Perhaps RBI shouldn’t backstop loans beyond the FRBM limits.
It is clear now that the finances of both the Centre and the states are quite stretched. The Centre had surpassed its fiscal deficit target for 2018-19 at the end of January, while the aggregate fiscal deficit of 19 states had touched 62.5% of the budget estimate in the nine months to December 2018. The consolidated fiscal deficit is close to 6.5% of GDP and, if one includes the large off-balance-sheet borrowings that the Centre has resorted to—of close to Rs 2 lakh crore—this would be closer to 8.5% of GDP. The primary reason for the high deficits is the shortfall in tax collections and, in a couple of years, the shortfall from non-tax receipts, whether from disinvestment or telecom.
Should tax collections be buoyant from here on, a distinct possibility given that the GST has helped formalise the economy, and that the economy should start looking up post the elections, both the states and the Centre can continue to help boost growth with capex spends. However, if tax revenues aren’t in line with estimates, they will need to cut back on expenditure, and the axe will fall on capex. That is a big concern at a time when the economy is slowing down. Perhaps those states that have seriously mismanaged their finances—like Bihar, Rajasthan and Madhya Pradesh—need to be taken to task? Right now, with an RBI backstop for all states, markets don’t really distinguish between state government bonds and even the profligate borrow at rates similar to the more disciplined states. While RBI can’t possibly not guarantee state borrowings in a federal structure, one possibility is that RBI guarantees be limited to state loans that fall within the FRMB limit; at least some element of market-pricing will then be introduced.
The Centre’s elevated extra-budgetary borrowings have already spooked the market; the benchmark yield remains elevated despite open market operations and the premium between the repo rate and the yield on the 10-year benchmark is near historical highs, as are the spreads between the benchmark and corporate bonds. To be sure, there is no guaranteeing that the private sector will start investing once interest rates are lower; in fact, it is highly unlikely given how leveraged promoters are. However, an entire universe of companies will benefit since their interest costs will fall. One could argue that, in some senses, the spends by the government are helping the economy; capex by the states, for instance, has increased by a healthy 23% year-on-year in 2018-19 so far, aided by a very favourable base. But loan waivers, while they do put more money in the pockets of consumers, are detrimental to the system. These need to be stopped. In the last two years, the finances of the states—in aggregate terms—have taken a turn for the worse and some remedial measures are needed.