The Telegraph
Since 1st March, 1999
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- Rethinking state government debts

The deficit chatter is heating up. As the finance minister, P. Chidambaram, prepares for the first budget of his second innings, conversation has begun in dead earnest on the size of the fiscal deficit. Was his predecessor doing some window-dressing to keep it under 5 per cent for 2003-04' Given some of the lofty goals of the common minimum programme, the wish list of the worthies who support the government from outside, and the demands of Laloo and his pals, can the Harvard-educated advocate keep the deficit in check for 2004-05' Is a deficit of 5 per cent sustainable' How does this government propose to eliminate the revenue deficit by 2009, as promised by the CMP' These are just a few examples of the discussions that have begun in the drawing rooms and board rooms of the denizens of corporate India.

Interestingly, almost all these discussions centre around the Union government’s deficit. The fiscal problem of the state governments is invariably forgotten. That’s a shame — because the real crisis lies with state government deficits and debt, and the truly great fiscal challenge is to fix these in the next five years.

Every major state government has been running sizeable budget deficits over the last decade, if not longer. West Bengal, Andhra Pradesh, Karnataka, Bihar, Uttar Pradesh, Punjab, Maharashtra…each of them have systematically spent much more money than what they earned. Indeed, the Nineties and the new millennium have seen more fiscal profligacy by the state governments than ever before. For example, until a decade ago, Maharashtra was a well-managed state that earned a modest budget surplus. In the last seven years, the Shiv Sena and the Congress governments have spent way more than what they earned and methodically bankrupted the coffer.

The combined deficit of the state governments for 2003-04 is around 5 per cent of India’s gross domestic product. This is more than the 4.8 per cent fiscal deficit racked up by the Central government’s fiscal deficit in the same year. If you add to this another one per cent on account of losses of public sector enterprises and the oil pool — numbers that don’t show up in budgets — then the total deficit of India exceeds 10 per cent of GDP. As any self-respecting economist will tell you, this not only ranks amongst the highest deficits in the world, but is also unsustainable. In simple terms, we are rapidly being sucked into a debt trap; and we cannot expect to run up such monumental deficits and then hope that economic growth will bail us out of the trap.

The consequence of such profligacy is that the Centre and states have accumulated huge public debt — way more than what they can ever service through their revenues. Beyond a point, all public debt is bad. However, those of the states are even worse. Let me explain why.

Unlike the government of India, states can’t print notes or issue sovereign treasury bills. Up to the mid-Nineties, the states had less of a problem. For one, the deficits and public debt were lower. For another, the Reserve Bank had the green signal from the Centre to continuously roll over state government debt and, thus, effectively offer an open-ended overdraft facility. That stopped when C. Rangarajan at the RBI and Manmohan Singh at the North Block got rid of these “ways-and-means” advances. The hard budget constraint was supposed to kick in.

But it didn’t, for a couple of reasons. First, coalition politics with razor-thin margins meant that critical partner states could circumvent budget constraints. There used to be a joke that every Delhi visit of N. Chandrababu Naidu raised the combined deficit of the nation. Second, investment bankers with their Hermès ties and their Jermyn Street, £300-per-pair, hand-tooled, calf-leather laced shoes taught state finance ministers all about Special Purpose Vehicles and “off-balance sheet” debt. Essentially, states were told that funds could be raised by issuing attractive (read “high cost”) bonds of public sector enterprises and corporatized projects. Since these offered high interest rates and were backed by state government guarantees, nobody quite cared about the quality of the enterprises that were issuing such bonds. According to conservative estimates, such off-balance sheet debt was as high as Rs 210,000 crore by 2002-03. Since money is fungible, it is not surprising that most of it went to financing state deficits.

Even if we were to ignore the off-balance sheet debt — though it will sooner haunt the bankrupt states — the stock of official public debt of the states is very high. Other than putting the states in serious financial risk, the high debt burden has given many chief ministers the excuse to overlook key development issues. The argument goes as follows: “After the seventh pay commission, wage and salary bills have gone up. After paying the Centre interest on exorbitantly high cost debt, why do you expect us to have anything substantial left for development expenditure'”

It’s a good excuse, and the time has come for the Central government to deal with it. Here’s what I have to suggest. Let the states and the Centre design and freeze a set of clear reform priorities. For instance, the list could include implementation of value-added tax by a given date; a number of e-governance targets; goals relating to minor and medium irrigation; rationalizing of state taxes and cesses; eliminating procedures that hinder industry; objectives for primary and secondary education; rural road targets; electricity reforms; and so on. Three things have to be kept in mind. First, the targets must be clearly measurable — because without measuring one cannot monitor. Second, while there may be some state-specific variations, the list must largely consist of elements that are common across all states. And third, the targets must have some degree of “stretch” in them.

Then the Centre can offer the following deal. If a state achieves a given set of targets in the first year, the Centre will (i) swap a well-specified share of the state’s high interest rate debt to the Centre for lower cost debt, and (ii) retire a certain percentage of debt as well. The first will reduce the interest outgo from the states to the Centre and, hence, leave more funds on the plate to finance development programmes. The second will partially reduce the liability of the states, and hence, future interest burden.

No doubt, this programme of debt swap and forgiveness for state-level reforms has to be carefully designed and calibrated. It also requires the discipline of saying “No” if a state hasn’t met the committed target — which is not a politically easy task for any coalition government. However, it is perhaps the only way that I can think of saving the states from utter bankruptcy. And it will get rid of the excuse of state finance ministers that they just don’t have the funds for development.

So, let the Centre take an interest and a debt haircut over the next five years on account of states that are pursuing an agreed programme of reforms. Reduce the interest burden of the states. And then let’s see what development they actually do. That’s fiscal federalism in my book.

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