Whose standards are poor? – part 2

In response to my post here, a friend responded. Here are select extracts from the email correspondence:

States deficits have indeed increased (excluding UDAY) but are still within the 3% limit that was fixed for them. They have not exceeded the limits, and they do have a binding force that prevents them going above–namely the Finance Ministry which can refuse permission for bond issuance.

There is very low probability of states exceeding 3% (not counting UDAY). In the 10+ years since Fiscal Responsibility and Budget Management (FRBM) was legislated  in states, out of a potential 300 or so violations of the 3% limit, (30 states X 10 years), only about 10 cases (state-years) has it happened till now and in each case it had to be offset by reduction in borrowing the next year. By the way, the 14th Finance Commission recommended a higher Fiscal Deficit limit for states (e.g., Telangana) that meet stringent debt criteria. About 5 states meet them, and they would be within the limits permissible even if they reached 3.5%. This also could skew the average.

Further, the states cannot, on their own, violate the ceiling –because it is fixed in advance in absolute rupee terms at 3% of the estimated Gross State Domestic Product (GSDP) calculated by the Centre. Permission to issue bonds is controlled by RBI at this absolute level for a given fiscal year. Bonds are issued through the RBI’s debt office. What can happen is that, ex post, the Central Statistical Organisation (CSO)’s calculation of GSDP may be different from the earlier estimate. IF the denominator moves adversely, what was 3% (same numerator) may become 3.2% because of a smaller denominator.

However, the reality does not appear so straightforward. My friend is not necessarily wrong but it would be difficult to explain away the ex-post deficit ratios of many States over the years as marginal overshoots. More below.

In the month of May, ‘The Economist’ wrote a Leader and an accompanying article on the finances of Indian states. You can see them here and here (may be, behind paywalls).

In the ‘Leader’, there is a sentence:

Indian states are meant to keep their budget deficits below 3% of GDP. But this rule is often trumped by political expediency.

There is another sentence:

It is time to signal that they bear responsibility for their own borrowing, and to end the perverse incentives that encourage them to dig themselves ever deeper into debt.

Both these comments are partially true. Evidence points to the opposite for non-special category states but evidence conforms to the above statement for special category states. I had painstakingly manually entered the actual GFD/GSDP ratios for 28/29 states from 2008 to 2015 – that is seven financial years, from the RBI Annual Study of State Budgets. Violations of the 3% deficit rule are not sporadic.

That special category states are seen to have violated the ‘Fiscal Responsibility’ in hindsight is a bit disappointing because they get additional grants from the Union government. To understand what ‘Special Category’ status means, see here.

It points to many forces at work. Either they underestimate their spending or overestimate revenues or growth wilfully, gaming the system, or there is no competence or expertise to do them correctly. Or, it is that the denominator,  GSDP, is so badly overestimated ex-ante that the final numbers push up the GFD/GSDP ratio.

May be, ex-ante, the Union government never allows a deficit more than 3% except under very special circumstances. But, ex-post, what is the penalty for doing so? To be sure, non-special category status States are not serial violators of the deficit rule. That is, if the GFD/GSDP were above 3.0% in one year, it would be much below in the following year.  That is mostly true for the 17 or 18 non-special category States. But, there are exceptions even there. Until 2014-15, for which actual data are available, West Bengal, Kerala and Punjab have been somewhat persistent in their violations of the deficit rule.

In fact, the XII Finance Commission provided for special grants to West Bengal, Punjab and a bit to Kerala, to bring down its revenue deficit. See Table 10-12 of the Twelfth Finance Commission Report for the full details of the various special ‘Grants-in-aid’ allotted Special and Non-Special Category states.  Yet, these three States – West Bengal, Kerala and Punjab – have been offenders on the deficit ratio.

With the exception of Jharkhand, most of the other States signed up to Fiscal Responsibility Legislation (FRL) between 2005 and 2006.  See Table 2 of the RBI’s Study of the State Budgets 2008-09.

The article has a following sentence:

a 3% annual deficit cap is waived as often as it is enforced.

Even though FRL exists, it is not clear what penalties does the Union government impose for violations of FRL. It would be difficult for it to do so given its own ‘fair weather’ record on fiscal probity and prudence.

It is true, though, on a consolidated basis, the States’ GFD ratio had not exceeded 3% since 2004-05. See page 42.

Indian Public Finance Statistics for 2015-16 are available here.

May be, it will all be more consistent and credible with the Fourteenth Finance Commission.

This article in ‘Indian Express’ (from 2016) does a far better reporting job:

There will be year-to-year flexibility for relaxing fiscal deficit to states subject to fulfillment of conditions as specified in the FFC recommendations. States should have had no revenue deficit this year and in the preceding year. The states will be eligible for flexibility of 0.25 per cent over and above the fiscal deficit limit of 3 per cent of GSDP if their debt-GSDP ratio is less than or equal to 25 per cent in the preceding year….

… States will be further eligible for an additional borrowing limit of 0.25 per cent of GSDP this year if the interest payments are less than or equal to 10 per cent of the revenue receipts in the preceding year….

If a state is not able to fully utilise its sanctioned fiscal deficit of 3 per cent of GSDP in any particular year during the 2016-17 to 2018-19, it will have the option of availing this unutilised fiscal deficit amount only in the following year but within FFC period.

On May 12, RBI released its annual study of state finances. Appendix Table 1 has a statement on combined fiscal deficits of States. The number for 2015-16 is 3.6% and that includes UDAY – restructuring of State Electricity Boards – related expenditure.

In the final analysis, what all this means is this:

The main impact of farm loan waiver and the implementation of the Seventh Pay Commission recommendations will be on quality of state expenditure–less for good projects/ desirable schemes and more for sops. Tamil Nadu has perfected this over the years without violating the FRBM limits. In case, any one has forgotten, Tamil Nadu offers Amma Idli, Amma water, Mangal Sutra, wet grinders, laptops, free electricity to farmers and free and subsidised rice at the fair price shops.

So, this post is all about clarifying the quantitative aspects of fiscal deficits of Indian states. The evidence is mixed. Violations by individual states have been reasonably widespread even after FRL in 2005 and in 2006. Overall, combined GFD/GSDP of States has remained below 3.0%, however. Going forward, as to whether  the quantum would also violate the 3% rule, judgement is reserved.

The quality of their expenditure might deteriorate in the coming years, unless the Goods & Services Tax collections far exceed expectations.


(1) Ragini Bhuyan’s well researched article in MINT shows that credit rating agencies do have a bias against emerging economies and not just India:

As a 2013 paper by Andrea Fuchs and Kai Gehring of the University of Heidelberg showed, ratings agencies tend to favourably rate their home countries as well as countries that share strong economic ties with the home country. This may explain why China, the US’s largest trading partner, is rated much better than other emerging market countries by US-based ratings agencies.


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