How state finances could delay investment cycle

Worsening state finances widely appreciated; their impact on private investments less understood

Ever since the mini balance of payments crisis of 2013, Indian policymakers have placed a premium on restoring and maintaining macroeconomic stability, manifested in lower central fiscal deficits, muted minimum support price increases, the move to inflation targeting and building a war chest of reserves.

The only blemish against this impressive record has been deteriorating state finances. This is particularly surprising, and perhaps why it took so long to emerge into the public consciousness, because states were always seen as paragons of fiscal virtue, with their combined deficit at just two per cent by 2012-13. Then things began to inflect. The combined deficit widened to 2.6 per cent by 2014-15, but alarm bells went off next year, when — despite much high transfers from the Centre under the 14th Finance Commission — their combined deficit widened further to 2.9 per cent of gross domestic product (GDP), a worry we had flagged two years ago. Consequently, the one per cent widening of state deficits between 2011-12 and 2015-16 —even excluding the UDAY liabilities — completely undid the Centre’s consolidation during that time.

Furthermore, fiscal risks for states are on the rise: States are yet to implement their Pay Commissions’ recommendations, several states have announced farm loan waivers (which have added up to 0.6 per cent of GDP thus far) with the risk it proliferates further, key sources of state revenue —stamp duties and alcohol — are under pressure and states are liable for the interest on UDAY bonds in the future. The fiscal outlook for states is challenging to say the least. 

Thus far, worsening state finances are seen mainly as undoing the Centre’s good work, keeping the combined deficit elevated and imperilling consolidated debt dynamics. Indeed, state primary deficits need to halve if state debt to GDP needs to stay anywhere close to the recommendations of the Fiscal Responsibility and Budget Management Review Committee.

However, we want to frame the debate differently. What’s not appreciated is how worsening state deficits imperil the private investment cycle. How so? State market borrowing has doubled in just three years. In 2013-14, states market borrowing was 35 per cent of the Centre’s. By 2016-17, this jumped to 84 per cent. We suspect states will end up borrowing more than the Centre this year, which is unprecedented. This surge in supply is understandably having price implications. The spread of state bonds over central bonds tripled from 30 basis points (bps) in March 2015 to 90 bps in March, 2017. 

The real concern, however, is there is a direct and mechanical spillover from spreads on state bonds to those on corporate bonds. The intuition is simple. Investors hold both state and corporate bonds for the yield mark-up they get over government bonds. Therefore, these can be considered yield substitutes. Why would an end investor (insurance fund, pension fund, banks) hold a corporate bond, when they get the same yield on a state bond, complete with an implicit sovereign guarantee? 

The consequence is whenever state spreads rise, corporate spreads rise in sympathy. Using data over the last five years, we find econometrically that every 100 bps increase in state spreads pushes up corporate spreads by 62 bps, all else equal. Unsurprisingly, therefore, as state fiscal positions have worsened, corporate spreads have widened from 60 bps in March 2015 to 120 bps in March 2017.

This has significantly undermined monetary transmission in the corporate bond market. The Reserve Bank of India (RBI) has cut policy rate by 175 bps thus far, and between Match 2015 and March 2017, 10-year government bond yields declined by 90 bps, but corporate bond yields only by 35 bps, because rising spreads offset much of the decline of the underlying asset. Over the last three months, state spreads have edged down, a seasonal phenomenon because supply is relatively low in the first half of the fiscal year, and there has been better transmission into the corporate bond yields. But this simply underscores the importance of state spreads in determining corporate bond yield. 

Looking ahead, if state deficits were to widen further and further push up spreads at the long end — thereby steepening the yield curve — there’s a real risk that any potential RBI easing at the short end would not transmit into lower cost of capital for the private sector.

Illustration: Binay Sinha

But how does this square with corporate bond issuance picking up over the last year? The real question, however, is the counterfactual: How much stronger would issuance have been had corporate bond yields not been kept artificially high because of widening state-bond spreads? Our estimates suggest that higher spreads depressed corporate bond issuance by about 11 per cent over the last two years. This, then, is the crowding-out effect on the private sector.

Furthermore, the timing couldn’t have been worse. With the banking sector so beleaguered and credit growth so depressed, vibrancy in the corporate bond market is critical to picking up some of the slack. Keeping corporate bond yields higher than they need to be is the worst possible outcome at the moment.

So what should be done? To rein in state deficits, some market discipline is critical. Gujarat with a deficit of two per cent of GDP and Uttar Pradesh with a deficit of 3.1 per cent of GDP pay the same cost on their market borrowing, because of perceptions of implicit sovereign guarantees. This needs to change. Similarly, banks are allowed to mark state bonds on their books at (GSec+25bps), and so are incentivised to become captive sources of demand for state bonds. This needs to change.  Furthermore, we need timely and public ratings of state finances to influence investor decisions. 

India’s fiscal centre of gravity is fast moving away from the Centre towards the states. If market mechanisms are not found to incentivise state fiscal prudence, the deleterious impact would be felt not just on macroeconomic stability but — by keeping private sector borrowing costs high — potentially further delaying the private investment cycle.

Sajjid Z Chinoy is chief India economist and Toshi Jain is India economist at J P Morgan. The views are personal