India's enigmatic state finances

India’s public sector borrowings remain stuck at elevated levels. However, the underlying mix has been changing. The period FY13-17 was characterised by the central government lowering its fiscal deficit and the states offsetting these efforts by running wider deficits. Then, in FY18, after lowering the deficit every year since FY13, the central government paused. Meanwhile, after rising almost every year since FY13, the state fiscal deficit fell notably in FY18, according to our analysis. What’s driving this? And are we at an inflection point for state finances?

First, we need to address the data limitations we face with state finances. The fiscal data for India’s states have several peculiarities. At the start of the fiscal year, every state announces the budget estimate for the fiscal deficit. Towards the end of the year, they announce a revised estimate. And, one year later, they release the actual data. Actual data are superior as they are audited and, therefore, final. The coexistence of three versions of the data would not be a problem but for the fact that the actual aggregate state fiscal deficit has turned out to be lower than the revised estimate over the last few years. And the difference is rising.

This creates a problem. Until the actual data are available a year later, how does one think about the states’ fiscal stance? Is it rising, or falling?

We have a technique to figure this out. What is not subject to revision is every state’s net market borrowing. Over the past three years we find that net market borrowings are funding about 80 per cent of the state fiscal deficit (excluding UDAY borrowings).

Assuming that the proportion remains unchanged, we can work out a rough estimate of the actual fiscal deficit, long before the data are released. Armed with this, we look into recently released state budgets.

Our study of 18 state budget documents suggests that the FY18 actual could be closer to 2.5 per cent of GDP, lower than the 2.8 per cent actual fiscal deficit in FY17. This marks the first notable fall in the state fiscal deficit in five years.

Illustration: Binay Sinha

A lower fiscal deficit in FY18 also makes sense from a bond issuance perspective. The states’ aggregate net market borrowing fell in FY18. It is not surprising then that the actual fiscal deficit also came in lower.

And this is not where it ends. The net market borrowings fell again in FY19, by 0.2 per cent of GDP. Assuming that the proportion of state deficit funded by market borrowings remains at 80 per cent, we believe the FY19 actual fiscal deficit to be released next year will be lower than the FY19 revised estimate of 2.9 per cent. Until we get the actual number, we are pegging the FY19 state fiscal deficit at 2.5 per cent of GDP. No worse and no better than the actual fiscal deficit of FY18.

And, finally, our analysis suggests that states are pegging a fiscal deficit of 2.5 per cent of GDP for FY20. In short, after almost touching 3 per cent, state deficits have fallen and seem to be resting at 2.5 per cent. 

What's driving this fall? A confluence of factors was pressuring the states during FY13-17: (1) The Seventh Pay Commission (SPC) called for higher wages and pensions; (2) UDAY borrowings raised the interest bill; (3) lower oil prices hurt tax revenues; and (4) the slowdown in the real estate sector depressed stamp duty revenue. Some of these pressures have eased. Most SPC wage increases are completed. UDAY borrowings are done. And oil prices are higher than a few years ago. As such, states are indeed on a better footing. 

Unfortunately, this is where the good news ends. State finances are just one part of the fiscal picture. Adding on the central government and the private sector enterprise (PSE) borrowings are likely to remain elevated at 8 per cent of GDP. 

Furthermore, there are several risks on the fiscal horizon. State finances are vulnerable to oil prices. Also, over the last year several states have announced farm loan waivers and direct cash transfers. If more states follow suit, without the weeding out of old schemes, this could lead to a ratcheting up of current expenditure.

The outlook for capital expenditure at the government level remains dull. For FY20, all three arms of government — the centre, the states and the PSE — are budgeting for lower capex.

Capex faces a double whammy. The government is not spending much on investment and the private sector is being crowded out as the government is running an elevated fiscal deficit. Over time, this could weigh on India’s potential growth.

All told, elevated borrowings and insufficient capex are likely to keep us on our guard, despite some improvements in state finances.

The writer is chief India economist, HSBC Securities and Capital Markets (India)