RBI now concerned about state finances

Deficits could come under more pressure in coming years as states implement own Pay Commissions

The ballooning fiscal deficits of states have found their way into Reserve Bank of India's (RBI) policy making thought process.

Minutes of the monetary policy committee meeting showed that one of the six members, Ravindra H. Dholakia, expressed concern about the state's finances.

"State Budgets have been the cause of concern of late because the movement in their fiscal deficits largely determines the variation in the combined fiscal deficit of the country," the minutes quoted Dholakia.

"States have now started forming a larger proportion of the public expenditures and having a clear idea on their fiscal deficits is important for the monetary policy," according to Dholakia.

This is how states' deficit puts monetary policy in jeopardy. When states run large deficits, they have to bridge those by borrowing from the market. As more bonds come in the market, the interest rate gets pushed up, even if RBI wants interest rate to be low. Second, the wide deficits of states happen because of expansion in expenditures. When states spend more, it strokes inflation and RBI's inflation mandate becomes challenging to meet. Therefore, both state deficit and centre's deficits are important for the RBI to consider, say economists.

The Union government has projected a fiscal deficit of 3.2 per cent of the GDP for the next fiscal. But states are not that disciplined.

"After narrowing to 2% of GDP between 2010-12, the consolidated state deficit has widened back to 2.8% of GDP (ex-UDAY) in 2015-16, despite a large windfall from the Centre on the back of the Fourteenth Finance Commission," JPMorgan wrote in a report.

At this run rate, JP Morgan economist Sajjid Chinoy wrote, the consolidated fiscal deficit in 2016-17 would be at 3.4% of GDP, without factoring in UDAY bonds or demonetisation impact, which would be the highest in 13 years - versus a budgeted deficit of 2.8% of GDP.

Furthermore, deficits could come under more pressure in coming years as states implement their own Pay Commissions.

The quantum of borrowing by the states brings home the point. So far this financial year, states have borrowed more than Rs 3.2 lakh crore from the market. Since the bonds, called state developed loans (SDL), are guaranteed by the state government, the bonds are considered high quality and bonds issued by top states can be good substitutes of even government bonds. On a gross basis, market expects states to borrow Rs 3.5 lakh crore in this fiscal and Rs 4.5 lakh crore in the next. This is almost equivalent to the centre's gross borrowings a few years back. In the next financial year, the centre plans to borrow Rs 4.25 lakh crore net and at a gross basis, Rs 5.8 lakh crore.

"Consolidated state expenditures are significantly higher than the Centre's, and state market borrowing is poised to overtake the Center's by 2018-19," JPMorgan said.