Crisis of State Government Debt
25th 2005, C.P. Chandrasekhar and Jayati Ghosh
Commission reports are typically all about the devolution
of resources. The statutory job of the Finance Commissions
is usually twofold: to determine the principles for
the distribution of the net proceeds of shared tax revenues
between the Centre and the States; and to provide for
revenue deficit grants from the Centre to those States
whose normative expenditures are likely to exceed normative
revenue. However, more recently, the Central Government
has taken it upon itself to extend the terms of reference
of Finance Commissions to cover issues of fiscal sustainability.
the terms of reference of the TFC include the following:
''The Commission shall review the state of finances of
the Union and the States and suggest a plan by which
the Governments, collectively and severally, may bring
about a restructuring of the public finances restoring
budgetary balance, achieving macro-economic stability
and debt reduction along with equitable growth.''
The issue of public debt has become a crucial one primarily
for the States in India. It is widely recognized that
the large overhang of debt of almost all state governments
has implied such large interest payments that the States
are effectively crippled with respect to the ability
to undertake important socially necessary expenditure.
Since the States are dominantly responsible for most
of the types of public expenditure which affect the
day-to-day life of the people, ranging from law and
order and basic infrastructure to health, sanitation
and education, the fiscal crisis of the States has meant
that these expenditures have been very adversely affected
in most parts of India.
The need to restructure the debt of the States has been
widely accepted, for several reasons. The first is the
adverse impact on expenditure noted above. The second
is the fact that for some years now, the States have
been paying higher interest rates for a variety of reasons
discussed below. The rules imposed by the Reserve Bank
of India, which require case by case permission to States
for accessing commercial debt in they are running revenue
deficits, have also operated to make borrowing difficult
and have driven several States to high-conditionality
debt from multilateral agencies such as the World Bank
and the Asian Development Bank.
The actual patterns of fiscal imbalances across Centre
and States are worth noting as background. Chart 1 describes
the fiscal indicators of the States since the late 1980s.
It is evident that in the aggregate, the fiscal deficit
of the States as share of GDP was well within sustainable
limits, at around 3 per cent of GDP, until 1997-98.
Thereafter there was a sharp rise, led almost entirely
by the rise in revenue deficit, and this can be traced
to Central government measures such as the Pay Commission
However, since the turn of the decade, the States' revenue
deficit as a share of GDP has been rising even though
they have cut spending and improved revenue effort.
The primary revenue balance has been in surplus, sometimes
quite sharply so, even as the revenue and fiscal deficits
have been increasing, largely because of the effect
of the debt overhang and the unduly high interest rates
the States have had to pay.
This has been further compounded by the decline in central
transfers to States over the years. Such transfers have
declined from 40 per cent of the central tax receipts
in the first half of the 1990s to an average of 36 per
cent after 1996. Since the Centre's tax revenues have
declined as a share of GDP over this period, this has
meant an even sharper decline as a per cent of GDP.
In fact, the States' tax effort has been significantly
better than that of the Centre. So the apparent ''lack
of fiscal correction'' by the States in recent years
relates entirely to the debt structure and its implications.
Contrast this with the performance of the Centre, as
indicated in Chart 2. While the fiscal deficit declined
in the early 1990s, it rose again quite sharply in 1994-95,
after financial liberalisation measures raised the cost
of borrowing by the government and led to increased
interest payments. The subsequent rise in fiscal deficit
ratios, post-1997, has not been only because of interest
payments, however, but because of other expenditures
essentially on the revenue account and declining tax
ratios, as revenue deficits and the primary deficits
have increased as share of GDP.
As Chart 3 shows, the total debt of the States was more
or less constant as a share of GDP for around a decade
until 1997-98, and so was the ratio of debt to total
revenue receipts. Thereafter, however, states' debt
as a proportion of GDP has ballooned and the ratio of
debt to revenue receipts of states has nearly doubled.
This is clearly an unsustainable situation, but, as
noted earlier, it has not been brought about either
by worsening tax generation (which has been broadly
stable) or excessive total expenditure, since the primary
balance (net of interest payments) generally been in
surplus except for only a few years. Rather, this is
due to the combination of falling central transfers
and related inability to repay the high interest on
previously contracted debt.
There are various indicators of debt sustainability
which are typically estimated, but it is generally accepted
that at the very minimum, the growth of nominal GDP
must be greater than or at least equal to the rate of
growth of interest that has to be paid. It is evident
from Chart 4 that until 1997-98, such a condition was
more than adequately met. However, since then, not only
has the rate of growth of nominal GDP fallen, but interest
rates have remained consistently high. As a result,
for three critical years since 2000, this condition
has not been met, which obviously makes servicing the
debt difficult if not impossible. It is this which has
then led to further debt accumulation, which obviously
makes the trajectory an unsustainable one.
But why have interest rates remained so high if the
general perception of declining interest rates is valid?
This is where the discriminatory attitude of the Centre
towards States in general has had such a negative impact.
Under the Constitution, the Centre has the power to
determine both the extent and the terms of borrowing
by the States from all sources, not only from itself.
This power has been used increasingly by the Centre
to restrict States from accessing different types of
loans and in effect dramatically increasing the cost
of borrowing for States.
There are several ways in which this has been done.
The central government has been charging the state governments
higher rates of interest on debt which it issues to
them, in fact substantially higher than the Centre has
been paying itself. The Centre has also used aggressively
its Constitutional powers to limit the ability of the
States to borrow from the market and from commercial
banks. Any state government which has a revenue deficit
therefore has to seek special permission from the Reserve
Bank of India to borrow from commercial banks, permission
which is not necessarily granted. Finally, state governments
taking on debt provided by multilateral institutions
or even loans from bilateral donors have not paid the
rate of interest charged by them, but a much higher
rate imposed by the Centre, which is the intermediary
for such transactions.
The consequence of all this is evident in Chart 5, which
gives some indication of the average rates of interest
paid on debt contracted by the Centre and the States.
This gives the average, not marginal, rates, but the
shapes of the curves provide an indication of the marginal
changes. From around 1997 onwards, the average rate
of interest paid by the Centre on its own debt has fallen
significantly, from 9 per cent to around 6.5 per cent,
which suggests a much sharper decline at the margin.
By contrast, the average interest rate paid by the States
has remained broadly stable over this entire period,
so marginal rates have not really come down for them.
So the Centre has effectively been reaping usurious
benefits from its lending to state governments, and
these have amounted in recent periods to around 1 per
cent of GDP, or around 20 per cent of the central fiscal
This is the context in which the TFC's discussion of
states' debt restructuring has to be analysed. The TFC
has indeed suggested a formula for reducing the burden
of debt of the states, and also for reducing the interest
rates payable by them. However, the positive effects
of such a proposal have been drastically undermined
by the proposed condition sought to be imposed by the
TFC, of forcing states to enact fiscal responsibility
legislation and holding to arbitrary targets for fiscal
indicators, in order to get the benefits of dent reduction.
We will provide a discussion of the debt restructuring
package and critically assess the possible effects of
such conditions upon state finances in the next issue