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Why Punjab, Bihar, Rajasthan, Andhra, UP must learn from Sri Lanka, cut debt and freebies

At 53% in 2021-22, Punjab has worst debt-to-GSDP ratio. CAG data shows UP’s interest payments have grown by 6% in 5 years. Andhra’s outstanding debt hit Rs 3.89 lakh crore in 2021-22.

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New Delhi: On 4 April, Prime Minister Narendra Modi held a long meeting with secretaries of the central government and, among the many concerns raised at the meeting, the most oft-highlighted one was the poor health of state finances.

Officials told the PM that some Indian states could go down the same path as Sri Lanka if they did not discontinue the freebies announced during election campaigns and manage their finances better.

Sri Lanka is currently facing its worst economic crisis in history: The public has had to suffer long queues for fuel, cooking gas and essentials, and long hours of power cuts, for weeks now.

The Sri Lankan government said Tuesday it was going to default on its external debt of around $51 billion, pending a bailout from the International Monetary Fund (IMF). The island nation’s debt has soared to 102.8 per cent of its gross domestic product (GDP) in 2021, with a shortage of foreign exchange reserves to finance its external debt.

Although there is some fear that Indian states could face a similar situation if they do not bring down their debt in the next few years, it is technically unlikely for state governments to default on the debt repayments, as the Centre imposes strict limits on their borrowings. 

Also Read: Why Modi govt’s large borrowing plan this year will also pinch all ordinary borrowers 

The problem

On a general level, the Covid-19 pandemic is seen as the primary reason for a surge in debt levels of Indian states. However, the slowdown in economic activity had begun in 2018-19, nearly two years before the pandemic hit. 

There was a decline in states’ own tax revenues, which led to them borrowing more in order to finance their scheduled spending.

Another factor said to be responsible for the poor financial health of state governments is Centre’s Ujwal DISCOM Assurance Yojana (UDAY) scheme, which allowed the state governments that own power distribution companies to take over 75 per cent of these companies’ debt till September 2015, and pay back the lenders by selling bonds.

However, state-specific factors have also resulted in declining finances.

N.R. Bhanumurthy, vice-chancellor at the B.R. Ambedkar School of Economics University, Bengaluru, said that after the Fourteenth Finance Commission, states got a lot more flexibility in spending on developmental activities, but most of their spending went into populist schemes with slow growth in revenues.

 “You need to distinguish the reasons for poor fiscal health for different states as they all follow a different political cycle. Therefore, they all have different policies to adopt,” he said.

These reasons have resulted in high debt-to-GSDP (gross state domestic product) ratios. Debt-to-GSDP ratio signifies how healthy a state is in terms of funding its expenditure without accumulating future debt.

A cursory glance at the data on state finances from the Comptroller and Auditor General (CAG) shows that for some states, interest payments have grown faster than revenues in the last five years, creating a debt trap and making their debt unsustainable.

Punjab and Uttar Pradesh — both states that recently went to polls — announced populist schemes with such unsustainable debt, making matters worse.

Take Punjab, for instance. Before the Aam Aadmi Party (AAP) won the elections, it promised the people 300 units of free electricity a month for every household. In addition, it promised Rs 1,000 a month to every woman in the state. According to experts, even the most conservative estimates suggest that together these schemes would cost the exchequer an extra Rs 20,000 crore a year. This is when Punjab’s outstanding debt has risen by Rs 1 lakh crore in the last five years to Rs 2.82 lakh crore.

Luckily, Punjab’s interest payments have increased only 3 per cent in the last four years as compared to its revenues, which have grown by 9 per cent. However, at 53 per cent in 2021-22, Punjab has the worst debt-to-GSDP ratio among all the states in India.

Interest payment for a state or a country is the interest that must be paid back on the loan borrowed.

UP, where the ruling BJP promised to give free LPG cylinders, saw its interest payments rise faster than their revenues. CAG data shows that while UP’s revenues have increased only 5 per cent in the last five years, its interest payments have grown by 6 per cent.

The debt situation in some states like Bihar, Rajasthan and Andhra Pradesh is even worse. Andhra’s outstanding debt has hit Rs 3.89 lakh crore in the financial year 2021-22, registering an increase of almost Rs 40,000 crore compared to the previous year, accounting for 32.4 per cent of the gross state domestic product (GSDP). 

