State finances: Why FPIs need a reality check before they loosen the purse

Greater scrutiny shows that stagnant revenues and unrestrained freebies have left most of them in a perilous position

Foreign portfolio investors (FPIs) may be allowed to invest larger amounts in state bonds, with an announcement by the Reserve Bank of India (RBI) expected soon. Currently, FPIs are permitted to invest two per cent of outstanding stock securities in state bonds; this could expand significantly to seven per cent. The implication of this expected move on state finances is that it will become necessary to price state bonds with greater transparency, a development that is, however, unlikely to enhance the big picture of state finances.

As RBI’s recent stress test of state finances matched against the yields on their papers show, there is a huge dissonance. In pre-Covid-19 years, the aggregate own tax revenue of the states compared to their Gross State Domestic Product (GSDP) came down from over 7.7 per cent to 7.3 per cent, according to an RBI working paper. No surprise, then, that most large states — Maharashtra, Andhra Pradesh and Tamil Nadu — have moved into deficits in the same period. Yet the current yields on the papers of these states and others that are getting perilously close to them in terms of deficits show no discernment in pricing by the markets (<see table>).

In this league there are two states the FPIs might want to avoid at all costs — Andhra Pradesh and Telangana. These two states are the standout examples of an unrestrained freebie culture. From April to the first week of August, Andhra Pradesh’s borrowings are almost double of last year’s level in the same period (Rs 325 billion against Rs 180 billion). In the last auction of state government papers on August 2, Telangana exceeded the amount it planned to raise by 20 per cent. These numbers are surprising since comparable states have either not borrowed even after planning to do so — such as Maharashtra — or picked up less than indicated, such as Gujarat and Haryana. The numbers are even more worrying given that these states, according to data from the Comptroller and Auditor General (CAG), have more than half their total revenue committed to wages, pensions and interest.

The only plausible reason these and other states seem to be fine, as of now, is that despite the Covid-19 impact when the national GDP contracted by 6.6 per cent and the corresponding tax collections plummeted, their revenues were seemingly protected because of the goods and services tax-sharing formula. For instance, in the pre-GST years between FY11 and FY15, the share of the same set of indirect taxes for the states registered a 9 per cent average rate of growth. In the post-GST years FY17 to FY22, it has averaged above 14 per cent. This includes the back-to-back loans raised by the Centre and passed on to the states. This latter growth rate has created a false sense of security, even in the bonds market.

Instead, the markets need to examine what creates laggards such as Andhra and Telangana against those states that perform better. The answer is rising expenditure placed against flat revenue.

It is not that other states have their finances offering a clean bill of health. Tamil Nadu, for example, has not revised its electricity tariffs since FY15, though it may do so soon. Its committed expenditure accounts for over two-thirds of revenue receipts — that includes the money the state gets as tax devolution. It is also adding rapidly to its outstanding liabilities at close to 20 per cent, according to CAG.
 

What saved the state is, however, its willingness to keep its data transparent. Unlike other states, Tamil Nadu’s off-budget borrowing is minuscule at less than 0.2 per cent of its GDP (CAG data). From the current financial year, the Centre has decided to become stricter about state’s off-budget borrowing. After FY21, such borrowings will be deducted from the net borrowing ceiling of the states concerned. Announcing the limits after some delay, the Centre also took the unusual step of fixing personal responsibility on officers who sign off on state finance reports.

Soon, it is possible that there will be a revival of a planned index to measure the debt sustainability and fiscal prudence performance indicators of states. The idea was floated by former RBI Deputy Governor B P Kanungo in 2018, and has been mentioned favourably in a central bank working paper in January this year. For the FPIs, this could be an extremely useful index since it will summarise the financial performance by the respective states.

Measures such as the cap on net borrowing and the proposed index could encourage the states to adopt more revenue-raising measures instead of focusing on welfarism. The 15th Finance Commission had asked states to raise property taxes, which should have been a simple exercise but states have baulked. RBI data shows the result. Till the pre-Covid-19 year of FY20, revenue deficits of most states have risen while their collection of taxes as a percentage of GSDP has stagnated. No surprises then that the capital outlay of the states, till Covid-19 struck, has stagnated at less than 20 per cent.

The long-standing inability of states to pass more revenue-raising measures has also impacted their ability to spend money. Here is a gem from the latest CAG report on Telangana. It notes that the amount available in the state government’s State Disaster Response Fund as on April 1, 2020, was Rs 977.67 crore. This sum was boosted in FY21 by a central government contribution of Rs 449 crore and a state government share of Rs 149.67 crore. During the peak of the pandemic, the sum sitting in the fund was Rs 1,576.34 crore. At the end of the financial year, the state had spent a princely Rs 21.03 crore.

Since the markets do not ask tough questions, many states have become bolder in their borrowing practices. Some have begun to take out loans from banks against assets such as the office building of the collectorate or even the courts. These buildings have no revenue potential in reality but are secured assets of the states (though it is unclear what banks are expected to do if they are handed over a district magistrate’s office against a loan default). Once such practices come under scrutiny, they may encourage FPIs to tighten rather than loosen their purse strings.