Context: State governments are at the frontline of the battle against the coronavirus pandemic. A lack of funds for states can have profound human consequences. 

Current fiscal position of states

  • Comparison of spending by states 
    • The combined spending by states is now much more than spending by the central government. 
    • According to the IMF(The International Monetary Fund), the Indian ratio of sub-national government expenditure as a proportion of total government expenditure is almost twice the global average.
    • It is thus unfortunate that not enough attention is given to state finances. 
  • Higher borrowing costs for states
    • Financial markets were demanding very high-interest rates from state governments in the early weeks of the pandemic. Therefore the borrowing costs surged.
    • Government of Kerala had to pay a premium of more than 200 basis points on long-term bonds over what the Union government was being charged.
  • State development loans
    • The recent auction of state development loans have thus been a relief. Borrowing costs along with the premiums have crashed. 
    • Maharashtra could ultimately borrow three-year money at 4.76%, a modest premium of 26 basis points. 
      • The state also borrowed two-year money at 4.45%, only slightly above the cost at which the central government borrows for this tenure. 
  • Short term and long term scenario 
    • The narrowing of premiums is more evident for state government bonds with shorter tenures. 
    • However, even the interest rates on longer-term bonds have come down by around 100 basis points since March 2020 for many states.

Background of state finances

  • Interest rates fluctuations
    • The weighted average of the borrowing costs of states has generally been higher than the comparable cost of union government borrowing. 
    • A look at the data over the past 20 years is instructive. In these years only fiscal year 2001-02 is the odd year out, when the average borrowing costs of state governments were actually lower than those of the Union government by 22 basis points. 
      • This might be because of the special debt swap scheme announced by the government to bring down the interest burden in state government budgets.
  • No divergence in borrowing costs by different states
    • This is another puzzle as far as state government borrowing costs go. State governments have different fiscal numbers.
    • If we consider the 17 non-special-category states. In the past four years, for example, 
      • Maharashtra’s highest fiscal deficit as a percentage of its state gross domestic product (SGDP) has been 2.1%
      • The lowest for even a well-managed state like Andhra Pradesh has been 2.6% of SGDP. 
      • Gujarat has been another fiscally conservative state. Madhya Pradesh has run relatively high fiscal deficits.
    • However, the divergence in state finances is not reflected in borrowing costs.
      • This is because investors know that all state government borrowings are implicitly backed by the central government.

Need of reviewing fiscal responsibility laws (FRL) of states 

  • Contingent liabilities
    • State governments have generally tried to keep their fiscal deficits within the limits imposed by their fiscal responsibility laws (FRL), often by cutting essential expenditure. 
    • However, state debt burdens have been rising because of contingent liabilities. States have also been exposed to fiscal shocks.
  • Bringing them at par with Union government
    • It may be pertinent to review the FRL adopted by the states in the 2000s, much the same way the Union revised their [Fiscal Responsibility and Budget Management rules] in the 2018-19 Union Budget.
      • In the revised rules debt was explicitly added as a target variable along with fiscal deficit.
    • This seems particularly desirable considering the fact that while the fiscal deficit of states remains well within their FRL threshold of 3% for [gross fiscal deficit] to [gross domestic product] ratio, the debt is rising at a high pace, crossing corresponding implicit thresholds.

Source: Mint