Subhash Garg: New paradigm for state loans

In the last National Development Committee meeting, the states have vociferously demanded a reduction in small savings loans transfers charged by the Centre and the rate of interest charged thereon. This demand led to the constitution of a committee presided over by the finance minister. Such a demand would have been unthinkable a couple of years ago when the states were prepared to accept any loan at any rate of interest. This will not only bring down the rate of growth of states' debt, but also has a substantial potential for making the states responsible borrowers, which will lead to more productive use of borrowings.

The Constitution envisaged state legislatures placing overall borrowing limits on states borrowing and the Central government acting as prudent regulator. Yet, the states placed no borrowing limits, nor did the Centre choose to regulate. Whatever borrowing was possible "" from the Centre (plan and non-plan loans), banks (state development bonds), households (small savings), especially created financial institutions such as HUDCO, REC and so on (sectoral projects) and employees (provident fund) "" was resorted to the maximum extent possible. Institutional structures and incentives also aided this objective. Not surprisingly, the states fiscal deficits rose to become a mountain of debt. They carried a debt of more than Rs 9,000 billion "" constituting over 27 per cent of India's GDP "" at the end of financial year 2004-05. The states annual interest burden at Rs over 900 billion consumed over 25 per cent of their revenues.

The maximum-borrowing mindset was further aided by the lack of creditors' discipline. The government being the direct lender (plan loans), owner of lending institutions and facilitator of households savings (off-market interest rates and preferential tax treatment for small savings with implicit guarantee of no default to savers) provided over 60 per cent of borrowing resources to the states. Instead of controlling states borrowings, the Centre became the primary lender and facilitator providing automatic approval of borrowings once a states' plan was approved by the Planning Commission. Being the deby manager of the states, the Reserve Bank of India created necessary conditions for full subscription to the states market borrowings, first by assigning the states borrowing status of statutory liquidity ratio (SLR) and then providing a no-default implicit guarantee.

The world over, sub-national jurisdictions have been subjected to hard budget constraints (determining and enforcing overall borrowing limits effectively) and eliminating the loan intermediation of federal government for a better credit discipline. This is a different policy paradigm than the one we had in India until some time ago. Under this policy regime, the states can run deficits only upto a permissible limit. Second, they have to raise the borrowings from the market with no guarantee from the sovereign, making creditors watchful as they run the risk of debt defaults if they lend to non-credit worthy states. The limits on overall borrowings of the states have been imposed federally (Brazil permits borrowing only to the extent that debt service will not require more than 13 per cent of the revenues), or by their own legislatures (most of the US and Canadian states have balanced budget laws with borrowing ceilings) or by markets (Australia). The Central governments of no major federal country, other than India, lend to states, thus avoiding moral hazard.

India is changing. The finance ministry started to impose overall borrowing constraints on states from 2002. The 12th Finance Commission has incentivised the states to bring their own fiscal responsibility laws laying down limits on fiscal deficits. States have been enacting laws to impose a ceiling of 3 per cent on their fiscal deficit. Plan size should not determine the size of borrowings; rather borrowings within overall constraint should determine the plan size.

The Centre has stopped lending to the states for their plans, thus accepting a key recommendation of the 12th Finance Commission. All the loans given by the government prior to March 2004, and outstanding on March 31, 2005, are to be consolidated in the new loans repayable over 20 years. If the Centre voluntarily consolidates or allows such loans to be prepaid, the government's entire debt (barring the small savings from NSSF) would stand either repaid, or consolidated into a new passive 20-year loan. Putting an end to new loans and the conversion of existing loans into passive loans will effectively bring an end to the intermediation regime in India, too.

Under these circumstances, the states will be encouraged to raise their borrowing requirements from the market. This emerging market discipline can be aided by RBI, by not conferring the SLR status to the states' market borrowings beyond a certain fraction of states' total borrowings (say, 15-20 per cent). States' borrowing programmes should further be rated by the credit rating agencies. Employees provident funds need to be organised into functional retirement/pensions funds, with inflows being invested in funds outside the government. The envisaged investment pattern of the new pension scheme offers the right recipe.

States' borrowing reforms have entered into a new paradigm. It will, however, take some time before the agenda is fully achieved. The Centre's role in this entire evolving and changing paradigm would be very important.

The writer is an IAS officer serving in the National Institute of Public Finance and Policy. Views expressed are personal