States Are Running Up Huge Debts And It's Likely To Get Worse

Some 21 out of 28 states in India account for 95 per cent of the country's GDP and 96 per cent of the population. A rise in their debt burden means India as a whole too is sinking into a debt morass. 

In this second part of our story on India's public debt, we focus on individual state debt accumulation and look at the relationship between debt and gross state domestic product (GSDP) of these major states. The first part can be read here.

Good, Bad & Ugly Of Debt Accumulators

Bihar, Andhra Pradesh, Chhattisgarh, Haryana, Himachal Pradesh, Jharkhand, Kerala, Punjab, Rajasthan, Tamil Nadu, and Telangana fall under the set of high-debt states. An average state in this category added 11.7 percentage points to its debt ratio according to an NCAER study.

The rise in debt during this period was highest in Punjab, at 15.6 percentage points.

The next category, “Medium Increase in Debt”, consists of five states: Goa, Assam, Karnataka, Madhya Pradesh, and Uttarakhand. The average increase in the debt ratio for this group between 2012-13 and 2022-23 was 5.8 percentage points.

The remaining five states — Maharashtra, Gujarat, Odisha, Uttar Pradesh, and West Bengal, in a show of fiscal prudence over the past decade — belong to the “Low Increase in Debt” category. The average decline in debt ratio for this group was 1.4 percentage points in this decade.

Gujarat, Odisha, and Maharashtra are the only states with debt-to-GSDP ratios of less than 20 per cent. These states are projected to remain the least indebted in the years ahead.

Except for these three, all others have debt-to-GSDP ratios greater than 20 per cent. The debt ratios in more than half of the states have exceeded 30 per cent.

Punjab and Himachal Pradesh are in what economists call "the red zone", meaning they are financially in a very unsound position with their debt ratios breaching the 40 per cent mark in 2022-23.

By 2027-28, the debt levels in every state are projected to increase. Punjab’s debt ratio will go above 50 per cent. Himachal Pradesh, Rajasthan, Bihar, and Kerala will have debt ratios over 40 per cent, thus placing five populous states in the fiscally imprudent "red zone".

Compliance To Fiscal Rules Also Vary Across States

Most of the states adopted their respective Fiscal Responsibility Legislations (FRL) at the beginning of the millennium. However, the period for adoption for all these states was spread out through this period.

Karnataka was first to adopt FRL in 2002, followed by Tamil Nadu, Kerala, and Punjab in 2003, and Uttar Pradesh in 2004. Apart from these early adopters, the bulk of the states adopted FRL between 2005 and 2006. Jharkhand, Nagaland, and West Bengal were late adopters. West Bengal became the last to adopt FRL, in 2010.

The FRL stipulates that the fiscal deficit of the states should not exceed 3 per cent of GSDP, along with the prescribed elimination of revenue deficit by 2008-09. To keep the debt low, the states are also supposed to keep their outstanding liabilities down.

These three are the main fiscal rules that the states must adhere to under the FRL.

The NCAER report compiled the compliance data for the decade spanning 2012-13 to 2021-22, and then attached a score of 1 for each year a state complied with the rules and 0 for every year it did not, before taking simple averages of the percentage compliance of the three targets for each state.

Gujarat, Odisha, Karnataka, Andhra Pradesh, and Madhya Pradesh came out as the top five states, with more than 80 per cent scores. Punjab, Rajasthan, Haryana, West Bengal, and Kerala were the bottom five in compliance under these fiscal rules.

While the national average compliance score was 59.4 per cent, West Bengal and Kerala were at the bottom of the table, with 18.5 per cent and 10 per cent scores respectively.

The rest were in the middle with more than 50 per cent compliance scores, except for Uttarakhand which had a score of 48.5 per cent.

Curious Cases Of West Bengal & Maharashtra

A comparison of the states with low fiscal compliance with the “Low Increase in Debt” states during this decade brought two intriguing cases to the fore. These are the cases of two industrial giants - Maharashtra and West Bengal.

These two states managed to lower their debt-to-GSDP ratios between 2012-13 and 2022-23 without complying heavily with the fiscal responsibility rules.

Maharashtra’s average compliance, though, was much better than West Bengal, at 55.6 per cent.

This was possible if nominal GSDP growth outpaced debt growth rates in these states. If income grows more than borrowings, then of course, the debt-to-income ratio goes down.  

While Maharashtra’s annual average nominal GSDP growth between 2013-14 and 2022-23 was 9.3 per cent, West Bengal’s annual average GSDP growth clocked 10.1 per cent during this period.

According to 2022-23 figures, Maharashtra, Gujarat, Tamil Nadu, and Karnataka are the frontline states in terms of GSDP at constant prices. So, the Maharashtra story is not that surprising, but the West Bengal story is.

The picture gets more complicated when the individual average GSDP growth rates of these 21 major states are compared with the national average growth of all these states. The average of all the states was 10.6 per cent between 2013-14 and 2022-23.

This high growth rate was however, still somewhat below the national nominal growth rate which was 10.6 per cent. There were other states which grew at a faster clip than Bengal and Maharashtra - Andhra Pradesh, Assam, Haryana, Karnataka, Madhya Pradesh, Odisha, Rajasthan, Tamil Nadu, Telangana, and Uttar Pradesh, but they also borrowed more as they grew.

So, while the four frontrunner states are still reaping the benefit of their past good economic performances, quite a few other states are making their best efforts to improve and catch up.

Policy Suggestions Miss The Forest For The Trees

So what is the way out? One suggestion is to create an independent fiscal council in every state to realistically and credibly forecast revenues and expenditures.

In other words, these councils will effectively plan state budgets. Though on paper this looks fine, the independent fiscal council (consisting of experts drawn from the world of academia, financial markets, and elsewhere) may end up being more of a showpiece whose recommendations may well never be accepted. On the other hand, if this body decides on budget policy, then the legislature's space is curbed. A move that could have law-makers up in arms.

Another important policy suggestion that has come forth is to limit the RBI’s intervening role to cap bond spreads of heavily indebted states.

A bond spread, or a yield spread, is the difference in yield between two bonds with similar maturity periods, but different credit qualities. A simple example: A 5-year treasury bond has a 6 per cent yield (as fixed by the government) and a 5-year corporate bond has an 8.5 per cent yield linked with the open market, resulting in a 2.5 per cent bond spread.

The RBI intervenes in the market to keep this spread at a sustainable level for the heavily indebted states. The NCAER study is nudging the central bank not to do so and leave everything to the market. The logic: The market will discipline the states and force them to follow fiscal discipline.

This may result in a contagion in the state government bond market, from the bonds of states with high debt, towards the bonds of states with low debt. This suggestion also ignores the past and present inequalities across the state.

A similar nudge has been suggested for the Finance Commission to penalise the states with high debts by withholding their share in transfers from the central government. This potentially impinges on the federalism that exists in India's fiscal structure.

The final suggestion made by the NCAER talks about a fiscal “grand bargain”, where states with chronically high debts will receive one-time debt relief by shifting a substantial part of their debts to the balance sheet of the central government. In return, those states will concede additional central government oversight and, in extreme cases, even fiscal autonomy.

This sounds like the central government taking over the states with high debt burdens. This is one of those proposals which can be called impractical at best and disastrous at worst.