Even though state governments collectively spend much more than the Union government every year, state budgets do not attract the attention they deserve. Some financial market analysts keep an eye on state budgets, but it remains largely an academic exercise since bond market investors neither reward nor punish states depending on their fiscal situations.

However, at the aggregate level, the state of state government finances has wider implications. It is in this context that the annual study of state government finances by the Reserve Bank of India (RBI) becomes important. The latest edition, published last week, shows that states missed the fiscal deficit target of 3% of gross domestic product (GDP) for the third year in a row. The fiscal deficit of states is estimated to be at 3.1% of GDP in 2017-18. This higher fiscal deficit at the state level in recent years has moderated the benefit of fiscal consolidation by the Central government. Higher borrowing, either by the Union or state governments, puts pressure on available financial resources and increases interest rates. India’s general government deficit is one of the highest among its peers.

To be sure, after the implementation of the fiscal responsibility and budget management rules in the last decade, state governments improved their finances significantly. While the deterioration in 2015-16 and 2016-17 was largely due to the takeover of debt of power distribution companies under the Ujwal Discom Assurance Yojana (Uday) scheme, government finances in the last fiscal were affected by factors such as a shortfall in revenue, implementation of pay commission recommendations and farm loan waivers. Some of these factors will continue to affect state government finances in the current year as well. As states aim to consolidate their finances by reducing the fiscal deficit to 2.6% of GDP in the current year, at least three broad issues are worth highlighting.

First, fiscal slippage in recent years has also led to deterioration in the quality of expenditure, with a rise in revenue expenditure. What this means is that higher fiscal deficits have not augmented state capacity, which can push growth. One reason for higher expenditure in the last fiscal, for instance, was a sharp rise in salaries. States employ more people than the Central government. Further, as per the revised estimates for 2017-18, debt waivers dented state governments’ budget to the extent of 0.32% of GDP. Put differently, if states had resisted populist farm loan waivers, their finances would have been in much better shape. Loan waivers are unlikely to benefit states in the long run. Studies have shown that while they reduce household debt, loan waivers do not help increase investment or productivity. On the contrary, formal financial institutions are reluctant to lend after loan waivers. This could make access to formal credit more difficult for some farmers. Expenditure on loan waivers also affects the ability of the state to undertake capital expenditure which can affect growth in the medium term. More announcements of debt waivers in the run-up to crucial assembly elections later this year and the Lok Sabha election next year could further reduce fiscal space for state governments.

Second, since state governments are increasingly raising resources from the bond market, higher issuance can complicate fiscal management. The share of market borrowing in the financing of fiscal deficit is expected to top 90% in the current year, compared with about 61% in 2015-16. The maturity profile of state government bonds shows that redemption pressure has started increasing since the last fiscal. Also, large bond issuances by state governments have resulted in a rise in the spread over Central government securities. Continued higher borrowing by states could further raise the cost of borrowing and affect their ability to undertake development work.

Third, the proportion of state deficits in the general government deficit has gone up in recent years. The RBI notes that in 2016-17, the general government sector pre-empted 68% of financial resources in the form of gross domestic households’ financial savings at about 9% of GDP. This has macroeconomic implications, as it is perhaps crowding out the private sector. Large general government borrowing keeps interest rates elevated and affects private investment. This is one reason why, despite the currency risk, large businesses tend to borrow from international markets. A sharp movement in currencies can always make debt servicing more difficult and also increase complexity in macroeconomic management.

Even though government finances should improve with the stabilization of the goods and services tax, India needs better fiscal management at both the state and Central levels to avoid crowding out the private sector. This will enable higher investment and help attain higher sustainable growth.

How can India reduce its general government deficit? Tell us at views@livemint.com

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