MacroScan - Budget 2004-05: Solace in Sight for Federal Debt Woes?

Such rising debt servicing commitments have severely affected States' ability to fulfill their developmental responsibilities. A disaggregation of States' total expenditure shows that non-developmental expenditure has been recording a higher growth than developmental expenditure. Consequently, the share of developmental expenditure in the total, which declined from as much as 70% in 1990-91 to 65% in 1996-97, has henceforth fallen sharply to 55% in 2003-04. Meanwhile, the share of States' total expenditures going into non-developmental heads has shot up from less than 25% in 1990-91 to over 37 %. Almost half of this increase came from interest payments being made on loans, with the share of these payments in total expenditure increasing from less than 10 per cent to over 16 per cent by 2002-03.

In view of the fact that the much needed revival in developmental expenditures on health, education, water supply, infrastructure, etc., fall under States' jurisdiction, the overhang of this high cost debt has been viewed with increasing concern.

The Centre attempted to lessen the debt burden on the States by allowing them to utilize 20 per cent of their net small savings proceeds from the National Small Savings Fund (NSSF) to pre-pay past high-cost Central loans through the Debt Swap Scheme. In the last year, States were also allowed to retire these loans through additional market borrowing entitlements, which offer a cheaper debt swap option relative to small savings.

State governments have saved over Rs. 3,000 crore so far, participating in the debt swap scheme which was announced in the Union budget last year (Budget 2003-04). Thus far, of the total debt swapped amounting to Rs. 60,368 crore, around 61 per cent have been financed through additional market borrowings at interest rates below 6.5 per cent - at less than half of the earlier cost. The remaining loans have been financed through the issue of special securities to the NSSF at interest rates fixed at 9.5 per cent, i.e., at less than three-fourth of the earlier cost.

Subsequently, in the last fiscal year, the share of special securities issued to the NSSF in total outstanding debt of all States stood at 25%, while that of market borrowings accounted for 18%, banks and financial institutions accounted for 9% and provident funds accounted for another 16%. At the same time, the share of Central loans and advances in total outstanding debt still stood at 32%.

With such a high proportion of States' debt still being accounted for by the higher interest-bearing Central loans, the proposal in the present budget to reduce the interest rate on these loans by one percentage point is heartening. By reducing the debt service burden, this will release additional resources worth more than Rs. 3200 crore for the States, which then can be effectively utilized for increasing developmental expenditure. This move should be continued in an accelerated manner, whereby the market rates and the Central rate will see a convergence.

In this context, a concept paper in the Planning Commission which called for a waiver of all Central debt to the States as a one-time measure should be viewed in a long-term perspective. This paper has proposed that subsequent to a complete write-off, the practice of issuing loans from the Centre to the States should itself be ended. With appropriate revisions in the Gadgil formula, all federal transfers would then take the form of grants. It has been estimated that once relieved of interest liabilities on Central loans, State revenue budgets would rapidly regain a semblance of balance^[3].

The proposal for the debt write-off is indeed attractive and will enable States to take developmental expenditures to much higher levels. But, a waiver will offer only a one-time solace, as seen in the case of privatization of public enterprises to meet fiscal deficit challenges of the Centre. Further, while the suggestion that all Central assistance to the States should henceforth take the form of only grant looks deceptively attractive from the point of view of fiscal devolution, accepting such a proposal may be playing into the hands of neo-liberal economic policies. The latter suggestion will only help to push the States towards the market and may in turn accelerate the withdrawal of the States from the social sectors.

‘Fiscal consolidation' has been the preferred euphemism of the proponents of neo-liberal economic policies for their obsession with reducing the budget deficit, which has been argued to hamper growth. Indeed, India is tackling its central deficit through the Fiscal Responsibility and Budget Management Law, which sets a target of 2008 for the Centre to eliminate its revenue deficit. But, the additional fiscal burden incurred by the Central government due to the declining tax-GDP ratio has been shifted to the State governments, by cutting down the transfers to the States. It can be clearly seen that as part of Centre's efforts to meet its fiscal discipline commitments, the Centre has already been reducing its assistance to the States. The share of Central loans in financing the gross fiscal deficit (GFD) of the States has already declined from 11.4% in 2001-02 to 6.7% in 2003-04.

