Even small changes to targets and paths often elicit disproportionate market reactions. But this obsession with the Centre’s finances belies the fact that India’s fiscal centre of gravity has rapidly shifted from the Centre to the states.
Every year, markets obsess about the Centre’s fiscal deficit. Even small changes to targets and paths often elicit disproportionate market reactions. But this obsession with the Centre’s finances belies the fact that India’s fiscal centre of gravity has rapidly shifted from the Centre to the states. First, state expenditure is significantly higher than the Centre’s. For example, in FY16, states budgeted a total expenditure of 16.7% of GDP versus just 13.4% of GDP for the Centre. Furthermore, market borrowing by states has been galloping in recent years, increasing by 26% (net of any UDAY issuance) in 2015-16 and by another 20% this year. Consequently, state market borrowing is expected to be 90% of central borrowing this year and we expect that by FY19 states’ market borrowing would comfortably exceed that of the Centre’s. Against this backdrop, to focus disproportionately on the Centre’s finances is to miss the forest for the trees.
Focusing on state finances, however, reveals a changed reality and throws up some inconvenient truths. About five years ago, states—in contrast to the Centre’s profligacy post Lehman—were the embodiment of fiscal discipline. Their consolidated fiscal deficit had more than halved from 4.3% of GDP in FY04 to 2% in FY13. But that reality has fast changed. Over the last four years, just as the Centre became serious about bringing its fiscal deficit down, states have let their deficits slip. Consider this: the combined state fiscal deficit widened from 2% of GDP in FY13 to 2.9% of GDP in FY15. Then in the FY16 Budget—based on the recommendations of the 14th Finance Commission—the Centre’s net transfers to states increased by a sizeable 0.4% of GDP. Many thought these extra resources would be used to reduce state deficits. But state deficits hardly budged, printing—almost identically—at 2.8% of GDP in FY16, confirming that three-fourths of the central transfers had effectively been spent. What’s more, an analysis of 15 large states suggests the bulk of the expenditures were devoted to current, and not capital, expenditures.
As if this was not enough, fiscal stress is poised to increase further in FY17. One constant in recent years is that state fiscal out-turns have consistently been worse than what was budgeted. To focus on budgeted outcomes, therefore, is to systematically undershoot the actual out-turn. In FY16, for example, states’ budgeted a (combined) deficit of 2.4% of GDP, but the actual out-turn was 2.8% of GDP (ex UDAY)—a slippage of about 15% over budgeted levels. In so doing, states had consumed 46% of their budgeted deficit between April and November. This year (FY17), however, the pressure appears even more acute. Not only have states started with budgeting a higher deficit of 2.8% of GDP (ex UDAY), but between April and November, they have consumed 60% of their fiscal deficit, vis-à-vis 46% last year. If things continue at this pace, the state fiscal out-turn (ex UDAY) would be 3.4% of GDP—the highest combined state deficit in 12 years.
But this is not all. First, the fiscal run-rate used for these calculations is till November, i.e., largely pre-demonetisation. Stamp duties constitute 12% of state-own sources of revenue. To the extent that the real-estate market remains depressed, state revenues and deficits could come under further pressure this year and next. Second, these dynamics don’t include State Pay Commissions for the most part. To the extent that states will implement their Pay Commissions in the coming years, deficits will be under even more pressure. Finally, note that these calculations do not include the UDAY liabilities, because those are one-offs. Including UDAY, for example, would have pushed the fiscal deficit to 3.5% of GDP in 2015-16.
Why does all this matter? First, states have completely undone the Centre’s consolidation such that the consolidated deficit is completely unchanged. Four years ago, the consolidated deficit was 6.9% of GDP, with the Centre’s out-turn at 4.9% and the states at 2%. In FY17, the Centre’s out-turn has reduced to 3.5% of GDP, but the states’ is expected to rise to 3.4% of GDP. The upshot: the consolidated deficit will still be 6.9% of GDP—exactly as it was in FY13.
Second, the sharp increase in state market borrowings has pushed up borrowing costs for states. Typically, states borrow at a premium of about 40-45 bps over central government bonds (GSecs). However, the raft of borrowing has meant that in the last two auctions, this spread has widened to almost 90bps.
Thirdly, state debt dynamics are poised to get onto an ominous path. In recent years, state debt has stabilised around 22% of GDP. But with the underlying primary deficit (state deficit minus interest payments) widening from 0.4% of GDP to 1.8% of GDP in recent years, state debt is poised to rise monotonically till the eye can see—rising to 30% of GDP over the next decade and continuing to rise thereafter—even under generous assumptions of nominal GDP growth and state bond-yields. Only a reduction of a full percentage point in the primary deficit will ensure that state debt-GDP stabilises at current levels. If things worsen, the risk of explosive debt dynamics is real. Why is this important? Because the FRBM Review Committee has proposed a new fiscal anchor of consolidated debt-GDP of 60% by 2023, with State debt-GDP at 20%. If state debt continues to secularly rise, either the debt target will be unachievable or the Centre will have to slash its fiscal deficit to unrealistic levels. Either outcome would be undesirable.
So, what is to be done? We have long argued that injecting market discipline into the state bond market is imperative. Currently, a largely captive investor and expectations of an implicit sovereign guarantee have meant that price discovery is severely impeded and investors don’t feel the need to discriminate between states. As a consequence, there is absolutely no correlation between a state’s borrowing costs and its underlying deficit or debt position. In the recent February auction, for example, Bihar (with a deficit of nearly 6% in FY16) and Gujarat (with a deficit of just 2.3% in FY16) were both paying the same yield. With profligate states not being disciplined by the market and prudent states not being rewarded, there is little incentive to consolidate. Something will have to give.
India’s fiscal centre of gravity is fast changing toward the states. It is therefore imperative that states operate under the right fiscal incentives. Those incentives will only arise when they are exposed to market discipline. Only that will ensure that state finances don’t completely undo the Centre’s good work. And only that will induce competitive fiscal federalism—a key objective of this government—among states.
Chinoy is chief India economist and Toshi Jain is associate, JP Morgan.
Views are personal