The central bank is regularly cautioning states to improve their fiscal management. Even after the publication of its annual report on state finances in March 2011, RBI has issued this advisory once again. Critics would argue for the need of this advisory when the states are managing their finances better than the central government. A better management of states? cash flows would result in a better than current scenario of state finances.
A variety of reasons?exceptional growth momentum, revenue buoyancy and Finance Commission awards?are responsible for this. Fiscal consolidation is reflective on the states? debt and liquidity positions. Barring Jharkhand and Madhya Pradesh (among the non-special category states) and Arunachal Pradesh, Jammu & Kashmir, Manipur, Nagaland and Sikkim (among the special category states), the debt-GSDP ratio of all states has declined between 2003-04 and 2010-11. At the same time, states? reliance on liquidity enhancement measures such as ways and means advances (WMA) from RBI and the central government, and overdraft from RBI have reduced.
An improved fiscal and liquidity position has a domino effect and states? investment in 14-days intermediate treasury bills (14-days T-bills; T-bills are short-term debt instruments issued by the government of India?being risk-free, their yields at varied maturities serve as short-term benchmarks) increased from R6,856 crore (0.25% of GDP) at end-March 2004 to R95,883 crore (1.71% of GDP) at end-March 2009 and further to R1,15,450 crore (1.45% of GDP) at end-March 2011. At end-March 2008, the state governments? investments in 14-days T-bills was 77.8% of state governments? aggregate net borrowing for 2007-08.
Prior to 2003-04, due to states? fragile fiscal health, only a handful had outstanding investments in 14-days T-bills. States are allowed to avail special WMA first, which is against the security of their holding of central government securities, before availing a normal WMA. The interest rate on a special WMA is one percentage point lower than the interest rate on normal WMAs. States? investment in 14-days T-bills is similar to the excessive holding of SLR securities by banks. At a time of tight liquidity, banks with excess SLR securities can borrow from RBI rather than the money market.
The state governments? excess investments in 14-days T-bills has repercussions not only for the state governments but also for the central government and money market. States financing the central government?s fiscal deficit by investing in 14-days T-bills are affecting their own fiscal consolidation.
While at aggregate levels, the states? investment in 14-days T-bills has increased drastically, some states are managing their finances and cash flows better. While on the one hand, Andhra Pradesh, Haryana, Uttar Pradesh and West Bengal reduced their investment in 14-days T-bills in 2009-10, on the other, Assam, Bihar, Gujarat, Jharkhand, Karnataka, Kerala, Madhya Pradesh, Maharashtra, Orissa, Rajasthan and Tamil Nadu increased their investment in 14-days T-bills significantly in 2008-09 and 2009-10.
As on March 31, 2010, aggregate state investment in 14-days T-bills was 932.6% of their aggregate WMA limit for 2009-10. Barring Haryana, Punjab and Mizoram, all other states had investment in 14-days T-bills in excess of their WMA limits. Assam?s investment in 14-days T-bills was 2,644.7% of its WMA limits. Even better fiscally administered states such as Gujarat, Karnataka, Tamil Nadu, and West Bengal, with its precarious situation of its state finances, had significant investments in 14-days T-bills in relation to their WMA limits for 2009-10.
Outstanding investment (as on March 31, 2010) in 14-days T-bills by Chhattisgarh, Karnataka, Orissa, Tamil Nadu, Arunachal Pradesh, Assam, Manipur and Meghalaya was in excess of their net borrowing in 2009-10. It is ironic that states have been investing their surplus funds in 14-days T-bills and resorting to market borrowing to finance their fiscal deficit. States earn 5% interest on 14-days T-bills. The average cut-off rate of state government market borrowing during 2009-10 was 8.12%. In other words, the borrowing cost of these states in 2009-10 was at least 2.79 percentage points higher than the interest earned by investment in 14-days T-bills.
Total state investment in 14-days T-bills as on March 31 , 2011, increased to R1,15,450 crore from R92,555 crore (as on March 31, 2010). Going by the observed trend of state investment in 14-days T-bills, most of the states must have increased their investment. The average cut-off rate of state government market borrowing in 2010-11 increased to 8.39% (varying from a low of 8.28% for Bihar to a high of 8.50% for Assam). Hence, the states have earned a negative interest of at least 3.28% from their investment in 14-days T-bills. In 2009-10, in aggregate, states have paid around R2,600 crore excess interest by investing R92,555 crore in 14-days T-bills and borrowing from the market at 7.79%-8.46%.
The sudden liquidation of state investment in 14-days T-bills also affects the central government?s cash flow and has repercussions for the money market. States have to assess their fiscal situation more carefully, improve their cash flow management and should carefully decide on the time of market borrowing by assessing money market conditions (inflation expectation, liquidity situation etc).
The author is director, Fitch Ratings India Private Limited. Views are personal