This whole process of global integration and related ‘disciplining' of government finances has proceeded in a manner wherein the dependence of both the Centre and the States on the mercy of the market is bound to increase. Given the prevailing system which precludes the scope for deficit financing, the Centre is increasingly forced to borrow capital from the market. In this context, the long-term implications of completely discontinuing all loans to the States and providing them only grants may not be practical from two sides. Firstly, without the normal return on capital from the loan assistance extended to the States, the Centre's own debt liabilities may spiral. Secondly, the granting of full Central assistance as grants will remove any disciplining on the part of States' fiscal responsibilities.

States will also be forced to increasingly finance their capital requirements through borrowings from other sources, to the extent that they cannot increase tax revenues beyond a certain level. However, the reasoning that States' liabilities will come down drastically as a result of the total removal of the high-cost Central loans and a dependence on market borrowings may not prove realistic when all States would approach the market for their budgetary needs.

Pushing States to the market for their developmental needs can be disastrous. States will have to compete with productive sectors for a share in the total pie. Further, in reality, in a totally market-dependent scenario with market perception of creditworthiness determining the credit rates, the actual interest rates for many of the ''under performing'' States and ''non-profitable'' social sector projects may be much higher than the prevailing market rates. For example, during 1996-2001, the market rate on outstanding loans as provided by the RBI averaged in the 12-17% range for the bulk of bank credit^[4], way above the prevailing ‘market rates'. Thus, the assumption that States' debt servicing expenditure will become more manageable with a complete substitution of Central loans with market borrowings may turn out to be baseless.

Moreover, while comparing the cost of borrowings from the Centre with that of the market, the cost of borrowing from other sources, on all of which States' dependence is rising, also should be considered. For instance, States' loans from financial institutions also carry high spreads over market rates. Further, in transferring funds from the small savings collections to the States also, the Centre charges a spread. In fact, it has been pointed out that the Centre not only charges a spread over its cost of borrowings, but ensures that the spread is charged for the entire tenor of the loan and not just for the period of the original liability^[5]. Clearly, all these practices are also adding to the interest burden of the States.

Therefore, rather than increasing the dependence of the States on the markets and other sources, the medium to long-term solution should be to reverse the trend in declining Central assistance and increase the share of States' budgetary requirements financed by the Centre, at sustainable interest rates. This will be very crucial for ensuring that the basic minimum requirements of the population will be protected. For State finances to be viable, the long-run requirement is that the average rate of interest must be substantially less than the medium-run rate of growth of nominal GDP^[6]. Meanwhile, in addition to getting rid of the existing debt burden on Central loans, correcting the anomalies in the transfer of funds from the small savings collections also is urgently warranted to reduce the unnecessary burden on the States in the short-term.

The recent discussions on sovereign nations' debt restructuring also point in the direction that as the Indian economy as a whole is getting more integrated than ever before with the global financial markets, increasing States' dependence on market borrowings bypassing the Centre may not be wise for national interests. In the case of federal governments going in for increased market borrowing with Central guarantees, besides the moral hazard problem which this creates by delineating the original borrowers from the risks of their external borrowing, there may also be other unforeseen implications. Even when the central government feels confident that their external liabilities are under ‘satisfactory limits', unrestricted borrowing by the States can lead to serious repercussions. This is because, as was seen during the still unresolved discussions at the IMF on sovereign debt restructuring, the proposals on the scope of the debts that would be covered under the national governments' debt liabilities as a sovereign in default, could include the liabilities incurred by the federal and sub-federal units, where they are not subject to domestic insolvency laws. This could have serious implications for debtor countries' sovereignty and for States' constitutional commitments towards social expenditure, as the rules on what kind of national assets can be called upon for meeting contractual commitments to creditors are still being contested.