Even without taking into account the increase in government expenditure due to increased farm loan waivers—BoFAML estimates this could eventually total Rs 2.6 lakh crore—state government deficits are growing at an increasing pace. From around 2% of GDP in FY13, despite the increased transfers from the Centre after the recommendations of the 14th Finance Commission, the combined deficit of states has risen to 2.7% in FY17 if you don’t take the UDAY bonds into account and 3.4% if you do—the budgeted amount, to put this in perspective, was 3%—and since this does not include Uttar Pradesh, the final number could be even higher. In sharp contrast, the central fiscal deficit has fallen from 5.2% to 3.5% in the same period, keeping the overall government deficit unchanged. As a result, if not in this year itself, certainly by next year, state government borrowings will exceed those of the central government—in FY14, state government borrowing was 34% of central borrowing and this rose to 84% by FY17.
And, as the latest RBI paper on state government finances brings out, while 37% of this was market borrowing in FY12, this rose to a whopping 52% in FY17. The immediate impact of state government paper rising by 25-30% every year over the last few years has meant an increasing spread over G-Secs. While the spread more than doubled to 70 bps by March 2016, this rose again to 90 bps by March 2017. At one level, buyers of government paper make little distinction between fiscally profligate states and prudent ones—since all their paper is guaranteed by RBI—but with so much more paper coming into the market, the spreads for all state government paper rising is not unexpected. While these spreads could rise even further if state government paper continues to grow as in the past, what is also worrying is the impact on other interest rates and its impact on impeding monetary transmission—so while RBI cut interest rates by 175 bps between 2015 and 2017, GSec yields fell only 90 bps, and those for state government paper fell a smaller 30 bps.
There is also a large, if unnoticed, impact on the corporate bond market since bond-holders seek to maximise risk-weighted yields. In the past, this was done only through buying G-Secs—there is now, however, also state government bonds that offer 90 bps more of risk-free yield. One set of analysis found that every 100 bps rise in yields on state government paper end up pushing spreads on corporate bonds by 54 bps—in March 2015, 10-year AAA corporate bonds had a spread of 60 bps over GSecs of a comparable tenure, but this rose to 120 bps by March 2017.
Higher yields are a matter of concern for the corporate sector since the bond market was seen as an alternative to bank finance at a time when banks have a low appetite for lending. Even more worrying is what happens as private sector credit starts rising again. While there is already a ‘crowding out’ happening right now—in the sense of higher state government debt causing corporate rates to rise—this will get worse as the private sector starts demanding more credit. At that point, India’s comfortable macros of low inflation resulting in lower interest rates may start to look a little less so. Bringing discipline in state government spending is critical.