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How long can states sustain on Centre’s fiscal support and perpetual loans?

New sources of risk such as a return to the old pension system, and mounting overdue of power discoms could push many states to a fiscal precipice

November 18, 2022 / 11:21 AM IST
Representative image

Representative image

On April 3, India’s top bureaucrats reportedly told Prime Minister Narendra Modi that election freebies can lead to many states falling off a fiscal cliff, and remain snowed under mountains of debt, similar to what the Sri Lankan economy is currently going through.

In public finance, as it is for households, borrowing in itself is not a bad idea, if (a) the bulk of the loans are spent on asset-creation; and (b) loans are not taken to fund current expenditure on a perpetual basis.

As per the Reserve Bank of India’s ‘State Finances: A Study of Budgets of 2021-22’ report, the combined debt to GDP ratio of states which stood at 31 percent at end-March 2021 and is expected to remain at that level by end-March 2022, is worryingly higher than the target of 20 percent to be achieved by 2022-23, as per the recommendations of the FRBM Review Committee.

According to the Comptroller and Auditor General of India (CAG), the state governments’ expenditure on subsidies has grown at 12.9 percent and 11.2 percent during 2020-21 and 2021-22, respectively, after contracting in 2019-20. This has pushed up the share of subsidies in states’ total revenue expenditure from 7.8 percent in 2019-20 to 8.2 percent in 2021-22.

A report by Crisil, a credit rating and research organisation, shows that off-balance-sheet borrowings of states are estimated to have reached a decadal high of more than 4.5 percent of gross state domestic product (GSDP), or Rs 7.9 lakh-crore, in 2021-22. That marks a rise of more than 100 basis points from 2019-20.

New sources of risks have emerged — re-launch of the old pension scheme by some states; rising expenditure on non-merit freebies; expanding contingent liabilities; and the ballooning overdue of power distribution companies — warranting strategic corrective measures.

The power sector — primarily distribution companies (discoms) — account for almost 40 percent of the outstanding state guarantees. These were taken to repay the dues of power generation and transmission companies with discoms continuing to make cash losses. With most of them expected to continue reporting losses this fiscal as well, due to higher input (mainly coal) costs, states will have to provide higher support for timely servicing of the guaranteed facilities.

As early as May 2019, the Reserve Bank of India (RBI) had flagged concerns about severe fiscal stress emerging in state finances for a variety of reasons. The RBI warned of the rising risks to fiscal consolidation of the states as their finances are saddled with farm loan waivers, income support schemes, and the Uday bonds for their power distribution companies.

A return to the old pension scheme (OPS) has evolved into a political rallying point during the ongoing assembly elections. Last month, the Punjab government took an in-principle decision to restore the OPS for its employees. The Congress and the Aam Aadmi Party (AAP) have made old pension scheme restoration demands a major poll plank in Gujarat. The Congress has also vowed to bring back the OPS if it returns to power in Himachal Pradesh.

The OPS is mainly an unfunded pay-as-you-go system. Pension expenditure alone accounts for 12.4 percent (average of 2017-18 to 2021-22) of total revenue expenditure of India’s 10 most-indebted states. According to the RBI’s estimates, the pension outgo will continue to be in the range of 0.7-3 percent of GSDP in these 10 states until 2030-31.

As the current state government retirees are primarily the beneficiaries of the old pension scheme, the immediate financial strain will not be felt if the states choose to revert to the old pension scheme. However, when state government employees who joined after 2004-05 under the NPS begin to retire from 2034 onwards, the cost of such a move will become apparent. “In other words, the adoption of the old pension scheme is likely to benefit the current generation at the expense of future generations”, the RBI has said in a June paper.

The Centre’s Goods and Services Tax (GST) compensation payout that came to an end in June, has further reduced states’ fiscal headroom for social sector spending. Many states can see their finances worsen if they start financing a range of non-asset creating social welfare schemes or ‘freebies’ by borrowing more from the market.

According to a study by PRS Legislative Research, during 2018-21, most states have relied on compensation grants to achieve the guaranteed revenue. This, while in 2018-19, states were able to achieve 88 percent of the target on their own and relied on compensation for only 12 percent.
Gaurav Choudhury is consulting editor, Network18.
first published: Nov 18, 2022 11:21 am