State finances are in a shaky state

There’s been extensive analysis on the damage wrought by Covid on Central government finances, but its fallout on the finances of States has gone largely under the radar. It is in this context that Reserve Bank of India’s annual publication ‘State Finances: A study of budgets of 2020-21’, which takes stock of the sustainability of State finances, provides instructive insights this year. The study flags three emerging vulnerabilities in State finances that policymakers need to take note of. One, it predicts that the hard-won process of fiscal consolidation that had States projecting a combined Gross Fiscal Deficit (GFD) of 2.8 per cent of GDP is likely to suffer a setback this year, with the GFD quite likely to top 4 per cent. This is the outcome of the ‘scissor effect’ that has seen State tax collections take severe hits from the lockdown even as their fire-fighting responses have escalated unplanned expenses. To juggle their cash flows, States have used stopgap fixes such as fuel duty hikes and deferred salaries, which are unsustainable.

When boxed into a tight corner, States inevitably axe productive capital expenditure. This could then pose a serious risk to the incipient economic recovery, as States would then be working at cross-purposes to the Centre’s stimulus efforts. Two, State governments are banking on funding 90 per cent of their budget gaps in FY 21 through market borrowings compared to less than 50 per cent in FY17. This, the study believes, can escalate both their borrowing costs and deficits in future. With the ₹7 lakh crore market borrowings of States almost matching the Centre’s, policymakers additionally need to worry about State borrowings crowding out the private sector, hampering revival. A related risk lies in the high State debt-to-GDP ratio (estimated 75 per cent in FY21) which could be further aggravated by invocation of State government guarantees on measures such as the ₹90,000 crore discom rescue.

This argues for structural solutions to the problem of loss-making discoms, rather than band-aid ones like the recent liquidity infusion. Putting numbers to the migrant exodus caused by Covid, the report says that MSME-dependent States such as Tamil Nadu, Maharashtra and Gujarat are particularly vulnerable to the loss of productivity and output. While the study is quite exhaustive in its diagnosis of challenges facing State finances, the solutions it provides are somewhat sketchy. It recommends that States re-prioritise their expenditure both in favour of capex and public health infrastructure, without explaining how States will find the funds for both. It suggests digitalisation and direct benefit transfers as the panacea for reducing revenue leakages and enhancing State efficiency without going into the contentious issue of exclusion errors. The report however ends with the useful suggestion that States, like the Centre, should consider adopting debt-to-GDP as the medium-term anchor for their fiscal policies rather than obsessing over rigid fiscal deficit targets that tie their hands in a crisis.

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