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Approach:

  1. Intro – current state of finances in States.
  2. Examine the reasons.
  3. Mention the risks that can emanate from poor finances.
  4. Conclusion – RBI suggestions to improve state finances.

According to a recent RBI study, 10 states have a significantly high debt burden. These include Punjab, Rajasthan, Kerala, West Bengal, Bihar, Andhra Pradesh, Jharkhand, Madhya Pradesh, Uttar Pradesh and Haryana. These 10 states account for around half of the total expenditure by all State governments in India.

Among the 10 states, Andhra Pradesh, Bihar, Rajasthan and Punjab exceeded both debt and fiscal deficit targets for 2020-21 set by the 15th Finance Commission. Further, ​​Punjab’s debt-GSDP ratio is projected to exceed 45% in 2026-27. Rajasthan, Kerala and West Bengal are projected to exceed the debt-GSDP ratio of 35% by 2026-27. So, the cumulative debt of States has risen from 19.1% in 2018-19 to 25.1% in 2021-22.

Reasons for high fiscal deterioration of states:

  • Declining Tax Revenue: The tax revenue of some of these states like Madhya Pradesh, Punjab and Kerala has been declining over time making them fiscally more vulnerable. Moreover, the revenue might fall sharply if the GST compensation is stopped from July 2022; e.g., significant part of Punjab’s guaranteed revenue was met using compensation (37% in 2018-19, 47% in 2019-20, and 56% in 2020-21).
  • High Revenue Expenditure: The share of revenue expenditure in total expenditure of these states varies in the range of 80-90%. This results in poor expenditure quality, as reflected in their high revenue spending to capital outlay ratios.
  • Significant Committed Expenditure: ​​Committed expenditure like interest payments (on debt), pensions and administrative expenses accounts for a significant portion (over 35%) of the total revenue expenditure in some of these states. For e.g., the interest payments exceed 20% of the Revenue Receipts of the Government like Haryana (23%), Punjab (21%), Tamil Nadu (21%).
  • High DISCOMs Losses: The combined losses of DISCOMs in the five most indebted states, viz Bihar, Kerala, Punjab, Rajasthan and West Bengal, constituted 7% of the total DISCOMs losses in 2019-20. While their combined long-term debt was 22.9% of the total DISCOM debt in 2019-20.
  • Freebie Culture: Political parties are outdoing each other by promising free electricity and water, laptops, cycles etc. These freebies constrain the fiscal position of State governments which can’t be easily taken back by succeeding governments.
  • Legal Loopholes: The current FRBM provisions mandate that the Governments disclose their contingent liabilities, but restricted to liabilities of explicit guarantee.
  • In reality, the State governments resort to extra-budgetary borrowings to finance their populist measures. This debt is concealed to circumvent the FRBM targets.

Risks flagged by RBI: The RBI study has also underlined several risks to State government finances, suggesting that most States would have a debt-GSDP ratio of over 30% by 2026-27.

  • These risks are: (a) Growing preference for distribution; (b) Some States reverting to the old pension scheme; (c) The guarantees extended to State-owned enterprises and the mounting debt of power distribution companies; (d) the off-budget borrowings of state governments have increased to about 5% of GDP; (e) The end of the compensation regime under the GST would further weaken the states’ fiscal position.

Suggestion by RBI: In the near term, State governments must restrict their revenue expenses by cutting down expenditure on non-merit goods. In the medium term, States need to put efforts towards stabilizing debt levels. In the longer term, States need to increase the share of capital outlays in the total expenditure. This will help create long-term assets, generate revenue and boost operational efficiency. Moreover, States also need to undertake large-scale reforms in the power distribution sector to reduce losses and make them financially sustainable and operationally efficient. Alongside, State governments need to conduct fiscal risk analyses and stress test their debt profiles regularly to put in place provisioning and other specific risk mitigation strategies.

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