Columns: Kautilya

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India Today, March 1, 1999
March 1, 1999

KAUTILYA
Grim News Out of the RBI

A new study shows that the state of the states is precarious.

By Jairam Ramesh

Brazil is in deep financial trouble again. The IMF approved a $41.5 billion rescue package for it in October last year. Markets heaved a sigh of relief expecting the worst to be over. Suddenly, disaster has struck in a most unexpected way. On January 6, Itamar Franco, governor of the Brazilian state of Minas Gerais, one-time president of Brazil and a bitter opponent of President Henrique Cardoso, declared a 90-day moratorium on about $15 billion owed by his state to the federal government. All hell broke loose. Other state governors talked of defaults and Brazil has started tottering again. The 27 states in Brazil collectively owe the federal government about $90 billion.

Could this happen in India? After all, at the end of March 1999, the collective debt owed by the 25 states to the Centre will have crossed Rs 200,000 crore ($50 billion) -- about 60 per cent of their total outstanding liabilities. The answer, strictly speaking, is no. India is not Brazil. In India, no debt can be incurred by a state without the knowledge and approval of the Centre. The RBI puts a limit on a state's ways and means advances. We also have multiple channels through which "Central" resources flow into a state -- through the Planning Commission, Finance Commission and financial institutions. As long as the inflows exceed outflows, a state will not take the risk of declaring a moratorium unilaterally.

Debt servicing by states as a proportion of gross transfers to them from the Centre in 1998-99 would average 27.5 per cent, high but not at a danger level. In states like Punjab, Maharashtra, Gujarat and Goa though, debt servicing is growing steadily and consumes 40-60 per cent of gross transfers. It would be a colossal mistake to think that state finances will not impact on sentiment. A landmark analysis by RBI, carried in its February 1999 Bulletin, shows Indian states are in dire financial straits. The total non-developmental expenditure of the states in 1998-99 would be close to 36 per cent of their total expenditure, a proportion that has been rising sharply. This year, the states will be financing 40 per cent of their fiscal deficit by dipping into their provident funds, reserve funds and through deposits and advances. The fiscal deficit of the states as a whole is budgeted to be 3.68 per cent of GDP, over double the sustainable level.

The difficulties in fiscal restructuring by the states should not be minimised, specially in view of the fact that two-thirds of all expenditure on agriculture, rural development, irrigation and the social sectors is carried out by the states and will only increase. The Centre has relatively greater room for manoeuvre. At times, the states also get penalised for Delhi's profligacy as can be seen from the havoc which the Fifth Pay Commission bonanza to four million Central government employees is causing. In fact, till 1985-86, state finances were in balance. The Fourth Pay Commission triggered the rot. A Centre living with a fiscal deficit well in excess of 6 per cent of GDP and which has to resort to gimmicks like buybacks and cross-holdings in oil PSUs to cut the deficit can hardly assume the role of a fiscal evangelist. Even so, there is much the states can and must do to raise tax and non-tax revenues as well as reorient public expenditure.

One of the best things to have happened is the permission given by the Finance Ministry to the World Bank in 1996 to enter into structural adjustment loans with the states directly. These loans typically cover power, education and health but the states don't get the money unless they make irrevocable commitments to reform their finances. Andhra Pradesh was the first to get almost $3 billion. Uttar Pradesh and Rajasthan will probably be next in line. Gujarat has a similar loan from the Asian Development Bank. These loans bring financial discipline. But while such loans are welcome, other measures to introduce fiscal discipline are needed.

RBI has been shouting hoarse for what it calls a "sinking fund" by states. This is a fund to which every year some money will be appropriated so as to meet future debt obligations. States say that in the presence of a revenue deficit such a fund may not have much meaning. But it is the principle and the signalling that is important. States like Rajasthan have agreed to this since it is the only way they can break out of the debt trap.

A growing source of worry is off-budget liabilities in the form of guarantees, letters of comfort and other such "incentives" that states are offering both while borrowing and attracting new investments. The outstanding guarantees of states in 1996-97, according to RBI, amounted to about Rs 64,000 crore. This may well increase as the states face a financial squeeze on transfers from the Centre as well as difficulties in raising funds from the capital market. Currently, these guarantees and contingent liabilities are not considered debt obligations. This is a prescription for disaster.

In a way, what happened in Brazil demonstrates the limits to fiscal freedom and decentralisation in a federation. The answer is not to look at the Centre and the states as fiscal adversaries as we have tended to but as partners in a painful but essential process of the reshaping of the public expenditure system -- that today is neither promoting growth nor enhancing equity. This is the true essence of economic reforms.

The author is secretary of the AICC's Economic Affairs Department.
The views expressed here are his own.

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