Should states cough up higher interest rates for their fiscal profligacy?

Debate over how states manage their finances likely to pick up as the constitution of the 16th Finance Commission is round the corner

The Reserve Bank of India (RBI), in its latest Financial Stability Report released in June, has sounded a note of caution on the high debt levels among states.

After reaching a 15-year high of 31 per cent of gross domestic product at the end March 2021, states’ outstanding liabilities came down to 27.9 per cent of GDP by end March 2023. “At 27.9 per cent of GDP at end-March 2023, the debt level of the states is still higher than the 20 per cent limit recommended by the Fiscal Responsibility and Budget Management (FRBM) Review Committee (2018) and warrants further consolidation. At a disaggregated level, a few large states have debt-to-GSDP ratios exceeding 35 per cent,” the report said.

A paper by economists Poonam Gupta and Barry Eichengreen presented at the recently concluded India Policy Forum, which was organised by the National Council of Applied Economic Research (NCAER), shows debt to GDP ratio of states is likely to increase in the baseline scenario to 30.8 per cent in FY28 given states have larger contingent liabilities than the centre. In comparison, the centre’s debt-to-GDP ratio is projected to decline mildly to 60.2 per cent by FY28 from 60.5 per cent in FY23 in the baseline scenario.  

However, there is wide variation among states as hinted by the Financial Stability Report. Gujarat is on a “virtuous path” and its low debt-to-GDP ratio is projected to further decline to 18.2 per cent by FY28 from 19.9 per cent in FY23. Punjab is on a “vicious path” with its already high debt-to-GDP ratio set to increase further and touch 55.4 per cent by FY28 from 47.8 per cent in FY23.

Gupta, who is the director general of NCAER, contended that since both Gujarat and Punjab borrow from the bond market in the form of state development loans (SDLs) almost at the same interest rates, it is indeed the fiscally prudent states which subsidise the profligate ones.

“We hear whenever the Finance Commission (FC) is set up, through horizontal devolution of taxes, richer states subsidise the poorer states. There is another subsidisation happening which is (the) more prudent states are subsidising the profligate ones through interest rate evening out. Gujarat should be certainly able to borrow at a lower interest rate than Punjab. But the fact that those rates (are) kept uniform, there is another element of subsidy that is happening,” she said at the NCAER event.

Eichengreen, who is a professor at the University of California, Berkeley, said the horizontal devolution of taxes among states, awarded by the FC every five years, does not provide incentives for fiscal rectitude. “FCs are mandated to allocate more resources to states with larger revenue deficits, an obvious source of moral hazard,” he said.

Responding to the discussion, N K Singh, chairman of the 15th Finance Commission and who chaired the session, said there is no incentive for states to manage their finances more prudently as compared to those which are fiscally profligate. “The yield curve must reflect the capacity of the states and in some ways penalise the states which indulge in unabated fiscal profligacy, rewarding states which have managed their finances more prudently. I think that needs to be considered. We need to move to a structure where RBI recalibrates (the yield curve),” he said.

In a telephonic conversation Pronab Sen, former chief statistician of India said state governments are not allowed to approach the market directly and all their borrowing is done through RBI. “If state governments approach the market directly, it would reflect in their interest rates because the risk premium will vary from state to state. However, municipalities of states like Gujarat who directly approach the market get debt at a much cheaper rate.”

Sen, however, is not in favour of capping borrowing limits of states as is the case now as well as asking profligate states to pay more interest rates. “You can’t have both because it could lead to a complete and immediate collapse in the financial situation of a state government. More money will be going into interest payment and since they are allowed to borrow less, the actual expenditure will go down even further,” he said.  

As the constitution of the 16th Finance Commission is round the corner, this issue may become a hotly contested topic in the coming days.