Red flag on waivers

States, not banks, should pay for populism

The newly elected government of Andhra Pradesh (AP) has tried to deliver on a campaign promise by waiving farm loans. This is obviously an enormously tempting solution to what is unquestionably a serious structural problem. Recall that the United Progressive Alliance government had done this in its pre-election Budget in February 2008. Other poll-bound governments might have been similarly tempted. It is, therefore, most reassuring that the Reserve Bank of India (RBI) stood firm in denying the AP government the opportunity to do this. The desire to provide relief to a relatively large segment of citizens is understandable. But using the banking system as a safety net is certainly amongst the most inefficient ways to do this. Waivers are well-known to distort incentives, inducing borrowers to default more often - a perfect example of moral hazard. The RBI's position clearly signals to Andhra Pradesh and other states that might be tempted to follow it down this path that if they want to provide safety nets, they must do it out of their budget and not dump it on the banks.

In sending out this message, the RBI relied on a technicality. When a state is hit by drought, debt-relief measures automatically kick in. For this to happen, crop yields must fall to half their normal levels. When the AP government announced its waiver, no drought was in sight and the most recent yield estimates certainly did not fulfil these rather stringent requirements. Consequently, the automatic relief did not kick in, and the state government does not currently have the space to implement its promises. Ironically, though, the monsoon performance in both AP and Telangana thus far may actually lead to drought, thereby making the states eligible for the relief. In effect, had the AP government waited for a while, it might have actually been able to carry out its plan without the RBI being able to stop it. In politics, as in so many other things, timing is everything.

An important aspect to this process is who actually bears the cost of debt relief. It is not a write-off; rather, the state government takes on the obligation to repay banks over a seven- year period. This way, the annual budgetary impact is small, while banks are absolved from declaring the waived loans to be non-performing. In the AP case, there were some indications initially that a three-year re-structuring would be feasible, as opposed to the seven years that the government wanted. This would have been a mistake; it would certainly have induced both ruling and opposition parties in other states to try their hand at this kind of competitive populism. Fortunately, with a complete denial, even if promises are made during campaigns, they should cut no ice with a savvy electorate. If a drought indeed manifests, there are enough safeguards in the system to protect farmers. Otherwise, if states want safety nets, they should be willing to pay the full price for them.