Many Indian states mirror costly debt slip-ups that rattled Sri Lanka

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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.

The analogy with Sri Lanka can be useful, if the analysis is limited to the state of public finances. Unlike Sri Lanka, Indian states are not sovereign nations. That said, there are a few aspects that have a striking resemblance.

The Sri Lankan economy collapsed into a debt default in May, pummelled by the pandemic, tourism income fell to a trickle, merchandise exports of textiles and tea fell in a heap as shipment orders dried out to COVID-19, and non-resident remittances shrank as the global slowdown hit incomes.

While many of these factors were exogenous, there were some internal public finance missteps that contributed to accelerating the economy’s march to the fall from the precipice.

As a recent Reserve Bank of India paper pointed out, the public policy slip-ups in Sri Lanka included a sharp cut in direct and indirect taxes just before the pandemic; shift to organic farming by imposing total ban on the use of chemical fertiliser and pesticides to save on fertiliser subsidy, but with severe effect on rice output and productivity of the plantation sector that resulted in a spike in food inflation and shortages of essentials; and ambitious infrastructure projects funded by costly Chinese debt.

How do Indian states fare in terms of macroeconomic prudency, and public finance management? Let’s assess a few data points. First, the debt situation. A standard way to scrutinise this is to examine the trends in gross fiscal deficit (GFD), a shorthand to find out how much a state borrows to fund its expenses.

For eight years, the better part of the last decade, during 2011-12 to 2019-20, the average GFD to GSDP (gross state domestic product) ratio remained at a manageable 2.5 percent, well within the Fiscal Responsibility Legislation (FRL) ceiling of 3 percent.

That said, it is important to bear in mind that the headline national average of states GFD/GSDP ratio masked strong inter-state variations. States such as Andhra Pradesh, Kerala, Punjab, and Rajasthan incurred an average GFD of above 3.5 percent of GSDP, while Assam, Gujarat, Maharashtra, Odisha, and Delhi contained it well within 2 percent.

The balance sheets, however, start deteriorating sharply from 2020, hit by the global pandemic, leading to mounting debt levels, and worsening expenditure management.

The RBI has identified 10 states — Punjab, Rajasthan, Kerala, West Bengal, Bihar, Andhra Pradesh, Jharkhand, Madhya Pradesh, Uttar Pradesh, and Haryana — to be the states with the highest debt burden. These 10 states account for around half of the total expenditure by all state governments in India.

According to this year’s (2022-23) budget estimates, Andhra Pradesh’s total debt is projected at 32.8 percent of its GSDP, Bihar at 38.7 percent, Kerala at 37.2 percent, Madhya Pradesh at 33.3 percent, Punjab (2021-22) at 53.3 percent, Rajasthan at 39.8 percent, Uttar Pradesh at 32.5 percent, and West Bengal at 34.2 percent.

A useful way of analysing the state of finances is also to examine what proportion of earnings or revenues are spent on paying interests on loans. Other things remaining the same, a higher slice of earnings have to be set aside for paying interest rates would imply a shaky fiscal situation.

In many states, this doesn’t present a happy picture. Punjab, for instance, spends 21.3 percent of its revenue receipts on interest payments, Tamil Nadu 21 percent, West Bengal 20.8 percent, and Haryana 20.9 percent.

The health of power distribution companies (discoms), and the guarantees that many state governments have extended for loans that these discoms have taken to pay off generation and transmission companies has also raised risks.

In 2020-21, such loans for 16 states stood at Rs 1.36 lakh-crore, which have been guaranteed by state governments. The combined losses of DISCOMs in the five most-indebted states (Bihar, Kerala, Punjab, Rajasthan, and West Bengal) constituted 24.7 percent of the total DISCOMs losses in 2019-20.

Any default by the discoms in repaying these loans will only add to the mountain of state governments’ debt as the liabilities will cascade through to them because of the guarantees. The fiscal risk, therefore, for states, is very high.

The states require comprehensive fiscal reforms with strict adherence to macro prudential norms to service their debt obligations. This would involve driving a strict distinction between welfare programmes that have strong positive externalities, and freebies that follow an electoral calendar only.