Hemanth Bharatha Chakravarthy

blog — Hemanth Bharatha Chakravarthy


Who Should Borrow? The fiscal federalism debate
March 15, 2021

Confidence level (?): Low

The RBI is buying states’ debt for the first time ever

The RBI just announced (three hours ago today, the 9th of October) that it is conducting open market operations on state government bonds. That is, the RBI is going to be buying loans of states. This is the first time in history that this move is being made.

(A bond is an instrument of debt. When you buy it, you give the government money which will be returned to the owner of the instrument at a later date with interest. That is, you buy debt.)

Fiscal federalism: catch up with this debate

This move is very interesting especially in the context of the debate on who should borrow (particularly to make up GST shortfalls). So far, states say that the center should borrow and give to the states because it gets a better interest rate. Meanwhile, the center says its deficit is too high (or that it wants to preserve the room for deficits to increase) and, so, states should do it.

Simultaneously, in the non-COVID recent past, there has been an effort to create differentiated rates for different states. The rationale for this being: why should, say, Maharashtra or Tamil Nadu pay the same rate on debt as Uttar Pradesh despite distinctly better fiscal performance. Any reading of this debate immediately brings parallels to the European Central Bank and how Greece/the PIIGS nations launched into a sovereign debt crisis (i.e., couldn’t pay back their debt) due to severe fiscal indiscipline (spending too much to win elections) because they were enjoying the low rates enabled by the implicit debt guarantee on their borrowings (given contagion—aka crisis spreading—risk for the Euro area) from the European Central Bank and, therefore, France-Germany.

This debate under COVID-19

Now, in the post-COVID era, especially with the GST shortfall, the question is should we prioritize a very federalist fairness, set efficient market rates, and reward and enable good governance or should we (indirectly) subsidize debt for poorer states?

This is all perhaps why RBI Governor Shaktikanta Das said today, “This is important from the point of view of smooth and seamless transmission of monetary policy impulses as well as the completion of market borrowing programmes of the centre and states in a non-disruptive manner with a normal evolution of the yield curve.”

States need funds

As is, even discounting the public health costs and the need for much larger expenditure to revive our economy after the virus, states’ capital expenditure—spending on infrastructure or projects—has been steadily declining due to lower funds. With restrictions on borrowing, states have been spending mostly on revenue expenditure—i.e., mostly paying salaries for existing work. This likely means there‚Äôs a significantly lower than desirable multiplier on state expenditure. In other words, every rupee spent by the government is someone’s income, who then spends it to create someone else’s income, and so on ad infinitum. So, when an external party, i.e., the state adds new consumption, it has a “multiplier” effect on everyone. Typically, when you spend on infrastructure, you create a far better multiplier effect besides the direct economic benefits of having new roads or, say, more electricity.

How does this all work?

Now, for the first time ever, RBI is buying the debt of states. This will be bought in the secondary market at a market-linked price—where existing owners of bonds sell them to buyers. So, as states issue more bonds, more people will buy them because the RBI is buying them from you.

A usual auction of bonds has a “spread.” The spread is the additional money that the investor seeks on top of the bond’s value to buy it—it is how the market sets the prices of bonds. So, right now, with states increasing borrowings after COVID-19, spreads are naturally higher—the more indebted you are, your additional new debt becomes less attractive. So, if spreads remain high, either fewer people invest in state governments or they do so with a less attractive deal for states. The RBI doing this will reduce the spreads on bonds by making them a more investable asset. So, this will allow states do more auctions and get more funds. As per the RBI calendar, states are expected to borrow an additional Rs 2 lakh crore during the October to December quarter.

This will also rationalize and cool down the yields on SDLs (as state bonds are called—state development loans) which have been a bit crazy in comparison to central government bonds (G-Secs or government securities). “SDLs are going through the roof at about 100 basis points (bps) right now, and hopefully that will come down,” said Neeraj Gambhir, the CEO of Axis Bank, to CNBC-TV18.

How will this be implemented? Many interesting questions.

How much of which bonds/states at what prices will the RBI end up buying? What will be the effect of this on the pricing of state government bonds? How lower will spreads get now that the RBI is showing confidence in state debt and demanding it more?