If errant states penalised, bond prices will do the rest
Despite getting a larger share of the Centre’s net tax revenues, courtesy the recommendations of the 14th Finance Commission, state governments this year are going to be running up the biggest deficits in a long, long time. While expenditure for states as a whole jumped 14% in April-November 2016, revenue growth was just 6.4%. As a result, the combined deficit of states is rising to levels that are distinctly discomforting; their net borrowings this year are tipped to climb to R3.2 lakh crore, a near 25% jump over last year and about 93% of the central government’s borrowings. Some number work by JP Morgan shows the combined deficits of state governments, after narrowing to 2% of GDP between 2010 and 2012, widened to 2.8% of GDP in 2015-16. They are now estimated to balloon to 3.4% of GDP in 2016-17. That’s not just way above the targetted 2.8% but the highest in 13 years, and even before UDAY bonds have been accounted for. Thanks to some extravagance on the part of a few states, the combined deficit between April and November has hit 60% of the target for FY17—in the corresponding period of the previous year, states had been a lot more circumspect and used up just 46% of their budget in the same period. Given these numbers relate to the period before demonetisation, there’s every chance deficits could slip seriously beyond targets.
The reason state governments are not losing any sleep even if they’re running up larger deficits is because there’s always more money to be got from the market—since State Development Loans (SDLs) can be used by banks to meet their statutory liquidity ratios, there is enough demand. And while it is true banks are paying a little more—coupons on SDLs are about 70-75 bps higher than those for GSecs compared with the historic 40-50bps—SDLs almost always find takers. More important, the implicit central government guarantee for SDLs means investors don’t really discriminate between profligate states and prudent ones—that is why Gujarat government bonds are not priced very differently from those issued by West Bengal or Bihar, even though the latter’s finances may be in far worse shape.
With little to discipline states, it will be difficult to bring down the consolidated debt-to-GDP ratio to 60% by 2023 as the FRBM review committee has suggested. But if, for instance, there was a hint—not a formal statement—that the central government backstop may not be unending, discerning buyers would get the message and start pricing bonds of states differently. This applies especially to FIIs who, over the next few years will be buying more state government paper since, with the central government firm on its FRBM targets, it will be issuing relatively smaller amounts of bonds. Once interest rates started rising for fiscally imprudent states, they will be chastened enough to start keeping a check on their expenditure.