PUBLIC DEBT OF STATES SINCE 1950

PUBLIC DEBT OF STATES SINCE 1950 The steady accumulation of debt and the growing interest burden feeding back into its accumulation raises serious questions about debt sustainability at the state level in India and constrains the ability of the central government in its macroeconomic management of the economy. Growing debt-servicing burdens reduce the resources available for the provision of public services by state governments.

Article 293 of India's Constitution empowers the states to borrow within India upon the security of the consolidated fund of the state and to extend guarantees within the limits fixed by the state legislature. Thus, the states can borrow from the central government, and the latter can extend guarantees of loans raised by any state. The states can also borrow from the market within India, but if a state is indebted to the central government, it must seek the latter's consent. All the states are indebted to the central government, and therefore, states' market borrowing each year is determined by Ministry of Finance in consultation with Delhi's Planning Commission and the Reserve Bank of India.

Loans from the central government have increased mostly in order to finance five-year plans. In the plan assistance given by the central government to the states, until 2004–2005, 70 percent was given as loans and the remaining amount as grants. From 2005–2006, the central government has stopped giving loans the states based on the recommendations of the Twelfth Finance Commission (India, 2004). From 2005–2006, the states are required to access funds for their plans mainly from the market. The states also get temporary accommodation from the Reserve Bank of India as ways and means advances. Before 1985 the states accumulated loans in this category as well, and the central government converted the overdrafts into medium-term loans. Since 1985, however, the overdraft regulation program was established, in which the central government disallowed continuous overdraft facilities for more than seven working days, the violation of which could invite dishonoring the states' checks. The present overdraft regulation limit is fourteen continuous working days, and a total of thirty six days in a quarter.

Thus, the Constitution envisages a hard budget constraint at the state level. However, the states have adopted a variety of means to soften the constraint. An important means used for this is to increase the liability in public accounts, particularly provident funds and small savings collections. Until 1998–1999, this was considered part of the loan from the central government. However, in 1999–2000, the National Small Savings Fund was created, and any loan from the fund is now treated as part of a state's internal debt. Since this source is uncapped and the central government has no control over it, the states have expanded their borrowing from this source.

In recent years, loans from banks and financial institutions have become an important source of state borrowing. These loans include borrowing from the Life Insurance Corporation of India, the General Insurance Corporation, the National Bank for Agriculture and Rural Development, the Rural Electrification Corporation, the Housing and Urban Development Corporation, the Industrial Development Bank of India, and other financial institutions. With the erosion of resources available for capital investment, these institutions have emerged as supplementary sources to finance infrastructure.

In recent years, off-budget borrowing also has become an important source of state liabilities. Many states resorted to borrowing through the public enterprises under their control, enabling them to float bonds by providing guarantees. Some states have floated special purpose vehicles to finance infrastructure projects, such as irrigation. These are contingent liabilities, and although they do not form an integral part of the states' debts, they carry a high degree of fiscal risk.

The aggregate indebtedness of India's states increased from a mere 3.8 billion rupees in 1950–1951 to nearly 7 trillion rupees in 2001–2002, or about 1,765 times. As a percentage of gross domestic product (GDP), states' indebtedness increased from a mere 3.9 percent in 1950–1951 to over 25 percent in 2001–2002. The increase in states' indebtedness in the initial years of independence was a concomitant of India's planned development strategy, but later increases in indebtedness were mainly to finance current expenditures.

Recent Developments

An important development in recent years has been the emergence of multilateral lending to the states. Though state governments cannot have direct access to loans from multilateral institutions, in recent years they have been allowed to negotiate loans contracted by the central government and passed on to the respective states as additional central assistance, by recasting the original terms of the loans. However, even after taking into account these multilateral loans, the share of central loans in total indebtedness of states has shown a steady decline, from 67 percent in 1990–1991 to 45 percent in 2000–2001, and this reflects the central government's own resource constraint.

Considering that there are constraints on all the states' borrowing powers, increase in their indebtedness during the 1990s mainly came about through borrowing from financial institutions and banks on the one hand, and increasing small saving loans on the other. Outstanding loans from banks and financial institutions increased from just about 2.6 percent of total loans in 1990–1991 to 6.5 percent in 2000–2001. Similarly, loans from small savings and provident funds increased from 15.4 percent to 18.5 percent during the same period. In absolute terms, outstanding loans from banks and financial institutions increased from 29 billion rupees in 1990–1991 to 322 billion rupees in 2000–2001, and liabilities from public account (small savings, provident funds, etc.) increased from 170 billion rupees to 920 billion rupees during the period. The increase in loans has been particularly sharp after 1997–1998, as many of the states impounded part of the additional emoluments and arrears in salaries in their provident funds or small savings certificates. In these sources, the central government cannot exercise any control over borrowing, and thus the states find an easy way to overcome hard budget controls.

