Implicit guarantees

State government debt may not be properly rated

Starting this week, foreign portfolio investors or FPIs will be allowed to invest in debt issued by state governments. The relaxation of rules in the last monetary policy review by the Reserve Bank of India (RBI) was welcome. The response has been positive, with FPIs picking up over Rs 900 crore in state government debt in the last few days. The RBI intends to raise the investment ceiling in state government debt for FPIs in several stages, taking it to Rs 50,000 crore by March 2018. FPIs already have holdings close to the permissible limits in central government debt. In the current calendar year, FPIs have bought close to Rs 50,000 crore of central debt. FPIs can now invest an additional Rs 16,431 crore, including in state government securities, and the limits will be enhanced by another Rs 16,600 crore from January 2016. Indian state government debt offers some of the best yields in the emerging markets category. India is also reckoned to be among the least risky of the emerging market economies. State government debt is available at significantly higher yields compared to those for central debt. The spreads in state government debt over central treasuries amount to 80-90 basis points for instruments with the same tenures.

However, state government debt may also be attractive for some of the wrong reasons. There are market imperfections and those imperfections could lead to potentially dangerous situations. In effect, there is an implicit sovereign guarantee for state government debt issued by any of the 29 states. Due to that, there is not much difference between state debt yields despite wide variations in state ratings. No Indian state has ever defaulted. It would be incumbent on the Centre (and the RBI) to ensure that no state ever does default, especially to foreign creditors. But against the backdrop of implicit guarantees, creditors are likely to look for the highest available yields, assuming that the default risk is effectively zero. Going purely by yields, the states with the worst financial policies are also likely to be the most attractive from an investor's viewpoint because the highest yield will be associated with the states that have the lowest ratings. Thus, it is possible that West Bengal (rated BBB-plus) could place larger quantities with FPIs than Gujarat (A-plus) because West Bengal will surely offer somewhat higher yields.

This factor - implicit sovereign guarantees for all - could in itself raise questions about the relevance of the rating system. It could lead to topsy-turvy situations with major misallocations. States raise debt for multiple reasons, of which only some are sensible. Many states, for example, subsidise power to consumers and raise debt to service the losses their electricity boards incur as a result. Some states are quite large and their gross domestic product could be equivalent to that of small countries. So the state government debt market could, in some senses, be considered analogous to the euro zone: states with widely different fiscal positions and economies of different sizes are unified in a single currency market. The Greece crisis points to the problems that can arise from distortions in such markets. Ways must be found to guide states towards greater fiscal responsibility. Unless the curbing of profligate expenditure goes hand in hand with this liberalisation, helpful access to more funding could lead to problems down the line.