Financial discipline a must for states

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Financial discipline a must for states

Monday, 01 August 2022 | Uttam Gupta

Financial discipline a must for  states

The Centre has to crack the whip on growing trend of states going for excessive borrowings else it could lead to a major financial crisis 

In recent years, indiscriminate borrowings by entities of the state governments, leveraging guarantees, has raised alarm bells. In June, 2022, the Reserve Bank of India (RBI) lambasted banks, mostly public sector banks (PSBs), for lending to such entities based on the escrow of the states’ future revenue streams or using collectorates and courts as security.

The RBI sought a review of such lending practices by the bank boards and reported compliance by September, 2022. The Union Finance ministry was more emphatic, seeking an end to the practice. The warning is a follow up to a letter from the Centre to the States last year pointing out that pledging of future tax revenues was in violation of Article 266 (1) of the Constitution, which mandates that all taxes and loans should flow into the Consolidated Fund of the State (CFS).

It is not as if the States are unaware of this provision. Yet, the states, including Andhra Pradesh (AP), Uttar Pradesh (UP), Punjab, Madhya Pradesh (MP) and Himachal Pradesh (HP), have made well-orchestrated moves to ensure that their entities get the loans. For instance, in AP which cornered a major chunk of the bank loan, the State government had transferred assets to the AP State Development Corporation (APSDC) to raise funds.

In 2020, Andhra Pradesh even enacted a special law to provide statutory status to APSDC for assignment of the identified ARET (additional retail excise tax) revenue to undertake specific social and developmental activity.

This paved the way for India Ratings -- the rating agency -- to rate APSDC based on “unrestricted pledged revenue” on (ARET) levied by the AP government. Armed with an assurance that cash flowing from the levy would be used for servicing the loan, eight banks, including the State Bank of India (SBI), gave loans.

Ironically, the state government enacted the legislation despite the Centre pointing out that some of its provisions were not in sync with Article 293 (3) of the Constitution, which mandates that states cannot borrow without the Centre’s permission.

A state agency or corporation whose majority ownership and control rests with the state government or a special purpose vehicle (SPV) floated by it raises loans for the purpose of implementing its welfare programs and development projects. Having raised the loan, although technically, the corporation/SPV/agency has to pay it back, the money has to come from the state government on whose behalf and directions, it has taken the loan.

This leads to an anomalous situation whereby the state government is servicing a loan which is not on its books.

But why does it allow such a situation to develop? Why does it not borrow itself and reflect the loan amount in its books?

Indeed, this is the logical way to go. But, it doesn’t suit the mandarins in the state finance department. Instead, they prefer an arrangement whereby the loan is taken by the corporation/SPV/agency and shown in the latter's books. This way, they manage to under-report State’s borrowings or its fiscal deficit (FD), thereby circumventing the Fiscal Responsibility and Budget Management (FRBM) Act, which requires a State not to let its FD exceed three percent of its gross domestic product (SGDP).

In other words, the state can continue to borrow in excess of the three per cent cap through its entities and yet remain compliant with the discipline under FRBM. Glamorously termed as off-budget liabilities or OBLs, the States use such borrowings to hide their fiscal profligacy -- a blatant manifestation of this particularly in recent years being the ‘freebies’ (a euphemism for benefits distributed by political parties using public money for garnering votes) promised in elections. This has even come in for strident criticism from the Supreme Court (SC). Hearing a PIL on July 26, 2022, the SC has asked the Union Government to come up with measures to put an end to this cult.

What can the Centre do to rein in OBLs?

Being the owner of PSBs, the Centre can always issue diktat to them for not giving such loans. But it is easier said than done. Nothing prevents the state government from getting loans sanctioned citing the ability of its entities to pay back. For instance, APSDC got the money citing “unrestricted pledged revenue” on (ARET) levied by the AP Government for which the former had full legal backing.

That the banks continued to extend loans to state corporations/agencies even after the Union Finance ministry flagged its concern last year and has to give reminders even now shows that the diktats to PSB managements is not working.

In the current session, Finance Minister Nirmala Sitharaman has told Parliament that “in future, off-budget borrowings of state governments -- made through State corporations or SPVs, where the principal and/or interest are to be serviced out of the budget or by assignment of taxes/cesses or any other state revenue -- will henceforth be considered part of the State’s own borrowings”.

Put simply, all borrowings of the state, including OBLs, must not exceed 3 per cent of the SGDP. This is a welcome move. It will make things transparent and help in enforcing fiscal discipline. However, to reduce the pain of States in making this transition, the Centre may consider raising the cap on borrowings to say 3.5 per cent.

On its part, the Union government has sought to address its own OBLs. During 2020-21, it spent a record Rs 525,000 crore on food subsidy, which apart from paying for the cost of giving free food to over 800 million persons under Pradhan Mantri Garib Kalyan Anna Yojana (PMGKAY), was used to pay back all dues (Rs 3,30,000 crore as on March 31, 2020) of Food Corporation of India (FCI) to the National Small Savings Fund (NSSF). Such loans were taken by FCI from NSSF since 2016-17 to finance the unpaid food subsidy dues from the Centre.

Likewise, the Centre spent Rs 138,000 crore on fertilizer subsidy during 2020-21, nearly 50 per cent of which was used to clear all deferred subsidy payments (DSPs) to manufacturers. During 2021-22, it made full provision in the budget to pay for all expenses on food and fertilizer subsidies. During 2022-23 also, it is making adequate allocation to leave no room for any off-budget borrowings.

It has also cleared the past borrowings of the National Highways Authority of India (NHAI). For the future, the Centre is not contemplating any borrowing by NHAI on its behalf. Making the state of Union’s finances transparent is fine. But, this should be accompanied by fiscal discipline. Sadly, this is not the case here.

For instance, during 2020-21, the FD turned out to be 9.2 per cent of GDP, 2.5 times the budget estimate (BE) of 3.5 per cent, which itself was 0.5 per cent higher than the 3 per cent threshold required by the FRBM. During 2021-22 also, at 6.7 per cent, FD was high considering that the year was not impacted much by Covid-19 and growth in nominal GDP was pretty high at around 20 per cent.

To conclude, both the Centre and states must make their finances transparent by including off-budget borrowings in budgetary statements. While the former has already started doing it, the latter should follow suit. At the same time, both should endeavor to ensure that their FD remains well within the threshold prescribed under the FRBM.

(The writer is a policy analyst. The views expressed are personal.)

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