Another important means adopted by the state governments to soften their budget constraints is to borrow through public enterprises under their control by enabling them to float bonds against state government guarantees. The contingent liabilities of the states are not fully recorded, and the available information shows that they have shown a sharp increase from 526 billion rupees in 1995–1996 to 1,687 billion rupees in 2000–2001. As a percentage of GDP, the contingent liabilities of the states increased from 5.7 percent in 1990–1991 to 7.2 percent in 2001–2002.

The attempt by the states to soften budget constraints by borrowing from sources not capped and controlled by the central government has steadily increased the average effective interest rate. The average interest rate on states' borrowing increased from 3.8 percent in 1960–1961 to 9.2 percent in 1990–1991, and increased further to 13.2 percent in 1999–2000 before tapering off at 12.5 percent in 2000–2001. The interest rate on small savings also reached a peak of 14 percent in 1998–1999, but was subsequently reduced to 9.5 percent by 2004. The rate of interest on central loans increased from 7.5 percent in 1984–1985 to 15 percent in 1995–1996, and thereafter was reduced to 10.5 percent by 2004. The interest rate on market borrowings is the lowest. Until the beginning of the 1980s, the rate of interest was kept artificially low. As part of the financial sector reforms, interest rates on government loans was aligned to the market rate, gradually reaching a peak of 14.2 percent in 1995–1996, and declining thereafter to 6.2 percent by March 2003.

The sharp increases in the indebtedness of India's states as well as increases in average rates of interest have increased the debt service burden and have raised serious questions concerning debt sustainability. The fact that the proportions of loans in plan assistance is much higher than the proportion of capital expenditures indicates a lack of viability in the system of central loans to the states. Furthermore, the attempt by the states to soften budget constraints by contracting loans bearing high interest rates only adds to the problem. In fact, the debt to gross state domestic product (GSDP) ratio in some states, notably Punjab, Uttar Pradesh, and Orissa, is in excess of 25 percent, and more than 30 percent of those states' revenues are spent on interest payments. Similarly, the debt-GSDP ratio in Rajasthan and West Bengal is more than 25 percent, and their interest payments are in excess of 20 percent of their own revenues. The problem is equally severe in the state of Bihar and the special category states of Arunachal Pradesh, Himachal Pradesh, Jammu and Kashmir, Mizoram, Nagaland, and Sikkim, where more than 50 percent of their own revenues are spent in debt servicing.

Concerned at this serious problem of debt in so many of the states, the central government initiated a debt swap policy in 2004, under which high-interest borrowing of the past is repaid by borrowing at prevailing lower interest rates, thereby reducing the overall interest burden on the states. This will bring some relief, but the long-term solution to the problem of increasing state indebtedness will require changing the structural nature of state finances.

Another important development in the states' borrowing scene is the discontinuation of the practice of central government's lending to states. Based on the recommendation of the Finance Commission, the central government has discontinued the practice of lending to states for financing plans and instead the states have been asked to access the markets. This is likely to create transitional problems in the coming years as the primary debt market is still in its infancy. In addition, many states do not have the credit worthiness and the Reserve Bank of India and the central government will have to persuade the banking system to subscribe to the papers of these states.

M. Govinda Rao

See alsoState Finances since 1952

BIBLIOGRAPHY

Favaro, Edgardo M., and Ashok Lahiri, eds. Fiscal Policies and Sustainable Growth in India. New Delhi: Oxford University Press, 2004.

Rao, M. Govinda, and Raja Chelliah. Fiscal Federalism in India. New Delhi: Indian Council of Social Science Research, 1996.

Rao, M. Govinda, and Nirvikar Singh. Political Economy of Federalism in India. New Delhi: Oxford University Press, 2005.

Report of the Twelfth Finance Commission (2005–10). Ministry of Finance, Government of India, 2004.

Srivastava, D. K., ed. Fiscal Federalism in India—Contemporary Challenges: Issues before the Eleventh Finance Commission. New Delhi: Har Anand Publications, 2000.