Column: State finances on the mend

Updated: Apr 10 2014, 08:42am hrs
In the Indian federal set up, while the states have limited fiscal powers to raise resources, expenditure responsibilities for most local public goods and services are assigned to them. As a consequence, there is always a gap between the income and expenditure of the states. This gap is filled by revenue transfer from the Centre which includes both grants and a share in the central taxes. In addition to this, states, from time to time, also borrow from the market through state development loans.

The fiscal health of the state governments began deteriorating in the second half of the 1990s and continued till early 2000. Combined fiscal deficit of the states, at 4.5% of the GDP, peaked in FY00 and has improved thereafter. It has remained in the range of 2-2.5% of the GDP since FY06, with the exception of FY10. Combined revenue balance of the states has been positive since FY11. These fiscal numbers are certainly much better than the fiscal number of the Centre.

Despite adverse macroeconomic conditions, improvement in the fiscal health of state government finances are commendable, though a bit surprising. Sub-national revenues and expenditure are normally found to move in line with business cycles. However, RBI, in a panel data analysis covering the period of FY81 to FY13, found that fiscal expenditures of non-special category states in India exhibit different cyclical behaviour across different components. While capital outlay is found to be pro-cyclical, primary revenue expenditure turns out to be cyclical. This clearly shows the rigidity in adjusting such expenditure (which mainly consists of salary, pension, interest burden, etc) in tandem with growth cycles.

Revenue and expenditure

Notwithstanding the pro-cyclical behaviour of the capital outlay, the increase in the proportion of developmental expenditure of the states in total spending in recent years is a welcome change. Although there is still significant scope for the state governments to cut down the non-development expenditure, particularly subsidies, states which have accumulated revenue surpluses may utilise these to increase the capital outlay, particularly for infrastructure projects.

State governments salary and pension burden increased sharply in FY10 and FY11, after the revision of the salaries of their employees in line with the recommendations of the sixth Central Pay Commission. However, after the salary revision process concluded in FY12, growth in salary and pension expenditure has been following a normal trend and is expected to do so till FY17-FY18 when the seventh Central Pay Commission will submit its report.

However, the key reasons for improvement in the state government finances since the middle of the last decade have been the framing and passage of the FRBM act by the state governments and the two schemesdebt swap scheme (DSS) of FY03-FY05 and the debt consolidation and relief facility (DCRF) offered by the Central government to the states to reduce their interest burden. While all states took advantage of DSS, Sikkim and West Bengal were not able to benefit from the DCRF as they failed to frame their fiscal responsibility laws and rules to achieve fiscal consolidation in time. However, the Twelfth

Finance Commission allowed these two states to take advantage of DCRF during its award period (FY11-FY15).

These schemes have improved the credit profiles of most state governments with the average interest rate on states aggregate debt declining to 6.8% in FY10 from 10.2% in FY04. However, with focus now shifting to market borrowing, it increased to 8.7% in FY14 (budget estimates) due to tight monetary and liquidity conditions in the economy. Although selected committed expenditure (administrative services, pension and interest) is growing annually, a faster revenue growth even during the current sluggish economic growth phase has been providing comfort to state finances.

Fiscal balance

The consolidated revenue account of the states is likely to remain in surplus even in FY15. It is estimated to decline to 0.1% of the GDP in FY14 from 0.4% of the GDP in FY14 (budget estimate) and 0.2% of the GDP in FY13 (revised estimate). Although the slippage is minor, states receiving large Central transfer (mainly special category states) will be affected more than the others.

Expected fiscal slippage in FY14 is mainly due to a decline in the nominal GDP growth rate of the national economy. According to the advanced estimate put out by the Central Statistical Organisation, the nominal GDP growth for FY14 has been pegged at around 12%, with the FY14 budget estimate at 13.4%. An offshoot of this decline in nominal GDP growth would be a fall in the growth of states share in Central taxes, now likely to grow at 9.2% in FY14 as against the budget estimate of 19.0%.


Although the combined debt-to-GDP ratio of the states has improved in the past few years, the pace of correction has declined due to decline in the difference between nominal GDP growth and the interest rate on debt. Although the aggregate debt of the states is expected to increase to 21.7% of the GDP in FY14 from the budget estimate of 21.5%, it is expected to decline to 21.1% in FY15. So long as state economies continue to achieve nominal growth in excess of interest rate on debt (rate spread), fiscal outcome would remain favourable and sustaining debt would not be a challenge, as the accompanying chart shows.

Indirect risk

The autonomy of the states to borrow from market is limited and is subject to approval by the Centre. However, these regulations have been circumvented by off-budget borrowing through state-owned public sector undertakings

(SPSUs) as these accounts are not consolidated with the state government accounts. Moreover, guarantees given by the states are contingent liabilities and will be devolved to government if SPSUs fail to pay off their debt.

Among various SPSUs, the finances, particularly of discoms, are in a precarious condition. Taking advantage of the financial restructuring package (FRP) announced by the central government for discoms, several states have restructured their debt lately. As a consequence, consolidated state guarantee has declined to 0.9% of GDP in FY14 (BE) from its peak of 8.0% of GDP in FY04. On the whole, therefore, SPSU debt is unlikely to pose any significant risk to the state government finances.

Sunil Kumar Sinha & Devendra Kumar Pant

Sinha is principal economist and Pant is chief economist, India Ratings and Research Pvt Ltd(Ind-Ra). This article is based on Ind-Ra FY15 State Public Finance outlook