Reserve Bank of India (RBI) study on “State Finances: A Study of Budgets of 2016-17” has just been published. An important yearly central bank publication it provides a consolidated view of the fiscal health of states. Generally, it is published in the month of December. But this particular report was delayed by a couple of months. The delay in the publication was probably to capture the evolving Goods and Services Tax design being negotiated in the GST council. The state finances report reflects the fiscal position of states in detail for the year FY15, revised estimates for FY16 (RE) and budget estimates FY17 (BE).
It is particularly important for three reasons: (a) this is the first report which provides an understanding of what has happened to state finances post Fourteenth Finance Commission with more reliable data of FY16 at the RE level; (b) it provides some understanding of revenue gain from GST, taking into consideration an almost final GST design; (c) it captures the effect of Ujjawal Discom Assurance Yojana (UDAY) on states’ fiscal imbalance. This report is a well-researched piece of work and provides useful insights on emerging issues in state finances in India. Fiscal imbalance An analysis of state budgets shows that consolidated fiscal deficit of states will be above the Fiscal Responsibility and Budget Management (FRBM) target in FY16 (RE) and is expected to revert to the mandated FRBM target of 3% by FY17 (BE).
The central bank study cautions that this may not happen given the chance of fiscal slippages in the year FY17. The reason for fiscal deficit target overshooting in the year FY16 (RE) is the borrowing of Rs 990 billion under UDAY by eight states during FY16. This works out to 0.7% of gross domestic product (GDP). Excluding UDAY bonds, deficits will be below the mandated FRBM target of 3%. The report further observed that states have started borrowing more in recent years compared to the period between FY06 to FY12, which is a reflection of rising fiscal imbalance.
It is true that rising fiscal imbalance has the potential to derail fiscal consolidation at the general government level. However, this increase in deficit needs to be seen from a different perspective. We should not forget that state governments were borrowing and not spending in a period when the actual fiscal deficit was well below the FRBM target. States in the post–Fiscal Responsibility and Budget Management Act, 2003 (FRBMA) period generally is extremely cautious in spending, as reflected in their overcorrection of deficits. This has, in turn, depressed capital spending in many states in the past. This spending inertia had also contributed to a large accumulation of cash surplus holdings by the states in the past. RBI’s “Study on State Finances: 2011–12” observed that:
The surplus cash balances of the states stood at Rs 852 billion as on March 11, 2012. These cash balances get automatically invested in the central government’s 14-day intermediate treasury bills as well as in auction treasury bills (ATBs) where states are non-competitive bidders, without any ceilings/limits. Consequently, there is a spillover of the surplus position of the states to the liquidity position of the Centre. The build-up (and volatility) of the central government’s cash surplus, in turn, reflects the unintended absorption of liquidity from the banking system which poses a challenge to the reserve bank’s monetary management.
The same study also pointed out that in its report submitted in FY10, the Thirteenth Finance Commission “advised the state governments to first utilise their cash balances before taking recourse to fresh borrowings, to finance their deficits so as to reduce the interest burden.” However, in practice, this did not happen. Thus, the recent increase in fiscal deficit needs to be seen from the perspective of capital spending in states. If this increase in borrowing resulted in an increase in capital spending and elimination of the practice of holding cash surplus, we need not worry too much about the increase in the non-UDAY part of the deficit.
A shift in focus: revenue deficit & capital spending
If we consider an aggregate picture of capital spending in the states, capital outlay was 1.9% of GDP in 2012-13 and is expected to increase to 2.8% of GDP in FY16 (RE). The report also mentioned that capital expenditure expanded by 1 percentage point of GDP in FY16 (RE) with development expenditure rising faster than non-development spending. At the same time, states have started recording deficits in revenue account since FY14. This increased to 0.4% in FY15 and is expected to be 0.2% of GDP in FY16 (RE).
This has primarily happened due to a deceleration in own tax revenue growth in many states. Own tax revenue to GDP ratio remained stagnant at around 7.5% of GDP during the period from FY12 to FY16 (RE). If there is anything that one needs to be concerned about with respect to state finances is the restoration of revenue account balance not the level of fiscal deficit, which without UDAY remained well within limits.
UDAY scheme and macroeconomic context
While doing fiscal impact analysis of UDAY scheme, we should not forget the asymmetric impact of Ujjawal Discom Assurance Yojana in some states. For example, post-UDAY, Rajasthan’s fiscal deficit shot up to more than 9% of gross state domestic product (GSDP) in the year FY16, and the debt to GSDP ratio to 31%. Interest obligation arising out of this large debt itself can create huge fiscal stress for the state in the medium term. This asymmetric impact needs to be factored in any analysis on the impact of UDAY on state finances.
Second, since discoms are mostly state-owned and have a large debt, a major part of this debt is with the public sector banks and financial institutions. To the extent power sector debt owed to the banking system is taken over by the state governments, this arrangement provide overdue settlement to the banks and improves bank balance sheet. Finally, if we take a larger view of deficit due to public sector economic activity, to the extent discom debt was due to the power purchase from public sector generation companies, in a way arrangements made under UDAY by nature would be intra-public sector transactions.
Can GST be the game changer?
As observed in the state finances report, GST impact on the economy and on government revenue would be significant, which has the potential to improve revenue performance of the states. It is expected to reduce compliance cost and improve revenue to support fiscal consolidation. However, as highlighted, a lot would depend on the seamless implementation of GST. Since gains from GST would accrue only in the medium- to long-term, it is important that states remain fiscally prudent throughout, particular in managing their revenue account balance.
Finally, post-UDAY we are having a fiscal deficit which reflects the impact of power sector debt on state finances. It is time we develop a comparable set of data for deficits to judge fiscal prudence and sustainability at the state level bringing all-encompassing borrowing concept such as public sector borrowing requirements. Probably, Reserve Bank of India is the best institution to take up this challenging task of developing this extremely important data set.