States have benefited from the RBI's sage words and the introduction of rule-based fiscal consolidation. In contrast, there has been a deterioration in Central finances since 2008-09.
At a time when Standard & Poor's revised the outlook on the long-term ratings on India to negative from stable — mentioning that high fiscal deficits and a heavy debt burden remain the most significant constraints on the sovereign ratings on India — a silver lining in the field of public finances has been the gradual and consistent improvement of financial position of the sub-national State governments in recent years. This should not go unnoticed.
The Reserve Bank of India has been bringing out a study of State finances ever since 1950-51, a unique contribution from any central bank. The quality of the publication in terms of its analytical contents has been constantly improving. In its latest publication released at the end of March 2012, it has also incorporated a theme chapter on the ‘‘Role of the Reserve Bank in State Finances'', which traces the growing responsibilities that the RBI took upon itself, beyond its mandated roles of serving as a banker and debt manager of the State governments.
This thematic chapter is a must-read for anyone focusing on research in State finances. It traces the evolution of State finances historically and how at every stage, the RBI's policy and operational interventions helped State governments to move from strength to strength, in areas, among others, of greater market access for resources, innovative practices aimed at wider base of investors and reduction in cost of borrowings, measures for better planning and transparency in issuance of state loans, and facilitating introduction of Fiscal Responsibility and Budget Management Acts by the States.
The RBI has been effectively balancing the short-term financing requirements of States and created the enabling conditions for States to switch over to a full-fledged auction system for market borrowings. The RBI also played a pivotal role in facilitating rule-based medium-term fiscal consolidation of the States and advising them on policy issues emerging from time to time to ensure fiscal sustainability.
Evolution of RBI's Role
The study traces the evolution of State government finances since the 1990s into four phases, namely, (i) 1990-91 to 1997-98, (ii) 1998-99 to 2003-04, (iii) 2004-05 to 2006-07 and (iv) 2007-08 to 2011-12 (BE).
During the first phase, fiscal imbalances persisted, although the consolidated fiscal deficit-GDP ratio remained contained marginally below 3 per cent. The fiscal deficits of States were essentially financed through loans from the Centre, and small-savings collections earmarked for the States were also intermediated through these loans. Market borrowings played a subordinate role and their share in the fiscal deficit of the States remained quite low.
During the second phase (1998-99 to 2003- 04), the fiscal deficit-GDP ratio of the States reached a historical peak, crossing 4 per cent, on account of higher expenditures related to the implementation of the Fifth Pay Commission award and deceleration in State government revenues due to economic slowdown. The States were allowed to use the auction mode, albeit to a limited extent, for accessing market borrowings. Market borrowings, as a source of financing fiscal deficit for the States, increased in importance by 2003-04.
The third phase (2004-05 to 2006-07) saw operationalisation of fiscal rules by most of the States which led to a decline in their fiscal deficit-GSDP ratios. By 2006-07, the States were allowed to raise market borrowings completely through the auction route so as to allow market determination of yields on their loans. With market access for States switching completely to the auction mode, market borrowings steadily grew in importance for financing fiscal deficits during the fourth phase [2008-09 to 2011-12(BE)].
Consequently, the States were able to meet the enhanced requirements during 2008-09 to 2009-10 for implementing the Sixth Pay Commission award and fiscal stimulus measures, particularly in the wake of shortfall in small-savings collections.
Even after the States reverted to fiscal correction from 2010-11, the importance of market borrowings continued, as small-savings collections remained low. During this phase, market borrowings have emerged as a dominant source of financing and, on an average, accounted for around 65 per cent of GFD.
The overall budgetary position of States shows that except during the period 1998- 2004, when the gross fiscal deficit was higher than 4 per cent, it consistently remained below 3 per cent, during the rest of the period. In the recent past, it came down from 2.9 per cent in 2009-10 to a budgeted level of 2.2 per cent in 2011-12. Indications are that the actual for 2011-12 could be an improvement over the budgeted levels. More striking is the fact that the revenue deficit turned into a surplus in 2011-12 after remaining in the red for three years post crisis (Table).
Systematic reforms in the conduct of financial arrangements of States initiated by the RBI, based on the recommendations of advisory committees as also the introduction of the rule-based fiscal consolidation, have led to a structural improvement in the short-term fiscal management of the States. At the aggregate level, it can be captured in simple terms by two developments.
First, the occasions of temporary liquidity mismatches have progressively reduced particularly, from 2005-06 onwards. On the contrary, an improvement in the fiscal position of States as reflected in their overall surplus cash balances, in a positive way posed a challenge for managing these cash balances which were invested in 14-day intermediate treasury bills and auction treasury bills. In a way, this strengthened the Centre's financials which would have been much worse than what it is (Chart).
States versus the Centre
As a matter of fact, the RBI enabled the Centre to switch over to market-based borrowings much earlier than the States and promoted a healthy development of secondary market for Central Government securities since early 1990s. But, the deterioration in Central finances started from 2008-09 in the post-crisis period from which there seems to be no immediate sign of improvement. The advisory role of the RBI, which helped the State governments to strengthen their financials, could not succeed with the Centre in the recent past.
(The author is Director, EPW Research Foundation. The views are personal.)