Why states don’t go bust despite fiscal indiscipline

Freebies unsustainable, states can go bust, say secretaries at meet with PM, read the headlines in leading newspapers. This was with reference to the meeting of Prime Minister Narendra Modi with senior bureaucrats on April 2. The immediate context was the freebies announced by different states in the run-up to the recently held assembly elections and the promise by some others to go back to the old pension scheme for their employees.

Such a cautionary note is neither new nor has it come a moment earlier. When I was finance secretary of Punjab, a system was introduced under which the state’s cabinet was apprised of the poor state of state finances, every quarter. The note for the cabinet invariably concluded with a warning that the government is on the verge of bankruptcy. It was my unpleasant duty to call out this unpalatable truth. When I kept repeating it in meeting after meeting, the then CM gave me a short shrift by saying, “You are not the first finance secretary to say so. I have been hearing this since I have been the chief minister, without ever having to face such a prophecy.”

Ever since, the question: Why states don’t go bust, has been rankling my mind which, I will endeavour to answer in this piece. But this begs two more questions. Have states’ finances improved to an extent that the spectre of bankruptcy has disappeared? Or the state governments have managed their finances so adroitly as to keep such an eventuality at bay? Unfortunately, the answer to both these questions is a resounding no. Let us examine this in the specific context of Punjab.

Twin challenges of debt and deficit

The state’s economic and fiscal decline began from the early ’90s, when its rate of growth ebbed and it had to face the twin challenges of debt and deficit. Over the last three decades, these challenges have not only grown more formidable, but have also assumed a structural dimension. For example, in per capita GSDP ranking of major 18 states, Punjab slid from the 1st to the 9th rank between the triennium ending 2001-02 and the triennium ending 20182019. At the end of 2021-22, Punjab slid to the 19th rank among 28 states. At this rate, its per capita income is likely to fall below the national average very soon.

On the fiscal front, its performance is even worse. It is evident from its fiscal indicators, compared to the general states, as presented below: Not only Punjab’s major fiscal indicators are one of the worst in the country, it is deep into a debt trap, as its gross borrowings barely suffice to service its debt. This is more than evident from the following figures: Over a decade, the availability of debt funds, net of debt servicing, has shrunk from ₹3,011 crore in 2011-12 to a mere ₹178 crore in 2021-22. In other words, the state is using almost all its annual gross debt for debt servicing.

Worst fiscal situation only compounded by freebies

The foregoing analysis reveals that the state is in the worst fiscal situation in its history. Its financial woes are further compounded by the announcement of a slew of freebies in the run-up to the last state elections by all political parties. It begs the question as to how to fund them and what will it mean for the future of the state, which the people must ask and the government must answer. But such questions are neither asked nor replied to. A lay person may be excused for her belief that governments don’t go bust, but how can successive state governments shut their eyes to the writing on the wall.

Still, the titled question, why states don’t go bust, remains unanswered. The blunt answer is because they are a part of the Union government. Whenever any state is in financial straits, the Centre comes to its rescue, either by releasing its dues in advance or by allowing it to raise additional loans. Such a strategy may enable a state government to avert defaulting on debt servicing or payment of staff salaries, but pushes it deeper into debt and deficit. In fact, such cumulative profligacy on the part of states has the potential to jeopardize the macro fiscal stability of the country.

To avoid such an eventuality, the union government enacted the fiscal responsibility legislation (FRL) in 2003. Most of the states, including Punjab, followed suit. However, this legislation has been followed more in breach than compliance. In Punjab, it has been amended five times due to the state’s inability to achieve the stipulated fiscal targets. FRL is also rendered ineffectual due to design defects and the absence of enforcement mechanisms. The lax approach of the Union government has been hardly helpful.

Fiscal rules on states to live within means

Our founding fathers addressed the question of enforcing fiscal prudence on the states. A plain reading of Article 293 (1) of the Constitution would mean that managing public debt, including decision over borrowings, forms part of the executive power of the state.

However, under Article 293(4), the Government of India may impose such conditions as it deems fit, while granting consent to a state for raising loan. However, it applies only to those states which have an outstanding loan given to them by the Government of India.

With increasing reliance on market borrowings, most states may have already become free from central debt and their borrowings may not be subject to Articles 293(3) and 293(4).

In such an eventuality, the Government of India may be powerless to enforce fiscal rules on the states.

On the flip side, by granting consent under Article 293(3), isn’t the Government of India implicitly guaranteeing market borrowings by the states? And that too without enforcing any fiscal discipline?

While the primary responsibility for prudent management of state finances squarely lies with the state governments, the Union government should also put in place mechanisms such that profligate states are constrained to face the hard-budget option of having to live within their means. Temporary bailouts are nothing but to kick the can down the road.

HAVE STATES’ FINANCES IMPROVED TO AN EXTENT THAT THE SPECTRE OF BANKRUPTCY HAS DISAPPEARED? OR, HAVE THE STATE GOVTS MANAGED THEIR FINANCES SO ADROITLY AS TO KEEP SUCH AN EVENTUALITY AT BAY? UNFORTUNATELY, THE ANSWER IS NO