FRBM targets: On states’ borrowing, compelling need to go for fiscal reform: Financial Express JUne 12, 2017

RBI’s study on state finances has highlighted the travails that lie ahead for them as the discipline observed in the past has been disrupted.

RBI’s study on state finances has highlighted the travails that lie ahead for them as the discipline observed in the past has been disrupted. The performance of states varies quite significantly and the FRBM (Fiscal Responsibility and Budget Management) norms that were invoked and have worked well have gotten diluted over time especially with Ujwal DISCOM Assurance Yojana (UDAY) being launched. But are states to be treated on par when they access the market for loans? The present situation is one where all states are considered to be as good as the centre, as it is implicit that all debt will be honored and serviced with RBI stepping in if there are problems. It is this nature of securities, called state development loans (SDLs) which allow states to raise funds in the market, and institutions hold them as they can be used for regulatory compliance.

If there were a distinction between states on the basis of which they raise funds, the market would become more discerning and those which are not run well in the fiscal sense will have to pay a higher price for borrowing funds. Hence, when the central government borrows at say 7% in the market, the SDLs average 50 bps higher and all get the funds at virtually the same rate.

Differentiation will be a way to get them to run their budgets better. An analogy can be drawn to public sector banks which borrow at different rates even though they are all owned by the government and there is an implicit assurance that there will be no default.

RBI’s data in its report on state finances presents a wholesome picture. At the end of the day, the debt-to-GDP ratio is the most important indicator since if revenue cannot match the expenditure, then there have to be borrowings which result in higher debt and higher future interest payments. The FRBM now talks of states bringing down their debt/GDP ratio to 20%, which can be taken to be a norm.

The accompanying table clubs various states on this ratio for FY17.

At present, the corporate bond market exhibits fairly divergent spreads over government securities (GSecs) for a maturity of say, 10 years. While AAA bonds are priced at 90-100 bps higher than government securities of similar maturity, AA average 140-150 bps, A at 340-350bps and BBB 450 bps. This is how the market would treat corporate bonds with different ratings which are of investment grade.

Now, if a similar system gets imbibed in the SDL market, the assumption which can be reasonably made is that all of them are investment grade. The five ranges provided above could be classified into four, with probably the 20-30% range of debt-to-gross state domestic product (GSDP) being covered in the second category. These bonds could be priced hypothetically at 25bps higher progressively across these bands. Hence, the best states gets funds at 7.5% and those down the pecking order would be at 7.75%, 8% and 8.25%. Left to the market, the pricing could go anyway and will depend on how the demand for such securities develops. Banks, who are the main subscribers, would subscribe to these securities based not just on the returns, but also the investment valuation norms which would hold for them.

Alternatively, Reserve Bank of India could administer these rates such that some states end up paying a higher cost. If this is not possible, the premium can be loaded as a surcharge which goes into a special SDL fund created and maintained by the central bank which can be used for specific purposes as can be laid down in the charter. By having such pricing, states can be made to discipline their operations.

The main point is that all states should not be borrowing at the same rate. With Ujwal discom assurance scheme coming in there has been a major financial engineering exercise where `2.33 lakh crore of discom debt has been taken over by the states. As all such transactions are a zero-sum game, the original lenders have lost out on interest at the cost of assurance that the bonds would be serviced on time and principal repaid (though the discom debt is normally guaranteed by the state). As long as they resided on the books of the discom they were considered to be sub-standard assets. But UDAY has converted them, almost like alchemy, into higher rated bonds priced at just around 40-60 bps higher than SDLs, which is odd because once the bonds reside on the state government books, the distinction between UDAY and SDL fades. In fact, an argument against UDAY has been that through statistical accounting the debt of discoms has been conveniently transferred with both the state government and company being better off without any punitive action.

How can states be forced to work well? One option is to hold the 3% fiscal deficit rule and make no exceptions. Hence, as the interest cost rises, which has to be serviced, the state would have to cut back on the expenditure. But given the system of accounting, which is based on actual cash flows, states could defer payments into the new year and keep this scheme rolling over time so that they work well within the frontiers. To counter this, the accounting system should change from actual to accrual basis, so that there are fewer escape routes. Such a move will also help to ensure that there is credibility to the spread that is charged to states with differing debt levels. Alternatively, states which cross prudent limits must be asked to pay more for incremental credit over what is permitted so that they become more responsible.

In short, there is a compelling need to go in for state fiscal reforms which involves setting fiscal responsibility and budget management targets, making states more accountable for the budgetary numbers and tightening the accounting standards so that the system is well knit. As states are to take on the future losses of dicoms, too, which may lead to less pressure on these companies to revise tariffs as they are sensitive issues, checks have to be built or else compliance becomes a rollover process which erodes the sanctity of fiscal reforms. Clearly, there should be some deterrent built into this system.