The credit policy announced on June 6 has brought in quite a revolutionary change in the future structure of the government debt market, in the realm of state government loans or state development loans (SDLs). As of today, all SDLs are treated alike and the market is agnostic to the issuer, and does not hence distinguish between bonds raised by different states, irrespective of how their finances are managed. Hence, if states have high debt to GDP ratio or fiscal deficit or interest payments, it does not affect the cost of funds as there is a sovereign guarantee that ensures they all borrow at the same rate. In fact, these securities are treated on a par with central government securities for inclusion under SLR. This has been useful for the states as they have been able to borrow at low rates from the market.
This situation has created some level of discontent in states which manage their budgets in a more astute manner. The grievance is that they are being painted with the same brush. Good housekeeping gets no credit in the market while recklessness is not penalised. RBI, it appears, is set to change the rules of the game. The policy announced this time does not explicitly distinguish between SDLs issued by different state governments as they still retain their SLR status in the current form. But, RBI has made two significant changes in the terms of use of SDLs at the LAF window, as well as in marking to market (MTM) this investment portfolio.
First, it has been declared that when accessing the repo window, banks which provide SDLs as collateral that are rated would have to keep a margin of less than 1% compared with bonds which are not rated. This gives an incentive to holders, especially banks, to invest in SDLs that are rated. Now, by virtue of this dispensation, states will have to get their bonds rated as banks and other subscribers would prefer to purchase those that are rated, as there is an advantage when getting finance from RBI. Alternatively, they may find it difficult to find takers.
Considering that states are dependent on such funding, as this comes at a lower cost than small savings, they would prefer to get the SDLs rated.
Once a rating is given, there would automatically be varied interest rates on different issuances, as higher rated bonds can offer lower rates. This will be decided by market forces and, automatically, states will have to work hard to manage their finances in a better manner. This will be good for the market and will provide an incentive to states to adhere to fiscal discipline because, often, states deviate from FRBM norms due to various exigencies.
Second, to drive home the point, RBI has also changed the MTM norms for valuing SDLs. Hitherto, these securities were valued at 25 bps above GSecs for all the securities, irrespective of the issuer. Now, the formula has changed wherein SDLs, which are traded on the market, would be valued at the traded price. However, if the securities are not traded, then the valuation would be at the weighted average rate at which the states raised money relative to the GSec rate. Therefore, effectively, if the rating is not good, then the valuation would be at a lower price as the yield differential will be higher.
It can be intuitively seen that all holders of SDLs will prefer rated bonds and that states have to strive to get a good rating which is possible only if their fiscal balances are well maintained. This will present an opportunity to state governments to get their acts together.
Bringing in fiscal discipline is good for the system, and states will have to be better geared for the same. States would, however, encounter quite a few challenges in this regard as budgeting is an inexact science and is often dependent on various external conditions. Based on past experiences, the following deviations have been observed across states.
First, the revenue surplus target is seldom met even while the budgeted numbers make this assumption. This happens when there are revenue shortfalls in particular, given often, the expenses tend to be fixed while revenues will fluctuate if the economy does not do well. Second, fiscal deficit slippages are common for some of them, and while some keep a margin when budgeting, others run the exercise at the threshold level, which forces them to cut discretionary expenditure to ensure that the targets are met.
Third, extraneous decisions taken at the political level, like loan waivers, can jeopardise deficits. Populist schemes could be introduced during election time—that could upset the revenue budget. Fourth, some ongoing pressures would come from periodic salary revisions that are a part of the system. State pay commissions have to keep pace with the central pay commission recommendations that tend to push up expenses periodically.
Fifth, the flow of funds from the Centre is important as, with GST now in place, it is difficult to raise tax rates in areas that were within their purview earlier. Absence of alternative streams of revenue is a challenge for the states in the new GST setup. Sixth, they may have to cut down on discretionary spending to meet targets. This is often done to ensure that the FRBM norms are being adhered to.
Seventh, the guarantees given to state PSEs will have to end, or they will put pressure on state finances. This will require some stern action. The UDAY loans have already added to the debt of state governments and with most PSUs making losses, a call needs to be taken on whether or not they should be supported by the state government through the budget. Last, the pressures from pensions that get revised at the central level, and then get replicated by state finance commissions, can put more pressure on their ability to maintain their fiscal propriety.
Therefore, there will be interesting times ahead for the states as they work towards getting rated. The FRBM norms have been fixed for states and, once the concept of rating catches on, it will get cast in stone. RBI is goading them to do so, which will have collateral benefits, such as better fiscal management. Hence, moving towards such ratings comes with distinct sops, which is a unique way of going about this exercise. This will be good for the country and will enforce discipline as lower ratings increase costs of borrowing and make fiscal indicators look less satisfactory. To avoid such ratcheting of costs, the house will have to be kept in order. The demonstration effect of better-run states will work fast on others as they keep up with the Joneses.
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