Resolution mechanism for financially stressed states

Subnational insolvency is a recurring event in development, as demonstrated by historical and modern episodes of subnational defaults in both the developed and developing countries, say Lili Liu and Michael Waival in their work on Subnational Insolvency – Cross-country Experiences and Lessons. Recently, this column had tried to understand as to why states don’t go bust despite persistent fiscal indiscipline and had concluded that, it is because they are a part of the Indian Union. Presumably, the sub-national governments are not supposed to go bust or, if they do, they are to be unconditionally bailed out by higher governments. This article argues that as countries decentralise expenditure, taxation and borrowings, insolvency procedures become more important. In the face of the credo of competitive populism currently being followed by most states, even though persistently suffering from high debts and deficits, of which Punjab is a classic example, it is an absolute must.

Constitutional provisions

To begin with, let us look at the constitutional provisions governing the Centre-state financial relations. These are contained in Articles 270, 275, 282 and 293 of the Constitution. Article 270 governs the distribution of taxes levied and collected by the Union among the states on the basis of the recommendations of the finance commission. Article 275 provides for grant-in-aid from the Union to the states and the local governments. Such grants can be conditional or unconditional as recommended by the finance commission. Article 282 empowers the Union and the states to make grants for any public purpose. Article 293(3) prohibits a state to borrow without the consent of the Government of India, if there is an outstanding loan advanced to it by the latter. While granting such consent, the Government of India is free to impose any conditions it deems necessary to foster fiscal discipline among the states.

Weak constitutional framework

It may be observed from the above constitutional provisions that they don’t provide for a resolution mechanism for the fiscally stressed states. In contrast, in most of the Organisation for Economic Co-operation and Development

(OECD) countries, subnational governments are either required to keep their budgets balanced or are subject to bankruptcy resolution laws. Back home, the Government of India has neither itself exercised financial rectitude nor used the powers vested in it under Articles 275 and 293 of the Constitution to enforce fiscal rules on the states. Instead, Article 282 has been used by the Government of India to dictate policies to the states, even on the subjects that fall in the latter’s domain. Besides, the doctrine of public expenditure for public interest, enshrined in Article 282 has not been tested by judicial review. Consent to borrow under Article 293(3), within a fixed ceiling, as a percentage of states’ GSDP, has been routinely given, without going into a state’s debt-servicing capacity. In fact, additional borrowings have been proffered to even highly debtstressed states.

Existing framework untenable

Such a weak and poorly implemented constitutional framework could subsist so far because of relatively low levels of debt and deficits. At a time when the general government debt is close to 90% of the GDP and, in a few states, debt/GDP ratio is above 40%, the business-as-usual approach may not only further reduce the capacity of subnational governments to deliver public goods and services, but may also endanger macro financial stability.

Following takeaways from an analysis of the fiscal data of Punjab are illustrative of the grim situation on this front: The state’s fiscal suffers from a deep-rooted structural malaise epitomised by persistent debt and deficits.

● The state tops in per capita outstanding debt and debtservicing charges.

● The new annual debt contracted by the state barely suffices to service the old accumulated debt. At the current pace of debt accumulation, the government will have to dip into its own revenue receipts for debt servicing.

● As its own receipts don’t suffice even to meet its committed expenditure, there is a real danger of the state defaulting on its debt servicing.

● The quality of public expenditure is extremely poor, as revenue deficit is over 70% of the fiscal deficit.

Recent instruction of Government of India

It is, perhaps, taking note of such a grim fiscal scenario that the Government of India recently issued instructions to the states that their borrowings during 2022-23 will be net of the incremental borrowings by their public enterprises during 2020-21 and 2021-22.

This is too little too late. Instead of solving the problem of high debt and deficits, it will pose an immediate cash flow problem for states like Punjab.

If the GST compensation to the states is not extended beyond June 30, Punjab will be staring at a revenue loss of at least ₹10,000 crore per annum. In the current dispensation, fiscally stressed states will be pushed over the fiscal cliff. They will either have to drastically slash their already abysmally low capital and social sector spending or to default in meeting their debt servicing and committed expenditure responsibilities, an outcome fraught with very disruptive consequences.

The way forward

The way forward is not to suddenly shut the tap or let the sore fester. What may, perhaps, work in the given situation is that the Government of India may put in place a statutory resolution mechanism for all fiscally stressed states. As a first cross-country survey, Lili Liu and Michael Waival’s work has particular relevance for decentralising countries. The authors explain central features and variations of sub national insolvency mechanism across countries.

They identify judicial, administrative and hybrid procedures. Insolvency laws/ procedures predictability allocate default risk, while providing breathing space for orderly debt restructuring and fiscal adjustment.

The policy-makers ought to mitigate the tension between creditor rights and the need to maintain essential public services and, at the same time, to strengthen ex ante fiscal rules and to harden subnational budget constraints.

Therefore, time is ripe for the Union government to step in and enact a resolution mechanism for the fiscally stressed states on the above lines, rather than providing periodical bailouts.

As India is a Union of states, the choice may be left to the states to either file for resolution under the proposed legislation or face the hard budget option of disruption in the provision of essential public services/debt default and the consequences arising therefrom.

AS COUNTRIES DECENTRALISE EXPENDITURE, TAXATION AND BORROWINGS, INSOLVENCY PROCEDURES BECOME MORE IMPORTANT