India’s states will pay for populism

Not only would a waiver of farm loans be economically disastrous, it’s unlikely to help the neediest farmers.

Things only seem to get worse for India’s farmers. They’d barely recovered from two years of drought when they were hit by the government’s decision last autumn to declare 86% of India’s currency illegal. They struggled through that, and the consequent crash in prices, in hopes that this year’s monsoon would be healthy. And, although forecasters insisted enough rain would fall, an “unexpected dry spell” is now threatening to ruin their summer crop.

Their distress could soon be India’s as well. Politicians are rushing to address widening pressure from farmers, whose numbers give them great political clout, by writing off their loans. It’s hard to think of a more counterproductive idea. Not only would a nationwide waiver of farm loans be economically disastrous — by some estimates, the promises could add up to 2.6% of India’s gross domestic product — it’s unlikely to help the neediest farmers all that much.

In many ways, the government got itself into this position. While officials can’t control the monsoon, the chaos caused by their “demonetisation” policy set off the current round of farmers’ protests.

Prime Minister Narendra Modi then responded by promising voters in the massive state of Uttar Pradesh that his party, if it was victorious in local polls, would forgive farmers’ debt.

The new state government kept Mr Modi’s pledge in its first cabinet meeting, inspiring farmers elsewhere to issue similar demands. The government of Maharashtra state, also ruled by Mr Modi’s Bharatiya Janata Party, quickly followed suit. And then Punjab, controlled by the opposition Congress Party, got in on the act. Now, farmers have targeted just about any state government that hasn’t already offered debt relief.

The consequences of the competitive populism that Mr Modi has unleashed are likely to be severe. India’s state-owned banks are already struggling with a bad-loan crisis. Thanks to their stressed balance sheets, credit growth has slowed considerably, adding to the economy’s investment drought and thus to its sharp slowdown over the past year.

Now, banks have to deal with writing off their extensive portfolio of agricultural loans; according to Nomura, state-owned banks hold 85% of agricultural debt.

In the end, the banks can expect to be reimbursed. But some state governments, like Maharashtra’s, have threatened to do so only in annual instalments. Meanwhile, the states that will eventually bear the burden are already borrowing too much. Indian states’ fiscal deficits have ballooned to 3.2% of India’s GDP, partly because of a federal scheme that forces them to borrow to make up for the accumulated debts of their electricity utilities.

Even before the farm crisis, states’ debts may have been on “an explosive path”. The bond market is responding, slowly, to this information: Spreads for state paper over sovereign bonds have widened sharply.

Mr Modi’s determination to secure a ratings upgrade for India is likely to be one casualty of his populist politics. The government constantly complains that, in spite of its promises of economic reform and the Indian economy’s growth performance, credit rating agencies haven’t raised India’s rating above BBB-. Officials are particularly upset that the rating falls below China’s. That’s unlikely to change as long as the government’s future fiscal path remains so uncertain.

And ultimately, farmers aren’t likely to benefit much, either. For one thing, it turns out that many farmers don’t borrow from banks, but from informal providers of finance such as village moneylenders.

For another, loan waivers have historically had perverse consequences. Banks responded to a previous wave of such measures by shutting off credit to areas where farmers had most enthusiastically participated in the programme. Those who did manage to get new loans later defaulted in large numbers, believing that politicians would bail them out if needed. India’s central bank governor warned recently that waivers would “undermine an honest credit culture”.

If India’s politicians actually want to help farmers, they need to create a vibrant agricultural financial system, one that allows farmers to tide over the bad times. Loan waivers do the opposite — and they hurt the rest of the economy as well.

Mr Modi is obviously worried about what protesting farmers may do to his popularity ratings. He should remember a tanking economy won’t help his poll numbers either.