The Big Story. Why State deficits matter

Most discussions on the macro economy revolve around the Centre’s finances, its fiscal position, growth, etc. But how does the picture look when the aggregate figures — after combining the numbers of the Centre and all the States — are considered? Well, it is not very rosy.

A few weeks back, when the RBI released its report on state government finances, the grim state of State finances was brought to light. The combined deficit of the Central and State governments crossed 7 per cent in 2015-16. In 2009 and 2010, when the number hit the 8 per cent level, inflation had hit double digits.

This time around, inflation is not expected to be affected too much as the fiscal deficit is being reined at the Centre, thus keeping the aggregate number under check. But the additional issuances of State government bonds can affect interest rates.

Slipping finances In the mid-2000s, when the Indian economy was growing at a rapid clip of 8 per cent plus, State government finances were well ahead of the Centre in terms of fiscal prudence. Many States even reported a revenue surplus. The combined fiscal deficit of the Centre as well as State (henceforth to be called general) governments was at comfortable 6 per cent levels. Then, the global economic crisis hit the world, and things changed.

In 2008-09 and 2009-10, the general government fiscal deficit slipped to 8 per cent levels — thanks to stimulus measures adopted by the Centre. During this period, the finances of the Centre as well as that of States — at individual levels — slipped from the pre-crisis levels (see table). However, with reversal of stimulus measures, the trends started to reverse — especially post 2011-12. Since then, while the Centre has managed to report lower deficit percentage figures year after year, those of States have started to worsen.

Fiscal deficit for the State governments rose from 2.2 per cent of GDP in 2013-14 to 2.9 per cent in 2014-15. In 2015-16, it missed the budgeted figure for fiscal deficit (of 2.4 per cent of GDP) to report a higher fiscal deficit of 3.2 per cent (revised estimates and ex-UDAY), according to a research report published by Nomura India. If UDAY bonds are taken into the books of the States, the fiscal deficit of the state government is even higher at 3.8 per cent of GDP. This is much higher than the recommended norm of 3 per cent.

While the RBI publishes the budgeted figures of State finances, it hasn’t incorporated the revised estimates of FY 16 for many States. The revised estimates have been taken into consideration by Nomura.

At the combined level, the general government deficit for FY16 was 7.1 per cent, higher than the tolerance level of 6 per cent. In the past, whenever the combined deficit figures touched 8 per cent or more, it had proved inflationary. Especially in the crisis hit years of 2008-09 and 2009-10, when the combined deficit figures of the government were 8.4 per cent and 9.4 per cent respectively, inflation — as measured by WPI — had shot up to double-digit figures.

“At the moment, the combined deficit figures aren’t alarming, only mildly inflationary,” says Sonal Varma, chief economist at Nomura India. At the moment, the Central government is keeping its promises, reducing fiscal deficit over the past few years, which is comforting. The worry would be when its numbers also start to slip (like that of States), says Indranil Pan, chief economist at IDFC.

What went wrong? A fall in States’ own tax revenues and lower net transfers from the government did the damage for the States in 2015-16. For instance, lower oil prices reduced the ad valorem taxes on petrol and diesel, a huge income item for States, affecting revenue collections. On the other hand, while higher devolution of divisible pool (hiked from 32 per cent to 42 per cent) led to higher revenue transfers from the Centre, grants were also cut through reduced outlay for eight Centrally-sponsored schemes, such as National e-Governance Plan, Backward Regions Grant Fund and Rajiv Gandhi Panchayat Sashaktikaran Abhiyan (RGPSA). Interestingly, on a net basis, as per the RBI report, State governments received less net transfers to the extent of 0.3 per cent of their GDP in FY16.

Going forward, state finances are expected to deteriorate further. According to Nomura estimates, against States’ budgeted fiscal deficit of 2.8 per cent of GDP, they are expected to slip the target by 50 bps to 3.3 per cent in 2016-17; worse than the actual figures a year before.

There are two main reasons for the possible worsening of the fiscal deficit, going forward. One is the implementation of the Seventh Pay Commission recommendations and second is the ‘UDAY’ effect. With a larger workforce of 12 million, as against 8 million of the Central government, the Pay Commission recommendations are expected to have a major effect on state finances. According to the RBI, the Seventh Pay Commission would have an impact of 0.9 per cent of GDP on the revenue and fiscal deficit of general government (over a period of 3-4 years).

Secondly, the power revival package — popularly known as UDAY (Ujwal DISCOM Assurance Yojana) — whereby States will take over 75 per cent of outstanding debt of their power distribution companies — in a staggered manner — is set to increase interest payments, worsening the revenue deficit figures for States. As per the scheme, 50 per cent of the debt would have to be taken in FY16 and another 25 per cent in FY17. Therefore, the bulk of interest burden is expected to reflect in state finances from FY17 onwards. So far, 10 States have signed the memorandum of understanding (MoU) on UDAY, out of which eight have already taken the DISCOM debt in their books in FY ‘16.

