RBI Flags States’ Fiscal Stress

• 13 Jul 2018

RBI, in its annual report titled “State Finances: A Study of Budgets of 2017-18 and 2018-19”, warned that many States may face fiscal risks due to farm-loan waivers, Pay Commission awards and elections.

Highlights of the Report

• States’ consolidated gross fiscal deficit (GFD) overshot the budget estimates in 2017-18 due to shortfalls in own tax revenues and higher revenue expenditure and therefore states revised their gross fiscal deficit (GFD) to gross domestic product (GDP).
  • The GFD-GDP ratio crossed the revised Fiscal Responsibility and Budget Management (FRBM) target for the state-level debt to GDP threshold for third consecutive year. There is a risk that private investment gets crowded out of the finite pool of financial resources.
  • Capital expenditure may have to bear the brunt of the fiscal correction like the past two years.

Fiscal Responsibility and Budget Management (FRBM) Act, 2003

• The FRBM Act was enacted by the Parliament in 2003 to institutionalize fiscal discipline, reduce fiscal deficit, and improve macroeconomic management.
• The government was supposed to wipe out revenue deficit and cut fiscal deficit to 3% of GDP by 2008-09, thus bringing much needed fiscal discipline.
• Fiscal deficit is the total expenditure excluding revenue receipts, loan recoveries and receipts from disinvestment etc. It is a measure of the government borrowing in a year.
• The Act applies only to the central government and the States have to enact suitable legislations to adopt the rules under the FRBM Act.
• The implementation of the Act was put on hold in 2007-08 due to global financial crisis and the need for fiscal stimulus.
• In 2012, the FRBM Act was amended and it was decided that the FRBM Act would target effective revenue deficit in place of revenue deficit.
• Effective revenue deficit excludes capital expenditure from revenue deficit and thus provides space to the government to spend on formation of capital assets.
• In 2017, The FRBM Review Committee headed by former Revenue Secretary, NK Singh submitted its report to the Central Government. Few important recommendations being- A debt to GDP ratio of 60% should be targeted with a 40% limit for the centre and 20% limit for the states; creation of an autonomous Fiscal Council; an “escape clause”, i.e. the government can deviate from the targets in case of a national calamity, national security.

• Referring to the aftermath of the 2008 global financial crisis, when States borrowed big from markets, mainly due to the additional fiscal space given to them as part of stimulus measures, the RBI said several 10-year vanilla bonds had reached maturity from 2017-18, increasing redemption pressures on the States that issued them.
• This would imply that the borrowings of States are expected to soar.

Vanilla Bonds: They are the most basic or standard version of bonds. It is the opposite of an exotic instrument, which alters the components of a traditional financial instrument, and is more complex.

• The issuance of UDAY (Ujwal Discom Assurance Yojana) bonds in 2015-16 and 2016-17, farm-loan waivers and the implementation of Pay Commission awards which were not fully provisioned for in their respective budgets led to a higher debt-GDP ratio at 24 per cent in 2017-18, which is expected to rise to 24.3 per cent in 2018-19.
• Farm loan waivers create a more long term issue i.e. of impacting credit discipline by disincentivizing borrowers from repaying and giving rise to a problem of moral hazard. The bigger issue is that such a step actually incentives debtors, capable of repaying loans, to also default.
• Debt relief helps in reducing household debt but there are no evidences of increase in investment and productivity of beneficiary households.
• However, RBI has highlighted few positives as well as suggestion for the future:

• In 2018-19, states’ revenue capacity is likely to be augmented with the stabilization of GST and the consequent expansion of tax base and efficacy.
• With the implementation of the E-way bill for inter-state movement of goods from April 2018, states could also strive for generating more revenues by locking inefficiency in tax administration.
• According to the RBI study, there are visible signs of fiscal pressures emerging in several states, particularly due to certain expenditure schemes.
• These schemes could be made more productive by closing ‘efficiency gaps’, better targeting/ reducing leakages and careful planning as well as better forecasting.
• Enhanced efficiency must be coupled with improved public financial management practices may be necessary to rebuild fiscal space.