M Govinda Rao: Borrowing caps: One size doesn't fit all

Setting uniform fiscal deficit targets is harsh for poorer states like Bihar, Orissa, Madhya Pradesh, Rajasthan and Uttar Pradesh.

There is considerable disquiet in the Planning Commission and even more among states regarding the adoption of uniform fiscal restructuring targets for determining the borrowing caps. The Twelfth Finance Commission (TFC) recommended that the states should pass fiscal responsibility legislation and draw up a medium-term fiscal plan (MTFP) to phase out their revenue deficits and to reduce their aggregate fiscal deficits to 3 per cent of GSDP. It also recommended that borrowing caps for individual states should be determined to stabilise their debt and deficits to conform to the overall target. Based on this, the ministry of finance has set a uniform target to the states to reduce their individual fiscal deficits to 3 per cent of GSDP by 2008-09 and most of the states have passed laws and drawn up their MTFP. The important question is whether such uniform targets are appropriate to achieve the growth objectives and its inter-state spread.

In fact, the TFC's approach to determining the borrowing ceilings of individual states was ambivalent. In para 4.43 it recommended that annual borrowing ceilings for individual states conforming to the overall plan of bringing down their aggregate fiscal deficit to 3 per cent of GDP by 2008-09 can be determined in terms of the ratio of interest payments to revenue receipts, as detailed in Appendix 4.1. Individual states' debt-sustainability targets should differ, depending on their growth rates, effective interest rates and revenue-GSDP ratios. The TFC also recommended that a "Loan Council" should be established to set the borrowing caps based on the sustainability condition for each state. However, Para 4.79 (vii) of the Report stipulates that individual states should reduce their fiscal deficits to 3 per cent of GSDP or its equivalent defined as the ratio of interest payments to revenue receipts. In any case, the finance ministry did not accept the recommendation of establishing the Loan Council to determine annual borrowing ceilings and preferred to set the ceilings based on the uniform target of reducing the fiscal deficit in each of the states to 3 per cent of GSDP.

Indeed, there are methodological problems in the debt-restructuring plan. The TFC itself recognised that the sustainability conditions were derived in the debt dynamics equation by assuming that the nominal growth rates and nominal effective interest rates are exogenous. Therefore, at best, the prescribed targets may be taken as only indicative. Surely, the borrowing incurred by the states for strengthening infrastructure would contribute to growth, on the one hand, and could crowd out private investment by hardening the interest rate, on the other. Therefore, the correction paths should be worked out by taking account of the impact of fiscal deficits on economic growth, make accurate projections of growth rates, interest rates and revenue, and keep updating the correction paths every year. Taking the static targets recommended by the TFC and applying them for the medium term without any change would be inappropriate.

The issue is particularly important because the terms of reference of the TFC required the Commission to recommend restructuring public finances to restore budgetary balance, and achieve macroeconomic stability and debt reduction along with equitable growth, and in doing so, it should take account of the states' performance in their commitment to social sector spending and investment climate. This required that the fiscal deficit targets should be set not only to take account of macroeconomic stability but also to overcome infrastructure backlogs in lagging states and states with greater focus on human development. Thus, the deficit targets for the states with large infrastructure backlogs and those with greater focus on human development should have been higher.

The annual fiscal restructuring targets worked out by the ministry of finance do not conform even to the TFC's recommendations. At the aggregate level, the targets have been set as a percentage of GSDP and not revenue receipts, and as there is considerable lag in getting firm estimates of GSDP, the targets remain tentative. Second, the TFC's target of bringing down the fiscal deficit of the states to 3 per cent of GDP by 2008-09 is equivalent to about 4 per cent of total GSDP as the ratio of GDP to total GSDP works out to about 1.33. However, the states have been advised to bring their individual fiscal deficits down to 3 per cent of GSDP by 2008-09 and the fiscal responsibility laws of the states have been drawn up accordingly.

Setting uniform fiscal deficit targets is harsh on poorer states like Bihar, Orissa, Madhya Pradesh, Rajasthan and Uttar Pradesh. Indeed, accelerating growth in these states requires reforms in institutions as well as policies to create an enabling environment. Achieving inclusive growth and sustaining it at 9 per cent during the 11th Plan requires that their infrastructure levels are augmented to attract an adequate flow of private investments to create conditions for the efficient utilisation of their resources. The weak state of infrastructure, poor structure of incentives, and low capacity of institutions including market development in these states have inhibited their growth. Expanding infrastructure and strengthening the capacity of institutions in these states would require them to incur more borrowing and setting uniform fiscal deficit targets will not serve the purpose.

Ensuring macroeconomic stability is in the Central domain and it is the responsibility of the Central government to ensure that no state indulges in uncontrolled borrowing. In the ultimate analysis, hard budget constraint is imperative and this has to come through market discipline with additional assistance provided to the lagging states for overcoming their infrastructure backlog. In the interim, however, setting up a Loan Council with a well-qualified technical secretariat would be important to work out and monitor the borrowing limit for individual states. The prevailing system of unilaterally setting borrowing limits based on uniform targets by the Union finance ministry is not only biased against the lagging states but also adds to the irritants in Centre-state relations. The Loan Council could also be mandated to work out the roadmap for the development of the debt market. In any case, it is important for the Ministry of Finance to extricate itself from the one-size-fits-all tyranny if it is serious about inclusive growth and institute a mechanism to enforce hard budget constraints on the states.

The author is Director, National Institute of Public Finance and Policy. Comments at mgr@nipfp.org.in.