State deficits are set to narrow, though marginally, in FY19. But the debt-bill cloud looms large while the drag from govt finances will have its bearing on growth.
In Greek mythology, the song of the sirens was so alluring that enchanted sailors let their ships run on to the rocks. Odysseus tied himself to them so he could listen to the song and still not imperil his ship.
To resist the powerful lure of over-spending, Indian policymakers have set their own fiscal rules for both the central and state governments. The Centre and each individual state are mandated to contain fiscal deficit within 3% of GDP.
And yet, more often than not, exemptions emerge to play spoil-sport. And herein lies the problem. What is perhaps more dangerous than not being tied tightly to the mast is being tied loosely. It gives a false sense of protection.
Studying the state’s budgets alongside the Union government’s budget is important for at least four reasons: First, state deficits have ballooned since FY12, undoing much of the consolidation done by the Centre. Second, almost 60% of overall government spending is done by the states. Third, the rapid rise in state government borrowings has spooked bond markets in recent times, and understanding all aspects of the government bond market has become critical for macro stability. And finally, the new Fiscal Responsibility and Budget Management (FRBM) Committee has recommended lowering India’s public debt to 60% of GDP by FY25 (from about 70% now); this can only be achieved if India’s states also keep their deficits in check.
The Centre’s transfers to the states have been rising since the Fourteenth Finance Commission (14FC) came into effect in FY16. The Centre, through a mix of favourable circumstances and hard work, has done well in collecting taxes over the past year, which it has shared with the states according to the fixed formula. The non-tax transfers to the states have also risen gently over the past year.
Despite the higher transfers, the analysis of 18 state budget documents suggests that states, on aggregate, clocked a fiscal deficit of 2.9% in FY18, higher than the budgeted 2.6% but in line with our expectation of 2.8% (A study of India’s state finances: Balloons and rockets, March 30, 2017, HSBC Global Research)—100 bps higher than the 1.9% deficit during the disciplined days of FY12. And while, on aggregate, the overall state fiscal deficit remained under 3% as mandated, several individual states breached the 3% target. Some were allowed more space under the 14FC norms while others were allowed leeway for other state-specific reasons. In short, the rules and discretion collided.
The main source of slippage was not revenue collections. Although the states slipped on their own tax revenues, that was more than offset by higher transfers from the Centre, leaving overall revenues higher by 0.15% of GDP than budget expectations. Instead, the slippages were on the expenditure side (which rose by 0.45% of GDP compared with the budgets), led by (a) higher-than-expected salaries/pensions bill, (b) farm loan waivers, and (c) rising interest burden after the steep increase in the issuance of state development loans (SDLs). All told, the states slipped on the back of higher expenditures. The Centre was not able to meet its consolidation target of 3.2% of GDP as well, due to lower-than-expected non-tax revenues and GST compensation to states. As a result, it ended the year with a fiscal deficit of 3.5% of GDP—the same as in the previous year. Consequently, the overall fiscal deficit for the Centre and states combined, rose for the first time in six years.
FY19 budget documents from 18 states show that the aggregate fiscal deficit budget estimate is trending at 2.6% of GDP, lower than the RE of 2.9% last year—implying a consolidation after seven years of rise in state deficits. But is this estimate credible? To answer this, all the additional pressures and consolations impacting state finances in FY19 were summed up.
The pressures are:
* Seventh Pay Commission (7PC) wage bill: The 7PC is likely to cost the Centre about 0.6% of GDP. With states’ PC wage bill roughly equalling the Centre’s, they could sign up for wage increases costing about 0.6%. Of this, in aggregate, the states increased their pay-out of salaries and pensions by 0.5% of GDP in FY18. This leaves a likely increase of just 0.1% of GDP to come in FY19.
* Farm loan waivers: Six states have announced such waivers. The overall burden comes to 0.2% of GDP, which when compared with FY18, should amount to an additional 0.1% in FY19.
* Higher MSPs: The Centre has announced higher farm support prices. NITI Aayog estimates this to cost about $7 bn in FY19. About 20% will likely be borne by the states. This should amount to an additional burden of 0.05%.
The consolations are:
* More transfers from the Centre: The Centre has increased its transfer to the states by 0.2% of GDP for FY19.
* Higher oil prices: States’ VAT on petro-products, at 1.1% of GDP, account for nearly 15% of their self-collected tax revenues. A 15% y-o-y rise in oil prices in FY19 is likely to raise state oil tax revenues by 0.13% of GDP.* Assured GST compensation: The Centre had assured the states 14% y-o-y growth in state tax revenues for five years on the base of FY16. If there is a shortfall in this number, the Centre will cover the balance. This assured rise in state revenues amounts to 0.1% of GDP.
* No UDAY burden: Much of the interest burden from UDAY bonds were incorporated in the FY17 budget. Given there were no additional issuances in FY18, the interest cost shouldn’t rise; rather, it should fall by 0.02% of GDP.
Thus, fiscal pressures in FY19 could be fully offset, resulting in a 0.2% of GDP consolidation. With this, the states’ fiscal deficits could clock in at 2.7% of GDP, lower than 2.9% in the previous year, but slightly higher than the budgeted 2.6%.
The Centre, too, has promised to bring down its deficit by 0.2% of GDP in FY19. However, this hinges on GST revenues rising rapidly. To be specific, the government’s GST revenue target, by our calculation, hinges on a high growth rate of 25% y-o-y. And this is where the story has turned on its head. Until FY18, the Centre compensated for the states’ excesses. From FY19, states may find it easier to consolidate deficits than the Centre.
For now, on the back of recent positive developments, the FY19 GST target will eventually be met. Consequently, the overall fiscal deficit for the Centre and states combined could fall by 0.4% of GDP as both the Centre and the states lower deficits by 0.2% of GDP each.
Overall government capex ticked higher in FY18, which partly explains the uptick in investment indicators such as the IIP capital goods over the year. However, the overall capex contribution is budgeted to be slightly lower in FY19. The fiscal deficit consolidation of 0.4% in FY19 is likely to have a negative impact on growth. Indeed, our fiscal impulse model suggests a 0.3% of GDP negative impulse on growth in FY19, compared with a positive impulse in FY18.
However, private sector GDP is on the rise and could offset the drag from government finances. GDP growth could rise from FY18’s 6.5% to 7% in FY19—lower than market consensus of 7.4%.
Although the fall in the Centre’s deficit and efforts to lighten the borrowing calendar will result in lower gross borrowings from GSecs, the picture for states is likely to be less good. Even though the states’ aggregate deficit is likely to drop in FY19, the repayments bill is set to rise by 0.2% of GDP, leading to the gross-borrowing-to-GDP ratio rising by 0.1%. In order to finance ballooning deficits, state borrowings have soared since FY15. As they reach maturity, they will create large debt repayment pressure. In fact, the repayment bill is set to remain high for the next several years.
Co-authored with Aayushi Chaudhary and Dhiraj Nim, associates, HSBC Securities and Capital Markets (India) Private Limited
Edited excerpts from HSBC Global Research’s When rules and discretion collide: A study of India’s state and
Centre finances (April 23, 2018)
(First of a two-part series)
(The writer is Chief Economist, India, HSBC Securities and Capital Markets (India) Pvt Ltd. Views are personal)