Loan waiver schemes being doled out to farmers could have a significant impact on state government finances and pose risk of further fiscal slippages, Fitch Ratings said.
Four states-- Uttar Pradesh, Maharashtra, Punjab and Karnataka, which account for around one-third of India's population-- have announced farm loan waivers and other state governments are likely to feel pressure to implement similar policies, particularly in states with upcoming elections, it said.
"The farm loan-waiver schemes being discussed and rolled out across an increasing number of Indian states could have a significant impact on state government finances, and might undermine efforts to bring down general government debt," Fitch said in a statement.
Larger state deficits would delay an expected gradual reduction in general government debt, which includes central and state government debt.
"There is a risk that farm loan waivers - which we have not previously factored into our assumptions - will lead to further fiscal slippage at the state level or will reduce the funds available for public investment.
The central government has the authority to block states from borrowing to finance persistently large deficits, but it could be reluctant ahead of approaching elections in some states, with the 2019 Lok Sabha election drawing nearer," Fitch said.
The Centre has gradually consolidated its fiscal position in recent years, and has indicated that loan waivers will have to be funded from state coffers.
"However, the combined finances of the states - which are included in general government debt and deficits - have been under pressure.
Public pay hikes, election spending and higher interest costs stemming from the UDAY scheme - under which state governments have taken on debt from power distribution companies - are all likely to add to expenditure," Fitch said.
However, the impact on India's debt dynamics and capital spending will depend on the total size of loans waived, how the scheme is financed, and whether there are possible offsets from cuts to other forms of spending, including capital projects.
While affirming India's rating at 'BBB-' with stable outlook in May, Fitch forecast general government debt to fall to 64.9 per cent of GDP by fiscal 2020-21, from 67.9 per cent in fiscal 2016-17, and highlighted that potential changes to India's fiscal position are a rating sensitivity.
Public finances are a key weakness in India's sovereign credit profile, with general government debt well above the 'BBB' median of 40.9 per cent and the fiscal deficit of 6.6 per cent of GDP in 2016-17 much higher than the 'BBB' median of 2.7 per cent.
Fitch said banks could also be affected by the waiver schemes.
It will only benefit banks to the extent that they offload farm loans with weak repayment prospects to state governments.
Agricultural loans account for 14 per cent of total bank lending, and are equivalent to around 6.5 per cent of GDP.
"Uniform farm loan waivers could lead to moral hazard and weaken the general repayment culture among financially healthy farmers, but they will still have an incentive to repay loans in order to retain access to future funding," Fitch said.
The last widespread farm loan-waiver scheme was rolled out in 2008 by the central government under the UPA regime, and covered 43 million farmers. It reportedly cost around 1.3 per cent of GDP.
"The combined cost to the states could also become large this time," Fitch said, adding a roll-out of farm loan waiver scheme across much of India is not unthinkable.