The Devolution Of Reform

Six years into financial reforms, the focus is slowly shifting to the states. A lower fiscal deficit and the abolition of treasury bills have almost ended the Centres role. It is now becoming clear that the states urgently need to do their bit.

The following figures show why. The states combined fiscal deficit for 1997-98 is estimated at Rs 45,530 crore, accounting for 3.1 per cent of GDP. Their combined revenue deficit is placed at Rs 15,373 crore. And this fiscal, according to a Reserve Bank of India (RBI) report, about 33 per cent of the fiscal deficit is expected to finance the states revenue deficits.

 

State-level financial reforms are expected to accelerate now because of the progress in the infrastructure sector. With a number of state undertakings approaching the markets for finance for road, water and power projects and with states extending guarantees, prospective investors are beginning to question their finances.

Bankers reckon that guarantees issued by state governments now stand at Rs 50,000 crore. But given the crisis in most state finances, such guarantees seem to have become a major worry for investors instead of a source of comfort. So much so that credit agencies have also started examining state finances before they rate guaranteed debt paper from state-owned corporations.

Guarantees given by the state governments are basically to help infrastructure projects that cannot generate revenues to repay their debtors and comprise two types. First, explains Sujatha Srikumar, deputy general manager, Crisil, there are guarantees for loans to state enterprises or for bonds issued by state enterprises under market borrowing programmes. Second, there are the guarantees for advances to state enterprises for specific projects.

Then again, guarantees can be either provided through the budget or on a revolving facility, provided every year and can be explicit or implcit, revokable or irrevocable. Explicit guarantees are usually provided in the state budgets. And irrevocable guarantees, as the name suggests, can not be revoked under normal circumstances.

The trend towards setting up special purpose vehicles (SPV), or holding companies, for infrastructure projects has added to state governments burdens. All SPVs need state guarantees to raise money from the market. Adding to complications, state governments have often not made budgetary provisions for this purpose; ideally, they should make a contingent liability for them in case they have to fund the guarantees. In many instances, guarantees become extra-budgetary requirements.

This trend naturally has credit rating agencies worried. As one source points out, some state governments are not even aware of the size of the burden they have undertaken. In states where the figures are near-reliable, the trend is far from reassuring. In Maharashtra, for instance, government debt is 15 per cent of net state domestic product (NSDP). In Gujarat, the figure is 18 per cent, Karnataka and Tamil Nadu 23 per cent and Andhra Pradesh tops the list at 24 per cent.

These figures only reflect the broad contours of the financial problems that states face. Officials in rating agencies say many states are given to pursuing populist policies that add to the financial burden. Andhra Pradesh, for example, imposed prohibition two years ago which resulted in heavy revenue losses. The state also had a huge rice subsidy for the poor. Now that both issues have been solved and a political consensus on sound economic policy is emerging, the state should fare better, feels Srikumar of Crisil.

On the other hand are states like Maharashtra, where basic industrialisation results in good sales tax revenue. Populist policies adopted in the last three years are causing the state acute financial problems.

One solution is for a legislative ceiling on the volume of debt a state government can incur. So far, only Gujarat has imposed a limit -- of Rs 8,000 crore -- on debt. A cap is necessary on contingent liabilities of states and a ceiling of 25 per cent of the state net domestic product could be specified, suggests Mohan Nagarajan, chief economist at Credit Analysis and Research Ltd (CARE). The Reserve Bank of India (RBI) is believed to have set up a committee to examine this issue.

Several issues, however, are likely to delay such a law. For one, most state governments oppose it on the grounds that it would cripple their borrowing ability, especially when financial flows from the Centre tend to be inadequate.

For another, there is some confusion over whether the ceiling should include guarantees as well.

On the positive side, with international investors coming in a big way, the chances of invoking the guarantees have increased manifold. And even the states are now becoming aware of such a possibility. So the ceiling on state debt may come sooner than expected.

Market borrowings have become an important component of state finances, but the method involved is inconsistent. The coupon, the amount and the timing are predetermined by the Centre. While the central government follows the auction method for its market borrowing, states follow the tender system.

Some of the states, which have a weak financial basis, are known to have opposed the move towards the auction system for fear that their interest burden will increase. Could there be a system where efficient states are free to manage their own coupon rates while the Centre decides the rate for the weak states?

Another issue in state finances concerns cash management. State governments often find themselves temporarily cash surplus. Ideally, this money should be invested in short term instruments, but few state governments have the expertise to do this. State-level cash management is certainly not very sophisticated. Unlike bank treasuries, they do not get the best yields, says Nagarajan.

Adding to all this uncertainty is the fact that credit agencies follow different evalution methods. CARE, for example, looks at state-level management in terms of revenues, expenditure, deficit and debt. Crisil, on the other hand, considers two basic factors, the economic risk and the political risk. Within the first parameter, it puts under microscope the economic structure of the state, the overall finances, and the state governments past and future economic philosophy.

As a result, different agencies ascribe varying ranks to the same state. According to Crisil, Maharashtra ranks first with an AA- rating, followed by Gujarat which has had it rating recently revised from A to A+. Karnataka comes next with A followed by Andhra Pradesh with A-. All these ratings are with reference to the benchmark rating of AAA given to the Centre.

CARE, On the other hand, puts Karnataka on top of the list along with Maharashtra and Goa, followed by Gujarat, Haryana and Andhra Pradesh. UP, Bihar, Punjab and Assam bring up the rear.

The CARE ranking does not factor the state of infrastructure in each state. If infrastructure is included, the ranking may change substantially. For example, Kerala could jump from number 10 to number 3 or 4, points out Nagarajan. That is because Kerala has made noteworthy strides in terms of social infrastructure like schools, colleges, hospitals and roads.

While these differences in state credit ratings send out mixed signals, both the Centre and some states recognise the need to address the issue of state finances on an urgent basis. The RBI is believed to have held two meetings with state finance secretaries to find a solution. One issue that has been recognised as crucial here is that of user prices, particularly for state electricity boards, road transport corporations and irrigation facilities, which currently account for a major proportion of state fiscal deficits.

As a recent RBI report points out, states also need to focus on rationalising taxes and fees such as stamp duty and registration charges and explore the possibility of introducing VAT.

A beginning of state financial reform is likely to be made with the constitution of consolidated sinking funds (CSF) to cover the state governments market borrowings. The RBI has been insisting on such a fund for quite sometime and the recently held meetings between the state finance secretaries and central bank officials are believed to have discussed the issue in details and arrived at a conclusion. Accordingly, the consolidated sinking funds will be formed out of the states contributions, which will be in relation to their market borrowings. The CSF will thus provide states with a much-needed buffer.