GST compensation row: FM's 'act of God' can be a nightmare for RBI

The Centre’s move to find an alternative arrangement for paying states their due on Goods and Services Tax (GST) will complicate matters for the bond market and the Reserve Bank of India (RBI) that has struggled recently to keep yields under check.

The government has invoked “act of God” for not paying its due to the states directly. Instead, it asked states to borrow more from the market, through an RBI arranged mechanism. While the role of the RBI has not been spelt out yet, it is unlikely to be substantially different from what the RBI practices already, say experts. The central bank is the money manager of the government, and not a guarantor of any debt.

However, Section 21A of the RBI Act says it can “transact government business of states on agreement”. And so, every year, each state signs separate memorandum of understanding (MoU) with the RBI to manage its borrowing programme.

Banks and insurance companies are major investors of these bonds, while foreign investors tend to avoid them. In June 2019, the central bank tried to broaden the investor base by roping in retail investors.

No absolute guarantee

Answering to a Business Standard query on the safety of the state bonds for investors, RBI Governor Shaktikanta Das had said in a post-monetary policy conference in June 2019 that the state bonds “cannot be considered risky” as there is an implicit sovereign guarantee in them. Das also said the sub-sovereign debts are run through an “implicit debit mechanism which the RBI operates, on the due date of repayment the RBI automatically debits the state government account and makes the repayment”.

The governor’s use of the term “implicit” is of great importance because it is just that — an implicit guarantee and not an absolute one.

The central bank maintains a consolidated sinking fund (CSF) from which market borrowings of states are serviced, and a guarantee redemption fund (GRF), which can be used if there is a default. Contribution to these funds by states are voluntary, but the central bank has been trying to formalise investments in these funds for some time.

Under the cooperative federalism structure, however, the Centre is obliged to pay if a state defaults. But that is again, an “implicit” guarantee, and not an absolute one. The guarantee is a contingent liability of the Centre, a “below the line” off-balance sheet item, for which the Centre doesn’t allocate funds.

What the Centre can do instead is that in the event of a default, it can pay the investors adjusting the next year’s devolution amount due to the state. The devolution mechanism is controlled by the RBI. So, that way, the state bonds are safe for the investors even as there is no absolute guarantee.

But investors will demand higher yields for state bonds, considering the financial position of both Centre and the states.

Government’s plan

The government is saying that it is ready to pay the principal from the compensation cess, but the states must bear the interest rate, and count Rs 1.38 trillion, excluding the Rs 97,000 crore for GST only, as their own liability.

In all these, the RBI will be the conduit, a money manager, and surely not the guarantor of such bonds, say experts.

The RBI could enhance the ways and means advances, or short-term advances limits for states, while the rest could be borrowed by the Centre on behalf of the states, as state debt cannot be monetised the way Centre’s debt can be through OMO.

“It is always better for the RBI to deal directly with a sovereign entity rather than with close to 30 sub national entities,” said Soumya Kanti Ghosh, group chief economic advisor of the State Bank of India (SBI) group.

The RBI can then chip in through OMO purchases, or even manage the yields through primary auction devolvements, say economists and bond dealers. There would be no such choice when it comes to manage state bonds.

“These are indeed tough times. With a likely deep contraction in the economy, the Central government’s revenue shortfall will be acute,” said Rupa Rege Nitsure, group chief economist of L&T Finance Group.

“Escalation of market borrowings implies more printing of money and higher public debt. But what is the alternative? What matters now is how fast the economic engine gets started and the quality of spending by the state and central governments. If the tax revenues improve in the remaining part of FY21, we need not worry much about higher market borrowings. However, in the absence of this, the debt will become unsustainable,” Nitsure said.

Volatile markets

Dealers in the corporate bond markets are seeing dark clouds already.

“The finance minister invoking ‘act of God’ and reneging on paying commitments of the sovereign is a dangerous precedent. Borrowers can bring up force majeure and default. 

They can plead in the court that this has been publicly declared by the finance minister!” said a person requesting anonymity.

From a purely bond market perspective, there’s just not enough buyers for the deluge of supply to come.

The state government borrowings in the first half is pegged at Rs 3.45 trillion. The second half is typically busier, and coupled with the pandemic and GST stress, the borrowings could be as high as Rs 10 trillion for the full year, analysts estimate. The Centre’s plan so far is to raise Rs 12 trillion, and extra borrowing is a near certainty at the end of the year, especially if the government decides to introduce a fiscal stimulus.

All these borrowings will have to be managed by the RBI at lower yields. That’s a Herculean task, and the central bank has already started giving signals that it will not allow the yields to rise beyond its comfort zone.

“Amid sizeable system liquidity, demand-supply disequilibrium resulted in a recent spike in G-sec yields. However, the RBI action in the form of Operation Twist and subsequent primary auction devolvement at a yield lower than the market indicates the central bank’s discomfort towards the pace of yield rise,” said Ram Kamal Samanta, vice president-Investment at Star Union Dai-ichi Life Insurance. Samanta expects the 10-year benchmark to hover in the range of 6-6.25 per cent in the near term.

“The current unprecedented situation gives limited options to the Centre to work out a judicious way of dealing with such large extra borrowing over and above the 2 per cent (of state GDP), or Rs 4.28 trillion already mandated for the states as a part of the Atmanirbhar package,” said SBI’s Ghosh.