In 2017-18, the gross fiscal deficit of states was reported at 3.1 percent of the gross domestic product (GDP) compared to a target of 2.7 percent, according to Reserve Bank of India data.
Indian state government finances are under pressure, missing fiscal deficit targets for a third straight year in 2017-18. In an election year, with many states going to the polls and expectations of further farm loan waivers and pay commission awards, there is a danger of further fiscal slippage.
At a time of rising macroeconomic pressures such as rising inflation, widening current account deficit and a banking crisis, fiscal imprudence on part of the states will crowd out private investment, threaten macroeconomic stability and limit the room for an accommodative monetary policy.
In 2017-18, the gross fiscal deficit of states was reported at 3.1 percent of the gross domestic product (GDP) compared to a target of 2.7 percent, according to Reserve Bank of India’s report on state finances. The slippage was largely from farm loan waivers, pay revisions and a shortfall in revenues, with issues surrounding the goods and services tax still being sorted out.
These factors are likely to diminish the likelihood of the states meeting the target of 2.6 percent for the current fiscal. For instance, in 2018-19, states have allocated between 0.1 to 0.8 percent of gross state domestic products to loan waivers – that translates to between 2 percent and 29.8 percent of their individual fiscal deficits.
That does not bode well for the economy. With the central government also projecting a fiscal deficit of 3.3%, the general government deficit (including state and centre) will likely exceed 6% of GDP. That will crowd out private investment. Note that the states and the centre already mop up about 68 percent of gross household financial savings.
Private companies will then have to take recourse to external debt, which comes with its own set of risks at a time of US dollar appreciation and rising interest rates in developed countries. Some of this is already happening. In April and May, companies raised $5.3 billion from external commercial borrowings compared to $2.7 billion a year earlier.
Financing the states’ fiscal deficit is also not going to be easy. There are large redemption pressures courtesy the borrowing spree in the aftermath of the North Atlantic financial crisis a decade ago. About 16.7 percent of state development loans are set to mature over the next three years.
That, plus lower recourse to small savings schemes, means the share of market borrowings in financing the fiscal deficit is set to increase from 61.4 percent in 2015-16 to 90 percent in the current fiscal.
This jump comes at a time of limited appetite for government paper thanks to weak bank balance sheets and lower foreign investor interest. Consider these numbers: About Rs 8,000 crore of central government bonds (of a total of Rs 1.44 lakh crore) were unsold in the first quarter of 2018-19.
The states were able to raise only Rs 76,000 crore from the market compared to an indicative target of Rs 1.15 – 1.28 lakh crore. A recent central bank rule change that allowed banks to limit their mark-to-market losses on state bond holdings will lower their appetite further. State governments are already borrowing at elevated rates of close to 8.6 percent.
To be sure, economic growth is accelerating and the increased tax buoyancy from the tax reform could help mitigate some of these pressures. But states would do well not to stray off the path of fiscal prudence. Central bank incentives for state governments to get their bonds rated will also help in better pricing for this paper, which in turn will prompt states to cut fiscal deficit and debt.
