In its policy statement released last week, the monetary policy committee (MPC) of the Reserve Bank of India (RBI) pointed out that the implementation of farm loan waivers across states could hurt the finances of states and make them throw good money after bad, and stoke inflation.

How much of an impact will the waivers have on the Indian economy?

A Mint analysis suggests that the cumulative impact of farm loan waivers is likely to be lower than that of the power-restructuring package, Ujwal Discom Assurance Yojana (UDAY), unless they are extended to all Indian states. However, the debt waiver packages, even if limited to a few states, will likely prove to be counter-productive and offer little gains to farmers over the long run.

So far, three major states—Uttar Pradesh (UP), Punjab and Maharashtra—have announced large-scale farm debt waivers. The debt waiver packages of UP and Punjab were aimed to fulfil poll promises made by the Bharatiya Janata Party (BJP) and the Congress party, respectively, in these two states. The cumulative debt relief announced by the three states amounts to around Rs77,000 crore or 0.5% of India’s 2016-17 GDP.

UP’s debt waiver of Rs36,400 crore is equivalent to one-fourth of the total estimated farm debt in the state. Punjab’s debt waiver worth Rs10000 crore is equivalent to less than one-seventh of the total estimated farm debt in the state. Maharashtra’s farm debt waiver appears slightly more generous as it appears to cover almost one-third of the state’s farm loans.

If poll-bound states—including Gujarat, Karnataka, Rajasthan and Madhya Pradesh— too announce farm debt waivers and extend it to one-third of farm loans in their respective states, then the aggregate amount of farm debt waivers before the 2019 elections would balloon to Rs2 trillion, or 1.3% of India’s GDP.

The Rs2 trillion hit to state finances is not a small amount but it is lower than the fiscal burden of the UDAY scheme, which originally envisaged states to take over Rs3 trillion of discom (distribution companies) debt. As of now, the UDAY website shows that 15 states have pledged to issue bonds worth Rs2.7 trillion, or 1.8% of India’s GDP.

This means that the current cost of debt waivers, though large, is not yet alarming. But what if all states, and not just the poll-bound ones, decide to waive farm loans, and extend it to half of all farm debt rather than just one-third? In such a case, the total waiver amount will substantially increase to Rs6.3 trillion or around 4% of the GDP.

The extreme case of 50% farm debt waiver should raise concerns as it will worsen states’ debt-to-GDP ratio by 4 percentage points on average. This will jeopardize India’s stated aim to reduce its total public debt, Centre and states combined, to 60% of the GDP.

State-wise outstanding farm debt has been estimated by using available break-up (for previous years) of agricultural loans extended by scheduled commercial banks and regional rural banks. The estimates thus obtained have been scaled up to the total value of institutional farm loans at Rs12.6 trillion. This figure was cited by Union minister of state for agriculture Parshottam Rupala in November last year in response to a question on farm debt.

While the effect of increased public debt will play out over the long run, the increased interest burden due to higher debt will hit state finances immediately. Even if we assume a benign scenario, where debt waiver amounts to only one-fourth of all farm debt, as in the case of Uttar Pradesh, the aggregate interest payment burden of states will rise by 8% (over their 2016-17 levels). Interest payments of states are already quite high, and often eclipse their spending on important infrastructure areas such as roads and irrigation.

The impact on state finances could have been justified had the waivers provided meaningful relief to India’s distressed rural economy. But that is unlikely to happen since the poorest farmers in India typically rely on non-institutional sources of credit, as a previous Plain Facts column pointed out. Instead, as the experience of 2008 shows, farm loan waivers can discourage subsequent lending by banks in districts with greater exposure to the debt waiver, harming farmers over the long run.

Given that farm loans will be transferred from the assets side of banks’ balance sheets to the liabilities side of government’s books as part of the waivers, will distressed banks gain from such moves? Not much, according to a review into the non-performing asset (NPA) portfolio of banks.

Banks might gain in the short run as their loan book gets lighter and they get rid of some non-performing assets. But such waivers and their anticipation in future would damage credit culture. It is not surprising that after the farm debt waiver in 2008, the drop in banks’ agricultural bad loans or NPAs lasted for barely a year before rising sharply once again.

But to put things in perspective, the share of agricultural loans in the total basket of NPAs today is low. In fact, banks with more NPAs tend to have a smaller share of agricultural loans in total NPAs, as the chart below shows. This means that even temporary relief for stressed banks will be quite modest.

Given that the promise of farm waivers have seemed to help both the Congress and the BJP win in Punjab and Uttar Pradesh, respectively, it is likely that India’s political class will increasingly adopt this option in the run-up to the 2019 Lok Sabha elections.

But the above analysis suggests that such waivers are unlikely to help the cause of either distressed farmers or troubled banks over the long run. And they may well impair the quality of public spending by states, as the central bank fears.

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