Budget 2004-05: Solace in Sight for Federal Debt Woes?
A
decade and more of liberal market-oriented economic
policies have seen increasing stress on Indian federal
finances. As has been highlighted by many economists
recently, the higher than market interest rates paid
by the States on their borrowings from the Centre has
been a significant contributor to States' financing
worries. The Union Budget 2004-05 presented by finance
minister P. Chidambaram last week has offered a one
percentage point reduction in the interest rates paid
by States on Central borrowing, bringing it down to
9 per cent. How much of an impact will this have in
ameliorating State's fiscal constraints?
The dire state of State finances is evident from the
fact that while the Centre's debt to GDP ratio showed
a decline in the last year for the first time since
1997-98, the gross fiscal deficit (GFD) of the States
as a proportion of GDP has worsened steadily. None of
the elements that helped the Centre, like a decline
in interest rates, reduction in expenditure and an increase
in revenues on the back of a growing economy, seem to
have benefited the States. Quite to the contrary, in
addition to increasing pension and wage liabilities
on account of the Fifth Pay Commission and a deceleration
in Central transfers, growing interest burden on States'
borrowing from the Centre has been contributing to a
persistently higher revenue deficit. The latter in turn
has led to a higher fiscal deficit and spiraling debt
for the States. From about 22 per cent in 1997-98, the
total outstanding liabilities of the States as a percentage
of GDP has continuously gone up and reached almost 30
per cent in 2002-03.
Loans from the Centre have constituted the largest component
of States' borrowings traditionally. The share of Central
loans in States' total outstanding liabilities, which
was as high as 60% in 1998-99 dropped sharply after
that, largely because of certain accounting changes
that were brought into effect in 1999-2000[1].
Until then, small savings collections channeled to
the States by the Centre had been considered as part
of its aggregate loans. But, in 1999-2000 State governments
were allowed to issue special securities to a newly
designated agency called the National Small Savings
Fund (NSSF), to meet a part of their borrowing requirements.
This meant that just between the fiscal years 1998-99
and 1999-2000, the share of gross fiscal deficit (GFD)
recorded as financed by Central loans dropped sharply
from about 42% to about 14%. However, if we look at
States' outstanding liabilities, it is evident that
Central loans and advances still constituted the largest
component of their existing debt stock, despite the
fall seen in their share to 52% in 2000. On these loans
to the States, the Centre has been using its discretionary
powers and charging significant spreads over the market
rates.
The argument that has often been put forward for this
is that the State governments should play by the rules
of the game of the market economy, by paying the market-determined
interest rates on its liabilities. Thus, ironically,
while the Centre currently borrows at interest rates
which vary between 4 and 6 per cent, it has been lending
to the States at 10 per cent or higher. In some cases,
it has been estimated to be as high as 13%. At a time
when the market interest rates have been coming down,
the effective interest rate that the States have to
pay on their liabilities went up from 8.96% in 1992-93
to between 10.5 - 11% on an average for the years 1998-99
to 2002-03[2]. Thus, even
though the average cost of funds raised by States through
market borrowings and loans against small savings collections
has fallen substantially since 1997-98, the interest
payments by the States have increased due to the much
higher rates of Central loans.
This has meant that the ratio of interest payments to
revenue expenditure for all the States has steadily
increased from 18% in 2000-01 to 22% in 2003-04. Based
on RBI estimates, it is seen that states like Orissa,
Rajasthan, Punjab, West Bengal and Uttar Pradesh had
ratios of interest payments to revenue receipts for
1996-2002 averaging higher than 25%. On the other hand,
States like Andhra Pradesh, Assam, Bihar, Chattisgarh,
Gujarat, Haryana, Himachal Pradesh, Kerala, Madhya Pradesh,
Maharashtra and Tamil Nadu also had ratios of interest
payments to revenue receipts averaging between 15 –
25%. Indeed, in terms of share in gross transfers, Punjab
followed by Haryana and West Bengal were spending
between 70%-80% of their gross transfers on servicing their debt.
The rising interest payments have in turn contributed to the widening of
the revenue deficits and fiscal deficits of the States as can be seen
from the table below.
Gross
Fiscal Deficit as a ratio to Net State Domestic Product: Major States (Per cent) |
||||||
States |
1997-98 |
1998- 99 |
1999-2000 |
2000-01 |
2001- 02 |
|
1 |
Andhra
Pradesh |
2.8 |
5.5 |
4.4 |
5.8 |
5.0 |
2 |
Bihar |
3.2 |
6.9 |
9.5 |
11.7 |
8.7 |
3 |
Goa |
3.0 |
5.2 |
5.9 |
6.4 |
6.1 |
4 |
Gujarat |
4.1 |
6.3 |
7.5 |
8.7 |
6.2 |
5 |
Haryana |
3.3 |
5.8 |
5.0 |
4.7 |
5.2 |
6 |
Karnataka |
2.5 |
4.0 |
5.0 |
4.5 |
6.0 |
7 |
Kerala |
5.4 |
5.9 |
8.0 |
6.1 |
4.7 |
8 |
Madhya
Pradesh |
3.4 |
6.7 |
5.7 |
4.2 |
5.1 |
9 |
Maharashtra |
3.8 |
3.9 |
5.4 |
4.2 |
4.5 |
10 |
Orissa |
6.4 |
9.3 |
10.9 |
9.8 |
10.5 |
11 |
Punjab |
5.7 |
7.6 |
5.9 |
6.7 |
7.9 |
12 |
Rajasthan |
4.5 |
7.9 |
7.7 |
6.1 |
7.3 |
13 |
Tamil
Nadu |
2.3 |
4.5 |
4.8 |
4.0 |
3.6 |
14 |
Uttar
Pradesh |
6.3 |
8.7 |
7.6 |
6.7 |
6.0 |
15 |
West
Bengal |
4.5 |
6.6 |
10.0 |
8.5 |
8.2 |
Source:
RBI, 2004, opcit. |
||||||
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.
[1]
The figures are based on data provided in RBI, 2004, State Finances:
A Study of Budgets of 2003-04.
[2] See Das, Surajit, 2004, ''Fiscal Federalism Undermined
under the NDA'', available at
http://pd.cpim.org/2004/0328/03282004_surajit%20das.htm
[3] See for example the discussion in Muralidharan,
Sukumar, 2004, ''For a new fiscal covenant'', available at http://www.flonnet.com/fl2112/stories/20040618003004000.htm
[4] Based on data provided in Kallummal, Murali, 2003,
''Small Investor Protection and Issues in Corporate Governance'', Paper
Presented at the Seminar on Regulation: Institutional and Legal Dimensions
Organised by the Centre for the Study of Law and Governance, JNU, New
Delhi.
[5] For example, while the savings instruments may be
for seven years, the Centre locks in its spread over the entire tenor
of its loan to the States, which could be 30 years. See Ram Mohan, T.T.,
2004, ''States lose as the Centre gains'', at http://economictimes.indiatimes.com/articleshow/631303.cms
[6] See Abhijit Sen, 2004, ''Act on State Finances to
Deliver What Voters Want'', at
http://www.macroscan.com/cur/may04/cur260504Act.htm