The impact Global rating agencies, be it Moody’s or Standard & Poor’s, usually look at the general government deficit, while giving sovereign ratings. This is not without a reason since a poor general government finance could have its implications on inflation and the growth potential of the economy.

Take, for instance, the way a State arranges its finances. Almost 65-70 per cent of its deficit is met by way of market borrowings — through issuance of State bonds. Increase in state deficit could mean the overall borrowings could rise even more.

Interestingly, state bonds are amassing larger share of issuances over the years. From a market share of just 12 per cent in combined borrowings in FY07, the share has increased to 33 per cent in FY16. “States which earlier had recourse to the excess cash in their kitty are now resorting to more borrowings with fall in cash levels,” says Sujoy Das, Head – Fixed Income, Invesco Mutual Fund .

Interest rate risk “If both the Centre and States start borrowing excessively, there is going to be the risk of interest rate shooting up,” says Indranil at IDFC. He highlights that there is a limited pool of resources for borrowing. Along with these bond issuances for deficit financing, resources are also likely to be mobilised for funding government projects through IEBR (Internal and extra-budgetary resources). IEBR are essentially funds raised by Central public sector enterprises by way of profits, loans and equity. Budget 2016-17 has factored for a higher IEBR target of more than ₹65,000 crore. There could be pressure on interest rate (at the longer end) with supply outdoing demand. However, he mentions that with the ‘cleaning up’ happening at the Central level, things haven’t hit a crisis yet.

Also, the RBI assurance on liquidity ‘neutrality’ is not a panacea. “The RBI is essentially addressing short-term liquidity concerns — where banks have had an issue in the past,” says Sonal. In the past, banks attributed short-term liquidity shortage for the poor ‘transmission’. They were meeting this shortage by borrowing at a slight premium to the repo rate. With the RBI assurance on liquidity, the liquidity situation is likely to loosen up — enabling banks to reduce interest rates.

However, issuances of state government bonds will increase supply at the long end of the yield curve. This is because typically the state bonds compete with ultra-long term G-Secs (20-30 years). “We are already factoring in a steepening of a yield curve with higher spreads of 50-70 bps for state bonds over that of 10-year G-Secs over the next one year,” says Sonal.

In the last one year, spread of yields of SDL (State Development loans) auctions over 10 -year G-Secs have already risen from 28 bps to 60 bps on concerns over the States’ fiscal situation and the expected increase in borrowings.

Inflation and growth concerns It is likely that those belonging to the Keynesian school might be bullish over the fact that fiscal deficits are rising; as it indicates the government is pump-priming the economy. However, even Keynes, who favoured running larger fiscal deficits to pull economy out of recession, spoke only of building roads from the deficit money and not hiking salaries.

The quality of spending of the States, is, therefore an important factor to watch.

“If deficit increases, and the (state) governments cut back on capital expenditure and investments on productive assets (instead of revenue expenditure), then it can have impact on growth,” says Abhishek Bisen, fund manager at Kotak Mutual Fund. This is because it could reduce capital formation — which, over the long term, could lower the growth potential of the economy, he says.

No crisis yet However, the situation is not as grim as it was during the crisis years. While the States went from a revenue surplus to a revenue deficit situation, revenue deficit of the general government fell to 2.8 per cent of GDP in 2015-16, thanks to better performance of the Central government on the revenue front.

Even the UDAY scheme might not be a negative. “This was an off-balance sheet item earlier, which is now in the books of the State government. If the power sector picks up, it could be good for the state finances — over the long term,” says an economist from a bank, who didn’t want to be quoted.

In fact, many mutual funds, including Kotak, are actively looking at investing in UDAY bonds. “There is now clarity as to its repayment capability, which gives us a lot of comfort in owning such bonds,” says Abhishek. Earlier, the bonds were issued by State Electricity Boards (SEBs) which, in turn, were guaranteed by the State government. Now, it would essentially be a state government issuance.

Fall in household savings However, what is discomforting is the fact that the deficit levels for the general government have risen, during times when the household savings into financial assets have been falling. Historically, the savings of the households have sponsored the borrowings of the government. However, household savings have now fallen to 7.5 per cent of GDP (from earlier level of 11 per cent), thanks to higher inflation – which in turn led to negative real interest rates (till recently). To prevent wealth erosion, investors invested in real assets in this period. However, now that inflation levels are much lower, leading to positive real interest rates, if households don’t begin re-investing into financial assets like earlier, a glum fiscal situation is likely.

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