State debt dynamics: Strict fiscal rules needed to reverse disparities

The Union Budget draws significant attention, but state finances are equally important. A new working paper from the National Council of Applied Economic Research examines Indian states’ public debt and risks. States hold a third of India’s public debt, account for about two-thirds of general government expenditure, and a third of revenue collection. The paper rightly raises concern about fiscal discipline and divergence in debt burdens among states. Understanding these dynamics is crucial for policymakers to tailor interventions.

 

From 2012-13 to 2022-23, the debt to gross state domestic product (GSDP) ratio has risen in all but four states, namely, Gujarat, Odisha, West Bengal, and Maharashtra. In fact, only three states have debt levels of less than 20 per cent of GSDP. Punjab and Himachal Pradesh are the worst performers, with their debt exceeding 40 per cent of GSDP. Projections in the paper suggest that by 2027-28, the number of states with debt ratios above 40 per cent will increase to four. Punjab will see a further spike in public debt, elevating its debt ratio to more than 50 per cent. The recently released fiscal health index (FHI), by the NITI Aayog, also pointed to a similar outlook. According to the FHI, Odisha emerged as the best-performing state, followed by Chhattisgarh and Goa, while Punjab fared the worst among all others. Divergent fiscal health among states implies divergent growth outcomes over the medium to long run.

 

Heavy indebtedness invariably translates into significant debt-service obligations, restricting states’ spending capabilities on developmental initiatives, such as education and infrastructure. On the other hand, low-debt states are generally able to manage their finances more effectively, allowing them to allocate resources to essential services and developmental projects. As the paper notes, fiscal disparities can be traced back to non-compliance with fiscal constraints and market-intervention impacts by the Reserve Bank of India (RBI). Fiscal rules enacted by the states generally target the revenue deficit, fiscal deficit and outstanding liabilities. But, on average, states were found to comply with the rules only about 60 per cent of the time. Kerala and West Bengal were found to have the worst records, with 10 and 19 per cent compliance, respectively.

 

Overall, as the recent RBI report on state finances (2023-24) noted, the aggregate debt-to-GDP ratio of state governments stood at 28.5 per cent, exceeding the 20 per cent limit set by the Fiscal Responsibility and Budget Management Review Committee. The RBI’s frequent intervention to cap spreads in bond markets of heavily indebted states also leads to market indiscipline. Moreover, the composition of state debt is evolving, highlighting a shift towards marketable securities and loans from the central government. State governments need to mobilise more revenue to manage their fiscal position better. Ways will also need to be devised to deal with heavily indebted states. However, it is worth noting that state spending is often heavily influenced by electoral cycles, leading to sharp increases in cash transfers and subsidies amid rising debt. This calls for more stringent rules to tackle the burgeoning debt and deficit.