States' capex more than Centre's but borrowing limits are the same

Over the past decade, there has been a significant shift in the composition of the general government (Centre and states) expenditure.

Put together, the combined expenditure of all states now exceeds that of the Centre.

In fact, capital expenditure by all states is now almost twice that of the Centre. Of the total general government capital expenditure of Rs 8.75 trillion budgeted for in 2018-19, state governments account for roughly two-thirds. 

But despite this rise in state spending, annual borrowings by states, barring exceptions allowed by the 14th Finance Commission, are placed at the same level as the Centre, even as their debt-to-GDP ratio is restricted at a lower level. 

Why is this so? Is this due to historical reasons or are other issues at play here? And, as state governments typically borrow to finance capital expenditure, shouldn't their borrowing limits be eased, as some state governments are believed to have asked in the meetings of the 15th Finance Commission? 

The origins of the limits on state borrowings can be traced to the 12th Finance Commission. 

The commission, under the chairmanship of former Reserve Bank of India governor C Rangarajan, had then noted that at the aggregate level, the financial savings of households were around 10 per cent of GDP. Add to that 1.5 per cent of external borrowings and the total savings pool works out to around 11.5 per cent of GDP. 

Of this, public sector enterprises were estimated to require 1.5 per cent, and the private sector 4 per cent.

The remaining 6 per cent of GDP was split equally between the Centre and the states, placing an upper limit on state borrowings each year, despite their lower debt-to-GDP ratios.

Much water has flowed under the bridge since then. An advisor to the 14th Finance Commission has pointed out, “The greater role that states are now playing, there is a legitimate argument to be made for increasing state borrowings under this 6 per cent threshold.”

Experts contend that the notion of allowing states greater borrowing capacity should be considered because the implementation machinery is largely with the states.

“The Centre has very limited capacity to do development work,” says Pronab Sen, former chief statistician of India. “Much of it is carried out by the states,” he adds. 

However, there are reasonable arguments to be made for persisting with the current arrangement. 

“Ensuring macro-economic stability is a central function,” says M Govinda Rao, former member of the 14th Finance Commission. “States can always borrow from the centre. But in the Centre’s case in case of any exigencies nobody will give the Centre additional resources,” he adds. 

There’s also the nature of debt. 

“State debt is quasi-sovereign in nature. The Centre’s debt is safer. If the Centre’s debt becomes a problem, it can always be monetised,” said Sen. 

Then there’s also the structural limitations of the central government budget. 

Budget documents show that the Centre’s establishment expenditure and interest payments alone add up to roughly 44 per cent of its total expenditure in 2018-19.

Expenditure on items such as home affairs, external affairs, defence and tax administration falls squarely under the purview of the Centre, leaving it with very little fiscal space.  

“There is also an additional borrowing space provided by the 14th Finance Commission which is available to states,” said a member of the 14th Finance Commission. 

The 14th Finance Commission had provided for states to borrow another 0.5 per cent of GDP conditional upon their revenue receipts, interest payments and their debt-to-GSDP ratio. 

Further, easing borrowing limits for states is likely to come with its own set of challenges, say economists. 

For one, the need to ensure fiscal discipline so that general government debt-dynamics don’t worsen. The trends in state finances are not very encouraging. 

For instance, the average debt burden of Odisha rose from 36.21 per cent of GSDP between 1993 and 1996 to 63.68 per cent between 2000 and 2003. Similarly, for West Bengal it rose from 23.26 per cent to 42.73 per cent over the same period, according to the 12th Finance Commission. 

Though these states have managed to bring down their debt burden subsequently, it remains above the 20 per cent threshold in some cases. For example, in the case of West Bengal, the debt-to-GSDP ratio is estimated at 34.2 per cent for 2018-19 (BE), while for Punjab, it is 34.3 per cent. On the other hand, Odisha’s debt burden has declined to 19.7 per cent of GSDP in 2018-19 (BE), according to the RBI study on state finances. 

There are also concerns over populist tendencies overtaking fiscal prudence especially in the run-up to state elections. 

All things considered, the 15th Finance Commission, therefore, has a singular dilemma before it.