of credit offtake in India: About 73 per cent of the private credit is issued in the second half. Thus, the demand on financial savings gets evenly spaced throughout the year. However, state governments continue to have a second-half skewed borrowing calendar (40 per cent in the first half, and 60 per cent in the second): While this did not hurt much when their aggregate borrowing was small, it is now driving a congestion in the final quarter of the financial year.

The second is timely availability and quality of data. All state governments have presented their budgets for this year, but there is no easy aggregate available yet of how much they are going to borrow this year. The Reserve Bank of India’s (RBI’s) compendium of state budgets is published with nearly a year’s lag (we do not have the compendium even for the year that ended!), by which time the information is not as useful for the bond market. Even accessing state government budget documents online is troublesome. The market only comes to know the total borrowing requirement of state governments when the RBI publishes approved borrowing limits for the final quarter in December. 

The third is a differentiation in yields of various state government bonds. The thinking behind state governments borrowing directly from the markets undoubtedly involved the markets imposing fiscal discipline. However, the bond yields of states with low debt to GDP like Chhattisgarh and Odisha are no different from those of states with high debt to GDP like West Bengal and Punjab.

This has been attributed to a range of factors: That the market assumes a sovereign guarantee (that is any state government would never default irrespective of its fiscal health, as the Union government would come to its help); that bond-holders effectively have first access to state government revenues, as the RBI, which coordinates the auctions, has access to state revenues in escrow; state governments must request the Union government for extra borrowing beyond the prescribed fiscal deficit limit, which reduces default probability significantly; mandatory buying by financial institutions like banks generates sufficient demand; and lastly that these were too small for the market to worry about differentiation. Some of these beliefs/assumptions are incorrect, but have not been tested yet.

While addressing the first two involves procedure and should be easier to address, the third, that is the lack of yield differentiation, is a whole lot trickier. At the same time, it is very important. The Union government can only enforce fiscal deficit targets for states as long as states owe it money. By the middle of the next decade, some of the states would have already repaid their dues to the Union, and the Union would lose that ability.

On a separate note: Through their growing deficits are the states not undoing the Union government’s fiscal discipline? That has indeed been the case in past years, but Credit Suisse aggregation of budget data of top borrowers among state governments suggests that the growth in state government borrowings is likely to slow to 16 per cent this year, against 28 per cent in the year that just ended, indicating a tapering of state government fiscal deficits, though the start of GST this year adds some uncertainty. 
 

The writer is India Equity Strategist for Credit Suisse