This results in a situation where states with poor fiscal prudence are able to raise funds at the same cost as that of states that have shown discipline in managing their finances.
The latest Mint Street memo — written by Reserve Bank of India officials but not necessarily interpreted as the RBI’s official views — hints at the possibility of reviewing implicit and explicit guarantees and regulatory treatment of State government bonds in order to allow the market to differentiate between them. Right now, there isn’t a big difference between the yield on the state development loans (SDLs) of different states. This results in a situation where states with poor fiscal prudence are able to raise funds at the same cost as that of states that have shown discipline in managing their finances. For example, according to the auction results of state development loans (SDLs) announced by the RBI on December 5, yield on the10-year paper issued by Karnataka stood at 7.65% while the yield on the same tenor paper by West Bengal stood at 7.68%— a difference of just three basis points.
This is because the market remains assured that in the event of a default, the RBI can deduct the amount from the state government’s balances held by it. What the paper authored by Seema Saggar, Rahul T and Madhusudan Adki indicate is the possibility of finding ways to signal to the market that these bonds should ideally have different rates. As the Mint Street Memo puts it, “…state-level consolidation of SDL issues along with investor diversification could help narrow SDL spreads. Further, careful assessment might have to be undertaken of various explicit or implicit guarantees and regulatory treatment of SDLs if it is deemed necessary to induce differentiation in inter-state spreads.”