State budgets: Less ‘crowding out’
Collective borrowing by the Centre and states this year will likely be half the financial savings of households
Given how important state government budgets are in the Indian economic framework, the Reserve Bank of India publishing its compendium of state finances 10 months earlier than it usually did is a welcome development. Not only will this improve market efficiency, it may also help policymakers manage the economy better. After all, the aggregate state government expenditure is now 90 per cent more than the net central government expenditure and states together incur nearly the same deficit as the Centre. Their bond issuances, an afterthought for the markets a decade back, now exceed the Centre's issuance in some quarters.
The compendium provides several insights, starting with the combined budgeted fiscal deficit of states in FY2019 being 2.6 per cent of GDP, the lowest since FY2014. In fact, even the absolute budgeted deficit of ~4.9 trillion is ~0.3 trillion lower than the revised deficit for FY2018. Given the poor fiscal marksmanship of the states, it would be a mistake to take this as final: Deficits generally turn out to be higher than budgeted, as, among other things, states have failed to meet their own revenue targets in the last five years. However, their combined deficits are unlikely to breach 3 per cent of GDP: As per the Constitution, they need the Centre's permission to borrow every rupee, a provision that the Centre uses to keep state deficits under control. It only permits a breach for special cases like the UDAY scheme two years back, where states took on power distribution companies’ debt.
Thus, contrary to the fears of pre-election fiscal profligacy by governments “crowding out” private investments by cornering a large part of financial savings, collective borrowing by the central and state governments this year is likely going to be just about half the financial savings of households. While still high in absolute terms, it is among the lowest seen in history and calls for lower bond yields. Only in the boom years in the FY2006 to 2008 period was this ratio lower, when corporate tax collections were robust. Central and state tax to GDP is budgeted to reach a record high of 18 per cent this year. While expenditure levels are higher now than they were a decade back, growth this year in state government expenditure is budgeted to be the slowest since FY2006, and central government expenditure to GDP ratio is budgeted to fall again to perhaps the lowest levels in history. This slowdown in general government expenditure growth can be a meaningful headwind for the economy.
Even if there is no "quantity" problem with deficits, is there a "quality" problem in the nature of spending? Undisciplined spending at this scale, after all, is not just wasteful, but also inflationary. While some states indeed seem to have given in to the temptation to turn profligate before elections, at an aggregate level there does not seem to be meaningful distortion: The split of incremental spending in states' FY2019 budgets is similar to the split of total spending in the year.
Further, on the two specific risks that often grab headlines — farm loan waivers and wage revisions, the quantum on the former is budgeted to be ~350 billion, about 1 per cent of total expenses and down 35 per cent from last year. On the latter, with states adding up to 75 per cent of wages having already announced the decennial hikes, it appears that the increase in the salary and pensions bills for states over the three-year implementation period may only be 58 per cent in this cycle, as against 79 per cent in the fifth pay commission two decades back, and 93 per cent in the sixth pay commission last decade. Only six states have not implemented the increases yet, of which three, Kerala, Telangana and Andhra Pradesh (14 per cent of the wage bill) do not follow the 10-year cycle of revisions.
The unrelenting rise in pensions though is worrying: These are already 10 per cent of total spending, 12 per cent of incremental spending this year, and already more than 40 per cent of salaries. In states like Uttar Pradesh and Bihar, the pension bill is already more than 70 to 80 per cent of salaries. The worry comes from the steady pattern of increases, and a lack of quantification of the future pension burden for governments.
Pay commission implementations have historically been associated with strong demand growth for both discretionary goods (two-wheeler and car demand, for example), as well as upgrade cycles for staples (like families moving to a higher-end detergent powder or soap). The surprisingly strong demand seen for these products in the last year or so may have been helped by the ~1.6-trillion increase in expenditure on salaries and pensions last year. The increase in FY2019 is budgeted to be ~1.2 trillion on that higher base: It will be interesting to observe demand growth in several of these categories as this stimulus starts to fade this year onwards.
State governments' capital expenditure (capex), widely considered a more productive form of spending (though there are others who believe this has significant leakage, and view the election-year spike suspiciously), is budgeted to rise 13 per cent this year to nearly ~6 trillion, a level that is 90 per cent higher than the Centre's capex. If one takes out defencerelated capex from the Centre's budget, states' capital spending would be 2.7 times the Centre's expenditure. States' combined budgeted spending on road projects and irrigation is currently each over ~1 trillion a year. This is in addition to significant extra-budgetary spending: almost all the metro rail projects (by some estimates India will add twice as many metro rail line kilometres in the next five years than it did in the prior decade) for example are mostly being funded outside the budget, as are road expressways and drinking water projects. Earlier, state projects were too small for the larger construction companies, but now, state governments account for more than half their order books.
As interesting as these aggregates are, there are several more fascinating takeaways looking at the variations between states. Over the past few years, there has been an encouraging increase in the attention paid to state budgets, but one feels much more is needed to improve our collective understanding of the Indian economy