At the last auction of state government papers by RBI this month, Jharkhand raised debt on better terms than Gujarat. West Bengal was rated a better paper than Andhra Pradesh and the banks and financial institutions thought the Punjab state government was the best place to put their money in, compared to all other states.

Just what sort of a credit appraisal does this pricing show? When successive finance commissions are putting their bets on larger market borrowings to discipline the state governments, the only signal from such a pricing is that fiscal indiscipline pays.

The worrying part of the cutoffs, however, is that there are not unusual numbers. In the world of state government borrowings, what matters is whether the papers have an SLR (special liquidity ratio) grade. The sweetener is whether the Centre has agreed to be the backstop for the state government’s loans for the current year, when the deficit has ballooned too much.

Thus, without fail, no matter the time of the year, the state government papers are priced just about 40-45 basis points above the ten year GOI papers. This is absurd when between them these states span the entire range from basket cases to high fliers even by best global standards. In some way the state papers are more like the Euro area bonds, at the root of the present turmoil. Greece needed to borrow more than Germany but as both were borrowing on the strength of the euro, the creditors gave a spread that they should have reserved for Germany.

Something similar is happening in the state government market in India. Armed with the SLR grade, every state government paper passes the first test of reliability.

At the next level, when a state empties out its treasury through freebies, the Centre moves in with a larger plan support. The backstop makes the paper better in the eyes of the borrower.

How significant is this difference? Planning Commission data shows there was a net drain on Punjab’s own resources in the last fiscal. In other words the state was using its tax and other receipts to pay off its past dues and had to borrow to even pay its current dues. At the same time the net resources of Andhra Pradesh, despite being strife torn, were covering 46% of its aggregate resources. But the yield on AP papers was worse than Punjab, at 8.56%, against 8.51% for Punjab. The advantage for Punjab is that there is distinct possibility the centre will intervene to reduce its debt overhang, the same as it has done for West Bengal.

Again where West Bengal has a draw on its resources to pay past dues ( as a percentage of aggregate resources, the state’s own resources are -18.09%), Uttar Pradesh provides nearly 30% of its budget requirement from its own resources. West Bengal had a cut off yield of 8.55%, compared with 8.58% for Uttar Pradesh.

Essentially, as in the Euro area, the worse off states are borrowing on the strength of their stronger neighbours. The muscle of the central government is in some ways a pooling arrangement the EU lacks.

Bankers concede that the pricing of state papers moves in a narrow range primarily due to their SLR status. When it is fairly obvious that a state could get a bailout the market rates improve. For instance, this month, in the RBI auctions of the clutch of 10 year papers of seven state governments, the cutoff yields ranged in a tight band of 8.52% to 8.58%. The total sum mobilised was R7,012 crore. Officers involved in debt negotiations with the finance ministry at the Centre therefore concede the operative principle for their annual market borrowing limit is how much can the banks pick up, rather than a clear assessment of the risk profile.

If the bottomline, therefore, is an RBI and central government guarantee, how safe should the markets think those are? As the EU crisis and the flood of easy money that the US released show, there is a finite limit to sovereigns’ guarantees. That piece of understanding seems to be pretty much absent in the centre-state fiscal relations in India.

But some statistics are rather worrying. The total internal debt of the central government at the end of March 31, 2011 has reached R37,74, 457 crore. That is above 48 % of the GDP. This includes the treasury bills issued to state governments, i.e. cash reserves parked by them with the Centre, but does not include support like that offered to West Bengal recently. So when states want to borrow more from the markets, that should be a cause for concern for the banks and financial institutions that subscribe to these papers. How different is this position from the Eurozone crisis in the essential framework?

These implications have become of consequence when the central government is walking a tight rope on fiscal deficit calculations. The numbers for the Centre could become worse if the international markets gum up soon. For the states, the big worry will be the unmet demands from the state electricity boards. As of now, there is no evidence that banks have become reluctant to pick up state papers. This is despite the excess SLR papers they are sitting on. But at the first sign of discomfort, the world of state government papers could come crashing down.

Again, just as the EU is being forced to accept the inevitability, of a fiscal union as the long-term goal, India too needs to move at an accelerated pace towards the national Goods and Services Tax to ensure the same mistakes are not repeated here.