T C A Srinivasa-Raghavan: Borrowing rules for scallywags

OKONOMOS/ Sub-national borrowings need rules. Here are some

Now that the Budget has asked the states to borrow more, rather than depend only on the Centre for financial succour, the question needs to be asked: how should such borrowings be regulated?

In a recent working paper* for the IMF, Raju Singh and Alexander Plekhanov provide some answers. Using a sample of 44 countries for 1982-2000, this paper provides a "panel data analysis to determine the most effective borrowing constraints for containing local fiscal deficits."

Their broad conclusion is that while there is no one-size-fits-all prescription, there are certain things that need to be done anyhow. These are the adoption of common standards of financial reporting and the avoidance of bailouts.

Thus "central governments should avoid bailing out sub-national governments whenever possible as bailouts significantly erode the effectiveness of borrowing controls."

That is, the old moral hazard problem. The authors also say that "when considering a bailout, the central government should weigh carefully the short-term benefits against the long-term negative consequences."

True, except that often the short-term benefits are political and the long-term negative consequences are economic and, therefore, the two can't be compared. The situation becomes even more complex when the Centre depends on some regional party for support.

How much freedom should be given to the states to borrow? The authors say that it is a bad idea to give unconstrained borrowing authority.

"At low levels of vertical fiscal imbalances, fiscal rules adopted by sub-national governments themselves seem to lead to better fiscal outcomes."

But when, as has happened in India, the vertical fiscal imbalances widen, it is better to go for centrally imposed fiscal rules. In other words, the Centre must play Big Brother.

One important question, which the authors do not discuss in adequate detail is, who should determine the borrowing constraint: the Central government or the market? They say some countries leave it to the latter, while others prefer the former, which leaves us none the wiser.

However, internationally, there seem to be many different models. Thus in some cases the states agree to impose administrative and financial sanctions and penalties among themselves.

"Higher levels of government can also retain the right to punish sub-national governments for non-compliance. Some countries have even adopted bankruptcy procedures for sub-national governments in case of a crisis, in order to avoid bailouts and achieve a more transparent resolution process."

It is always a pleasure to move from the general to the particular, so it comes as a pleasant surprise to see the Reserve Bank of India's Bulletin for March 2005. It contains a supplement** dealing with more-or-less the same issue.

During the deliberations of the 12th Finance Commission, the RBI agreed to provide technical assistance in the preparation of a model fiscal responsibility bill for the states. This supplement contains that report. It also contains a model legislation designed to become a template for what may become fashionable amongst the states in due course.

Although the report deals with rules for deficits, debt and borrowings, only the debt and borrowings parts are mentioned below. The main problem, as one can imagine, is that different states "adopt different definitions for the total liabilities... they need to broaden their definition to capture the entire range of liabilities that should ideally emerge out of the budget."

So the report has recommended that the definition include not only the total liabilities under the Consolidated Fund of the State but also all the items under the Public Account.

It also says that the rule should cover off-Budget borrowings, so that borrowings by the state PSUs, SPVs and "other equivalent instruments including guarantees where the liability for repayment of principal and/or interest is on the state would also be treated as borrowings".

Doubtless referring to Maharashtra and Enron, the report has suggested that liabilities rising out of guarantees should also be included.

Also, since many states don't as yet have a ceiling on outstanding guarantees, the report recommends "a provision of placing a limit on annual incremental risk-weighted state government guarantees." Well, good. But the proof of the pudding is in the eating and one cannot help wondering how these noble intentions are to be implemented in an era of ignoble governments.

*How Should Sub-national Government Borrowing Be Regulated? Some Cross-Country Empirical Evidence, March 2005, International Monetary Fund, WP/05/54

**Supplement to RBI Bulletin, March 2005