Context

• The RBI recently released a very important document about the economy of the States of India.
• Some of our Indian states have been managing their finances so bad that these states could be heading towards the same state as Sri Lanka’s economy!
• And we all know what’s happening in Sri Lanka right now!
• The worst part is that if this continues for a long time, the entire country of India will lose money and could face another economic crisis!

Questions raised:

• Why is this RBI document comparing Indian states to the economic crisis in Sri Lanka?
• How are these states doing the same mistakes as the Sri Lankan government?
• And most importantly as citizens of India what are pointers that you need to keep eye on before you cast your vote for the so-called leaders of India?

Crumbling state finances:

How can we arrive at this conclusion?

(1) Debt-GSDP Ratio

• Punjab, Rajasthan, Kerala, West Bengal, Bihar, Andhra Pradesh, Jharkhand, Madhya Pradesh, Uttar Pradesh and Haryana turn out to be the states with the highest debt burden.
• Highest debt-GSDP ratio in FY22 are Punjab (53.3%), Rajasthan (39.8%), West Bengal (38.8%), Kerala (38.3%) and Andhra Pradesh (37.6%).
• All these states receive revenue deficit grants from the Centre.
• What exacerbated the debt-GSDP ratio was that while numerator (liabilities) rose sharply, the denominator (nominal GDP) fell sharply.

(2) Fiscal Deficit

• The Fiscal Responsibility and Budget Management (FRBM) Act, 2005 prescribes the ceiling for debt to GSDP ratio at 25 per cent.
• Eight out of the 15 states studied here, exceed the prescribed limit in FY22.
• Odisha was a clear outlier with a 15.79 per cent Debt-GSDP ratio.
• States like Tamil Nadu and Karnataka were marginally higher than the mandated limit. 

(3) Fiscal deficit to GSDP

• Large borrowing by some States is due to the sharp expansion in their fiscal deficits, much beyond the mandated level.
• Bihar recorded highest fiscal deficit to GSDP ratio at 11.30 per cent as per FY22 revised estimates followed by Rajasthan (5.2 per cent), Punjab (4.60 per cent) and Uttar Pradesh (4.27 per cent).

(4) Interest cover

• High borrowings or fiscal deficit-GDP ratio is not something to be worried about as long as the States have adequate revenue surplus to fund them.
• This can be gauged by looking at the interest cover as measured by the revenue receipts of the State divided by its interest payment.
• For instance, Bihar had the highest fiscal deficit as a percentage of GSDP, however, the state has adequate revenue receipts to cover its interest burden, with interest cover of 11.3.
• Odisha topped the list with highest interest coverage ratio since it has been diligently lowering its borrowing as well as the resultant interest burden.
• Punjab, Haryana, West Bengal, Tamil Nadu and Kerala appear weak going by this metric with interest cover under 6 times. 

(5) Increase in Market Borrowings

• Most States increased their market borrowing during the pandemic as their fiscal deficits expanded.
• Tamil Nadu topped the list of states with highest gross market borrowings in both FY21 and FY22.
• But not all states were on a borrowing spree.
• Odisha stayed away from market borrowing through state development loans (SDLs) in FY22.

(6) Revenue buoyancy

• Revenue buoyancy of States has already been affected since the Goods and Services Tax (GST) came in and states’ ability to raise taxes has come down.
• Interest payments, salaries and pensions fall under the committed expenditure of State governments.
• This committed expenditure of Kerala and Tamil Nadu accounts for 71 per cent and 67 per cent of their budgeted revenue receipts respectively in FY23. 
• A larger proportion of the budget allocated for committed expenditure items limits the state’s flexibility to decide on other expenditure priorities such as developmental schemes and capital outlay.

(7) Dependency on Centre

• Own tax revenue of Haryana, Kerala and Andhra Pradesh constitutes about half of their total revenue collections.
• The major source of revenue of other States is Central transfers.
• Within own tax revenue, States’ goods and services tax (SGST), States’ excise duties and sales tax are the major sources of revenue

(8) Poor capital outlay

• High revenue expenditure results in poor spending quality, as reflected in their high revenue spending to capital outlay ratios.
• Capital outlay is the money spent on acquiring assets while revenue expenditure indicates daily operations expenses like salaries and pensions.

What factors led to the financial vulnerabilities of Indian states?

(1) Pandemic

• The prolonged COVID crisis has worsened fiscal positions of governments around the world as reflected in mounting debt levels.
• The sustainability of public debt at national and sub-national levels has again assumed centre-stage as the dominant fiscal risk.
• In particular, the pandemic has taken a heavy toll on finances of states in India.

(2) Freebie Politics

(3) DISCOM sector distress and payment crisis

• The power sector accounts for much of the financial burden of state governments in India, both in terms of subsidies and contingent liabilities.
• Illustratively, many state governments provide subsidies, artificially depressing the cost of electricity for the farm sector and a section of the household sector.
• Despite various financial restructuring measures17, the performance of the DISCOMs has remained weak, with their losses surpassing the pre-UDAY level of 0.4 per cent of GDP.

(4) Pension expenditure

• The government’s fiscal burden in providing a safety net to the elderly could rise to as much as 4.1% of the GDP by 2030 from 2.2% at present, a report by global analytical company Crisil has said.
• Currently, the central government spends 3-3.4% of GDP on education and just over 1% of GDP on medical and public health, water supply and sanitation.
• This is an ever-increasing challenge, as the old live longer, and demographic transitions reduce the number of young to pay for the old.
• Many states are opting out of New Pension Scheme (NPS) to the old pension scheme which is a huge burden on the exchequer.

A rational analysis

(1) Certain necessary expenditures cannot be avoided

• States often try and provide some kind of relief to voters.
• We can certainly be in favour of expanding, for example, the MGNREGA type of spending and subsidy in the form of food ration schemes.
• These go a long way in increasing the productive capacity of the population. So, they’re not just freebies.
• They build a healthier and a stronger workforce, which is a necessary part of any growth strategy.
• That is similar to a State spending on education or health.

(2) Certain election promises create dysfunctions

• There are obviously cases where State governments have gone astray and have gone into providing all sorts of freebies or gifts.
• But when it comes to simply giving away loan waivers, we cannot go in favour of these because they have undesired consequences such as destroying the whole credit culture.
• It blurs the very basic question as to why is it that a large majority of the farming community is getting into a debt trap repeatedly.

(3) Non-essentiality of welfare expenditure

• We know about free electricity that is being given in various States to rural communities.
• This has sometimes led to disastrous consequences in terms of the declining water table, wastage of electricity and various other things.
• There are nuances to the issue, and one will have to get into those nuances to take a final call on whether a certain welfare spending is necessary or not.

(4) Necessary expenditures/ merit freebies

• Some people have been questioning subsidies going into education, such as for laptops and other things.
• Some of them have now become necessities for increasing productivity, knowledge, skills, and various other things.
• So, we need a more nuanced understanding of the issue.

Way forward

• Fiscal discipline: The state governments must restrict their revenue expenses by cutting down expenditure on non-merit goods in the near term.
• Stabilize debt levels: In the medium term, these states need to put efforts toward stabilising debt levels.
• Power sector reforms: Further, large-scale reforms in the power distribution sector would enable the DISCOMs to reduce losses and make them financially sustainable and operationally efficient.
• Focus on capital creation: In the long term, increasing the share of capital outlays in the total expenditure will help create long-term assets, generate revenue and boost operational efficiency.
• Risk testing: State governments need to conduct fiscal risk analyses and stress test their debt profiles regularly to be able to put in place provisioning to manage fiscal risks efficiently.