Centre-led fiscal push is the only way

The past week has been dominated by Finance Minister Nirmala Sitharaman’s remark alluding to an “act of God”. She was referring to the Covid-19 pandemic which is now seen as the main cause of the unprecedented recession in India and the world. Never mind that the slowing of GDP growth, or investment ratio or the stagnation of exports, or rising of the bad loan ratio in banking, preceded the pandemic. Naturally the fiscal stress was rising, and the pressure of the inadequacy of tax collection was tangible even before the full fury of the pandemic. The FM referred to “an act of God” as a Force Majeure clause in a commercial contract. The “contract” in this case is actually an act of Parliament of 2017 which guarantees compensation to the States from the Centre, in case of a shortfall in tax collection from the Goods and Services Tax.

In the present fiscal year, the tax forecast and arithmetic will go for a toss, and the Central fiscal deficit will zoom.

The compensation clause, says that any revenue growth falling below 14 percent annual growth from year to year, will be compensated from the Central treasury fund for a period of five years, i.e. till 2022. Meeting this legal obligation was becoming difficult thanks to slowing GDP growth even prior to the pandemic. Even that 14 percent unconditional promise was faulty, but let us not dwell on it now. In the present fiscal year, the tax forecast and arithmetic will go for a toss, and the Central fiscal deficit will zoom. The situation of the States will be similar. But since the States were “insured” against loss of revenue, they were less worried. But now after the GST council’s latest meeting it looks like compensation will not be forthcoming. The Centre seems to be abdicating its legal obligation under the Act of 2017 citing exceptional circumstances caused by the pandemic. So, the Centre has basically told the States to go and fund their own shortfall, either by borrowing from the Reserve Bank of India, which the Centre will facilitate, or borrowing from the open market.

This is problematic on several counts. Firstly, unlike the United States of America, which was a voluntary coming together of provincial entities, the States of India are the creation of the Union. New States can be created by the Centre, as has been the case several times in the past few decades. Indeed, States have even been reconverted to Union Territories as was seen in the case of Jammu, Kashmir and Ladakh.

The Centre has told the States to go and fund their own shortfall, either by borrowing from the Reserve Bank of India or borrowing from the open market.

Hence federalism in India has a different nature from other federally organised countries. Secondly, the Constitution explicitly prohibits the States from further indebtedness without the permission of the Centre. The States are prohibited from borrowing from abroad. They cannot borrow in dollars, even if the rate of interest is nearly zero, as of now. The recent case of the State of Kerala borrowing via the rupee denominated “masala bonds” listed in London created a controversy.  This restriction on the States has good rationale, since a dollar bankruptcy of a sub-national entity can have repercussions on the overall country rating. We have seen such disasters in the debt crisis of Latin America in the 1980’s. Hence in India, an already indebted State is not allowed to increase borrowing from the RBI or the open market without explicit permission.  That is why some States resort to tricks like borrowing in the name of State-owned enterprises, and thus hiding the debt in a corporate balance sheet.

The restriction on the States has good rationale, since a dollar bankruptcy of a sub-national entity can have repercussions on the overall country rating.

The second reason for not pushing further debt raising to the States is due to debt servicing capacities. When States go to market or RBI they will probably have to pay a much higher interest rate than the Centre. Since their tax autonomy is considerably restricted, thanks to GST, their repayment capacity is also curtailed. The Centre’s debt to GDP ratio still has enough headroom to grow, fully understandable and justifiable in these pandemic times. Indeed, the Centre can also float a special long term, tax exempt Covid-19 bond to fund the extra fiscal push. There is some discussion about selling sovereign bonds to dollar investors, or to narrowly pitch it to non-resident Indians. These options are not available to the States.

This is the time that federal faith and trust will be tested. The Centre must bear the full fiscal burden.

 The parallels with PSU funding are worth remembering.

The Indian Railway Finance Corporation or the Power Finance Corporation is able to raise funds from the market at much finer interest rates because of their respective sovereign backing. This low cost fundraising is possible despite the fact that they raise funds for the Railways or the power utilities, both of whom are typically loss making. The same logic applies to the Centre raising Covid-related fiscal funds on behalf of the States.

The third reason is that even with the States borrowing individually, the overall borrowing requirement in the national aggregate will not be any different. It will be the same in the aggregate, whether the Centre does the borrowing all by itself, or it is done severally by the Centre and the States. You can’t fool the debt markets, or those country rating analysts. Hence it is more efficient to do it Centrally at a distinctly lower cost, and pass on the benefit to the states.

The Centre has many more options to raise fiscal resources (such as a loan against PSU shares from the RBI, or overseas borrowing, or a Covid bond) than the States.

The fourth and possibly the most important reason, is that the Centre simply cannot renege on a written and codified promise, act of God or not. We are all in this pandemic together. We are trying to build trust and a solid foundation for cooperative federalism. The GST curtails autonomy but gets us a unified common economic market across the nation. The States plus the Centre have to forge a common vision for the development of the nation. Balanced growth will need much more cooperation between the States and the Centre, and much give and take. This is the time that federal faith and trust will be tested. The Centre must bear the full fiscal burden. The Centre has many more options to raise fiscal resources (such as a loan against PSU shares from the RBI, or overseas borrowing, or a Covid bond) than the States. Let the GST compensation promise not be broken, saying the pandemic is an “act of God.”

(Dr.Ajit Ranade is an economist and Senior Fellow, Takshashila Institution)