Growth constraints

State govt finances would remain under pressure for years

Union Finance Minister Nirmala Sitharaman noted on Tuesday that the growth rate in the current fiscal year might be near zero. This is an overly optimistic estimate because most forecasters, including the Reserve Bank of India (RBI), expect a near double-digit decline in real output this year. The level of contraction might optically make the recovery look strong in the next fiscal year and position India as one of the fastest-growing large economies in the world. However, policymakers can’t afford to get carried away by such numbers. The pandemic pain is likely to be more enduring for the Indian economy, and the latest study of state finances by the RBI — released on Tuesday — underscored some of the challenges.

States are at the forefront of fighting the pandemic and providing relief to those displaced. They also undertake over 60 per cent of government capital expenditure. Thus, the state of their finances will have a significant impact on the economy. According to the study, the gross fiscal deficit of state governments is likely to go beyond 4 per cent of gross domestic product (GDP) in the current year under the baseline scenario, and revenues would remain under pressure over the next few years. However, pandemic-related spending would keep expenditure elevated and prolong the “scissor effect”. It is still not certain if the pandemic would decisively be contained over the next few months and all restrictions on economic activity would be lifted.

The fact that government finances at both Central and state levels are stretched is only adding to the problem. According to the revised estimates for last year, the consolidated gross fiscal deficit at state level was 3.2 per cent of GDP. The inevitable fiscal expansion this year will affect capital expenditure. As the central bank has noted, capital expenditure is normally treated as residual and is subject to adjustment, depending on revenue conditions. Capital expenditure was cut compared to the Budget estimate at least over the last three years because of revenue constraints. Although the Centre is extending a Rs 12,000 crore interest-free loan to states, it’s unlikely to move the needle. Budgeted capital expenditure is about Rs 6.5 trillion.

Besides the expansion in the budget deficit, the debt stock will also restrict spending at state level. The outstanding liability of state governments has gone up from about 22 per cent of GDP in 2015 to 26.6 per cent in the current year (Budget estimate). The final number would definitely be higher. Contingent liabilities of states are also increasing. The Central government provided liquidity support worth Rs 90,000 crore to state power distribution companies. This would take the total outstanding guarantees by state governments to well over 3 per cent of GDP. Therefore, government finances are likely to be a drag on economic growth. According to the International Monetary Fund, India’s public debt is likely to expand to about 90 per cent of GDP. The state of government finances would also test Centre-state relations. The differences over the issue of goods and services tax compensation are one example. This would again have implications for growth over the medium term. Therefore, India needs careful economic management at all levels. Just counting on revival in high-frequency indicators from the trough would not be enough.