Notes

A licence to borrow unwisely

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Last Updated07/10/2024

In 1975, New York City faced a fiscal crisis that put it on the brink of default. Initially, then U.S. President Gerald Ford opposed any federal bailout, reasoning that it would compel the city to address its financial mismanagement.
The infamous "Ford to City: Drop Dead" headline epitomized the sentiment. However, Ford eventually extended loans worth $2.3 billion to the city, recognizing the need for financial assistance.

In India, state government borrowings come with an implicit guarantee from the Union government. The auto-debit mechanism ensures that state liabilities are settled, essentially eliminating any perceived risk of default.
As a result, unlike private borrowers whose interest rates vary based on their financial health, yields on state bonds remain uniform, regardless of the fiscal position of the borrowing state.
This reduces the market's ability to penalize fiscally irresponsible states through higher interest rates, as would occur in a typical credit market.

States such as Gujarat, which has a stronger fiscal position, should logically be able to borrow at lower rates than states like Punjab or Himachal Pradesh, which are facing severe financial strain.
Himachal Pradesh, for example, was recently unable to pay its employees on time, yet the bond yields for these fiscally distressed states show little differentiation.
This failure of the market to price credit risk appropriately is a significant concern, as it allows states to continue borrowing recklessly without facing any immediate financial repercussions.

One proposed solution is to allow the market to determine the pricing of state debt. If fiscally stressed states such as Bihar, Kerala, Punjab, Rajasthan, and West Bengal had to borrow at higher interest rates, they would be forced to adopt fiscal reforms, much like New York City in the 1970s.
Market discipline could serve as a tool for ensuring fiscal responsibility, pressuring states to reduce expenditure and increase revenues. However, there is a concern that this approach could price certain states out of the market, exacerbating their financial difficulties and leading to political and economic instability.

Tariffs: Electricity and water tariffs do not reflect the true cost of provision, leading to significant subsidies that strain state budgets.
Interest Payments: A large portion of state revenues is consumed by interest payments on existing debt.
Pensions: Rising pension obligations, especially with states reverting to the old pension scheme, are increasing fiscal pressures.
Subsidies: The growing list of subsidies announced by states often does not come with adequate revenue streams to support them.
For many states, 70% or more of their own tax revenues are allocated to these three categories—interest payments, pensions, and power subsidies—leaving little room for capital expenditure (capex). Some states are now borrowing not for infrastructure investment, but to fund consumption spending, further deepening their fiscal woes.

States have responded differently to this crisis. Himachal Pradesh is reportedly reviewing the numerous subsidies it has extended, potentially in an effort to reduce its fiscal burden.
In contrast, Punjab has sought a bailout from the 16th Finance Commission, a move that raises concerns about whether yet another bailout will genuinely address the underlying fiscal mismanagement.
The experience of the Uday scheme, which aimed to rescue struggling power distribution companies (discoms), serves as a cautionary tale. While the scheme provided temporary relief, the fundamental issues of mismanagement and inefficiency within the discoms persisted, calling into question the effectiveness of such bailouts.

As states' ability to generate revenue remains limited by their constrained taxation powers, the solution lies in expenditure control. However, austerity measures are often politically unpopular, especially in states where subsidies are seen as essential for securing political support.
The question then arises: How long will the Union government continue to provide an implicit guarantee for state borrowings? At some point, this arrangement will have to be revisited.
One potential solution could be the implementation of a new set of fiscal rules that vary based on a state's fiscal position, incentivizing states to improve their financial management. Alternatively, greater reliance on market discipline could force states to adopt necessary reforms, though this approach carries risks of its own.

The 16th Finance Commission will play a crucial role in shaping the future of state borrowings in India. Its recommendations could help strike a balance between ensuring fiscal responsibility at the state level and preventing a full-blown fiscal crisis.
As India's states navigate their financial challenges, the lessons from New York City's 1975 crisis remain pertinent: sometimes, the threat of austerity and market pressure can be more effective than endless bailouts.