MacroScan - The Crisis of State Government Debt

Finance Commission reports are typically all about the devolution of resources. The statutory job of the Finance Commissions is usually twofold: to determine the principles for the distribution of the net proceeds of shared tax revenues between the Centre and the States; and to provide for revenue deficit grants from the Centre to those States whose normative expenditures are likely to exceed normative revenue. However, more recently, the Central Government has taken it upon itself to extend the terms of reference of Finance Commissions to cover issues of fiscal sustainability.

Thus, the terms of reference of the TFC include the following: ''The Commission shall review the state of finances of the Union and the States and suggest a plan by which the Governments, collectively and severally, may bring about a restructuring of the public finances restoring budgetary balance, achieving macro-economic stability and debt reduction along with equitable growth.''

The issue of public debt has become a crucial one primarily for the States in India. It is widely recognized that the large overhang of debt of almost all state governments has implied such large interest payments that the States are effectively crippled with respect to the ability to undertake important socially necessary expenditure. Since the States are dominantly responsible for most of the types of public expenditure which affect the day-to-day life of the people, ranging from law and order and basic infrastructure to health, sanitation and education, the fiscal crisis of the States has meant that these expenditures have been very adversely affected in most parts of India.

The need to restructure the debt of the States has been widely accepted, for several reasons. The first is the adverse impact on expenditure noted above. The second is the fact that for some years now, the States have been paying higher interest rates for a variety of reasons discussed below. The rules imposed by the Reserve Bank of India, which require case by case permission to States for accessing commercial debt in they are running revenue deficits, have also operated to make borrowing difficult and have driven several States to high-conditionality debt from multilateral agencies such as the World Bank and the Asian Development Bank.

The actual patterns of fiscal imbalances across Centre and States are worth noting as background. Chart 1 describes the fiscal indicators of the States since the late 1980s. It is evident that in the aggregate, the fiscal deficit of the States as share of GDP was well within sustainable limits, at around 3 per cent of GDP, until 1997-98. Thereafter there was a sharp rise, led almost entirely by the rise in revenue deficit, and this can be traced to Central government measures such as the Pay Commission hikes.

However, since the turn of the decade, the States' revenue deficit as a share of GDP has been rising even though they have cut spending and improved revenue effort. The primary revenue balance has been in surplus, sometimes quite sharply so, even as the revenue and fiscal deficits have been increasing, largely because of the effect of the debt overhang and the unduly high interest rates the States have had to pay.
Chart 1 >>

This has been further compounded by the decline in central transfers to States over the years. Such transfers have declined from 40 per cent of the central tax receipts in the first half of the 1990s to an average of 36 per cent after 1996. Since the Centre's tax revenues have declined as a share of GDP over this period, this has meant an even sharper decline as a per cent of GDP. In fact, the States' tax effort has been significantly better than that of the Centre. So the apparent ''lack of fiscal correction'' by the States in recent years relates entirely to the debt structure and its implications.

Contrast this with the performance of the Centre, as indicated in Chart 2. While the fiscal deficit declined in the early 1990s, it rose again quite sharply in 1994-95, after financial liberalisation measures raised the cost of borrowing by the government and led to increased interest payments. The subsequent rise in fiscal deficit ratios, post-1997, has not been only because of interest payments, however, but because of other expenditures essentially on the revenue account and declining tax ratios, as revenue deficits and the primary deficits have increased as share of GDP.
Chart 2 >>

As Chart 3 shows, the total debt of the States was more or less constant as a share of GDP for around a decade until 1997-98, and so was the ratio of debt to total revenue receipts. Thereafter, however, states' debt as a proportion of GDP has ballooned and the ratio of debt to revenue receipts of states has nearly doubled. This is clearly an unsustainable situation, but, as noted earlier, it has not been brought about either by worsening tax generation (which has been broadly stable) or excessive total expenditure, since the primary balance (net of interest payments) generally been in surplus except for only a few years. Rather, this is due to the combination of falling central transfers and related inability to repay the high interest on previously contracted debt.
Chart 3 >>

There are various indicators of debt sustainability which are typically estimated, but it is generally accepted that at the very minimum, the growth of nominal GDP must be greater than or at least equal to the rate of growth of interest that has to be paid. It is evident from Chart 4 that until 1997-98, such a condition was more than adequately met. However, since then, not only has the rate of growth of nominal GDP fallen, but interest rates have remained consistently high. As a result, for three critical years since 2000, this condition has not been met, which obviously makes servicing the debt difficult if not impossible. It is this which has then led to further debt accumulation, which obviously makes the trajectory an unsustainable one.
Chart 4 >>

But why have interest rates remained so high if the general perception of declining interest rates is valid? This is where the discriminatory attitude of the Centre towards States in general has had such a negative impact. Under the Constitution, the Centre has the power to determine both the extent and the terms of borrowing by the States from all sources, not only from itself. This power has been used increasingly by the Centre to restrict States from accessing different types of loans and in effect dramatically increasing the cost of borrowing for States.

There are several ways in which this has been done. The central government has been charging the state governments higher rates of interest on debt which it issues to them, in fact substantially higher than the Centre has been paying itself. The Centre has also used aggressively its Constitutional powers to limit the ability of the States to borrow from the market and from commercial banks. Any state government which has a revenue deficit therefore has to seek special permission from the Reserve Bank of India to borrow from commercial banks, permission which is not necessarily granted. Finally, state governments taking on debt provided by multilateral institutions or even loans from bilateral donors have not paid the rate of interest charged by them, but a much higher rate imposed by the Centre, which is the intermediary for such transactions.
Chart 5 >>

The consequence of all this is evident in Chart 5, which gives some indication of the average rates of interest paid on debt contracted by the Centre and the States. This gives the average, not marginal, rates, but the shapes of the curves provide an indication of the marginal changes. From around 1997 onwards, the average rate of interest paid by the Centre on its own debt has fallen significantly, from 9 per cent to around 6.5 per cent, which suggests a much sharper decline at the margin. By contrast, the average interest rate paid by the States has remained broadly stable over this entire period, so marginal rates have not really come down for them. So the Centre has effectively been reaping usurious benefits from its lending to state governments, and these have amounted in recent periods to around 1 per cent of GDP, or around 20 per cent of the central fiscal deficit.

This is the context in which the TFC's discussion of states' debt restructuring has to be analysed. The TFC has indeed suggested a formula for reducing the burden of debt of the states, and also for reducing the interest rates payable by them. However, the positive effects of such a proposal have been drastically undermined by the proposed condition sought to be imposed by the TFC, of forcing states to enact fiscal responsibility legislation and holding to arbitrary targets for fiscal indicators, in order to get the benefits of dent reduction.

We will provide a discussion of the debt restructuring package and critically assess the possible effects of such conditions upon state finances in the next issue of MacroScan.