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The state governments' precarious finances

R Ravimohan

Financial affairs at most of the state governments are troubled. Many are stretched such that they are unable to meet their running expenses.

Some are reaching crisis points where they are beginning to default on debt obligations. The luxury of investing in capital programmes has not been afforded by many states for many years now. There is more bad news to come.

The revenues are stagnant for most states, giving much discomfort for future, especially as the outflows are most certainly likely to mount on many accounts.

Notably, interest and debt repayment obligations, pension liability and subsidy payment have been rising alarmingly.

Thus the deficit levels are predicted to only worsen over the next several years. In the absence of any 'equity' these deficits will be funded by further debt, leading to more interest burden and further deficits. Some numbers will sharpen this argument.

In a study conducted by Crisil, the combined revenue deficit as a proportion of their combined revenue increased sharply from 11.7 per cent at the end of 1997 to 22.4 per cent as estimated at the end of March 2001.

What has caused this situation and what can be done about it?

While the Centre has been reining in its deficits, the states have become more profligate in this matter, right through the past decade.

Maybe the coalition politics has something to it. But it is clear that over the past decade, the state has gleaned more political power over the central control agencies.

While there have been little visible structural relaxations, states have been able to transcend both the fiscal responsibilities and the debt levels prescribed by these central agencies through political wrangling, innovative extra-budgetary borrowings and special purpose vehicles.

The laxity in fiscal matters is visible both in the revenue and the expenses side of the budgets. There have been little efforts to top up the shrinkage in revenue of taxes caused by industrial slowdown and distress.

What was needed was to restore the gap caused by the challenges faced by the industry with newer taxes on emerging areas.

However, the emerging areas have been in the tertiary sector (service oriented). There is still not much clarity on how these ought to be taxed. There are also signs of deteriorating efficacy of collection of taxes and cess. Thus the states efforts to shore up revenues have been short on innovation and diligence.

Rather than tighten the belt, most states have expanded their revenue expenditure. While there has been a seminal increase in the revenue expenditure, the Fifth Pay Commission recommendations for the Central Government were adopted by most states, with adverse impact on their finances, from which most states are yet to recover.

Parastatal entities especially in the power and road transportation sectors have been additional burdens that most states have had to contend with.

In some states various agriculture (for procurement of cotton, soyabean, et cetera) and housing schemes have been run on non-economic paradigm adding to the subsidies doled out by the state.

The power sector losses due to theft of electricity, unremunerative agricultural tariff, inefficient operation of State Electricity Boards and increasing regulatory risks have grown so big as to not only bankrupt the SEBs but also contribute substantially to the states financial distress.

Likewise, unremunerative fares charged by the State Road Transport Corporations lead to perennial losses and financial burden to the state exchequer.

Many states have also created special purpose vehicles, which raise borrowings at market rates of interest to invest moneys in infrastructure projects, which do not yield any worthwhile financial returns.

These borrowings are eventually met out of states resources and therefore are legitimately to be counted as states debt.

As a result of these cumulative burdens that have impinged on the states finances over several years, states have piled up huge liabilities. Essentially these were being managed by fresh borrowings for the past several years. So what is happening now?

The latest problem to face the state is the sequential drying up of avenues of financing. Pension, provident and insurance funds, nationalised banks, co-operative banks, Hudco, debt investors (both institutional and retail) and multilateral agencies were the main sources that have been traditionally tapped by the state governments over the past several years.

There have been several regulations including those mandating investments by special investor classes such as pension funds, charity trusts, non-profit organisations, cooperatives and banks into state government papers that have helped state governments garner funds.

However, over the past year, many of these sources have grown increasingly uncomfortable investing in state government papers.

Therefore the sources have been drying up one after the other. Currently the only investors in state government papers are the pension, provident and insurance funds and banks which are mandated to invest in them.

This development has obviously caused many problems for the state government treasuries to make the ends meet, while increasing the risks for the residual mandated investors.

They are valiantly trying to manage by postponing any payment that can be postponed, to meet those important liabilities such as debt obligations. However, these are mere tactics that are being employed to live for the day.

There is little evidence of any concerted efforts to set right the fundamental problems that have led the state governments to this mess. The states would of course attempt to get greater allocation from the Centre.

However, the Centre has been a lot more conscious of its deficit management responsibility, and has managed to stabilise the deficit levels to around 5.5 per cent over the past five years. Not to say that this is comforting.

The Centre itself needs to reduce its deficit by at least half, and therefore will be hard put to come to the states' rescue in any substantial way.

There could be some concerns that may be raised regarding the sagacity of continuing mandated investments in state government papers. If these mandates are withdrawn or diluted, it will surely put greater pressure on the governments.

The governments have run out of most of its option to soft peddle the reforms to set its house in order. It needs to set the following programme in force to get over the problem in a more enduring and sustainable basis.

The alternative will be to lurch from one crisis to the other, with all development put in a state of suspended animation.

It needs to privatise all that can be privatised at the earliest. This not only includes the state level PSUs but also such organisations that are undertaking potentially commercial activities such as power and transportation.

It must introduce logical and reasonable cost recovery for all the services it provides and introduce fail-safe systems to increase the collection effectiveness.

It needs to reduce the subsidies towards cash crop procurement, housing projects and distribution of food and clothes.

It must rationalise power tariff and set up metering systems to strengthen collection of electricity bills. It must also progressively sell-off all segments of electricity sector to generate good value for the state treasury.

It must also take a hard look at its head count and reduce the size of its government. Finally, it must include a larger base for taxation to resume the long-last buoyancy in its revenue inflows.

These measures will ultimately restore the confidence of the market in the states ability to be much more disciplined financially, to resume their financing activity.

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