RBI’s warning 

In a report in November, the Reserve Bank of India (RBI), while reviewing states’ budgets, highlighted that the debt-to-GSDP ratio for 18 states and union territories has grown to 31.2 per cent from 22.6 per cent in the last 10 years, ending September 2021.

The Fiscal Responsibility and Budget Management (FRBM) committee headed by former revenue secretary N.K. Singh had mandated states to achieve a debt-to-GSDP ratio of 20 per cent by the financial year 2022-23.

The RBI report also said that market borrowing, which forms the largest component of the total outstanding debt of states and union territories, reached 63.6 per cent of their GDP by March 2022. Market borrowing is the loan that governments, whether central or state, raise by issuing market securities such as bonds.   

“As the impact of the second wave wanes, state governments need to take credible steps to address debt sustainability concerns. The combined debt-to-GSDP ratio is expected to remain at 31 per cent by end-March 2022,” the report said.

States with the highest debt-to-GSDP ratio in 2021-22 include Punjab (53.3 per cent), Rajasthan (39.8 per cent), West Bengal (38.8 per cent), Kerala (38.3 per cent) and Andhra Pradesh (32.4 per cent). 


Budgets for the current financial year presented by 13 large states — accounting for 80 per cent of India’s GDP — show that aggregate gross fiscal deficit (GFD) is set to ease to 3.3 per cent in 2022-23 as compared to 3.4 per cent in 2021-22, according to a March report by ICICI Securities.

As the economy recovers, states’ own revenues have seen an improvement aided by higher transfers made by the Centre on account of tax devolution. According to the recommendations of the Fifteenth Finance Commission, the Centre has transferred Rs 8.83 lakh crore in 2021-22, Finance Minister Nirmala Sitharaman said in Parliament. Along with that, the Centre also transferred Rs 1.59 lakh crore to the state government on account of Goods and Services Tax (GST) compensation.

These are some of the reasons why states have shied away from fully utilising their borrowing limits, the report said. For 2020-21, the Centre had enhanced states’ net borrowing limit from 3 per cent of GSDP to 5 per cent in 2020-21, which was the Covid-affected year. This meant that states could borrow up to 4 per cent of the GSDP unconditionally in any given fiscal, but must implement certain incremental reforms for the remaining 1 per cent.

States did not fully utilise this limit in 2020-21, the ICICI Securities report said.

Preliminary data suggests that states’ fiscal deficit was under 3 per cent in 2021-22 until January — much below the 4 per cent normal limit recommended by the Fifteenth Finance Commission. 

In 2017, the FRBM panel had suggested a limit for general government debt – the debt that both Centre and states raise — of 60 per cent of GDP by 2022-23. Within this overall limit, a ceiling of 40 per cent was adopted by the Centre and 20 per cent by the states. 

The way forward 

Bhanumurthy said there is a need for some kind of fiscal council or interstate mechanism that can ensure that FRBM limits on spending are strictly adhered to, along with ensuring the quality of expenditure.

“Efficiency in public spending should now become part of discussions. This can happen through tax-benefit models that look at how state resources can be best utilised,” he said.

There is also a need to establish outcome documents that will keep the state spending in check, he said. 

A. Prasanna, chief economist of ICICI Securities Primary Dealership, said states’ overall debt-to-GSDP can be brought down by two approaches. One is to have different policies for each state.

“There has to be a differentiated approach for different states,” Prasanna said. “The policy, for example, for Gujarat cannot be the same as for West Bengal because the starting conditions are different and their political economy is different. So different states cannot shrink their debt-to-GSDP ratio at the same speed.”

The second, he said, is for the Centre to raise government loans and pass them on to the state.

“Another approach, which can also be a long-term solution, is that whenever there is a review of FRBM rules for both Centre and states, the Centre should run higher deficits and take more debt than states,” he said. “What we have seen from the GST borrowings episode is that Centre has more ability to borrow compared to states. Progressively states should be asked to adhere to a lower cap on deficits and debt.”

(Edited by Uttara Ramaswamy)

Also Read: Why Modi govt will meet its tax targets this year without much effort despite slow growth


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