State Government Market Borrowings - Issues and Prospects
(Keynote Address by Shri B. P. Kanungo, Deputy Governor, Reserve Bank of India, at the Financial
Market Conclave of the Bengal Chamber of Commerce and Industry, Mumbai, on August 31, 2018)1
Shri Chandra Shekhar Ghosh, President, Bengal Chamber of Commerce, Shri T.
Bandopadhyay, ladies and gentlemen. I am thankful to the Bengal Chamber of
Commerce and Industry for providing me the opportunity to be present here and speak
on the subject of 'State Government Borrowing'.
In the federal system of governance that we have in our country, both the Central and
the State Governments are responsible for the development of the nation. To discharge
the responsibility, the overall magnitude of the State Budgets is significant, and the
nature of spending incurred by the states is crucial for development. As states have
their own developmental priorities, financing the budgets assumes vital importance.
Given this scenario, it is important to examine the current conditions of budget and debt
management at state level, identify the issues and dwell on the prospects.
State Budgets have increased in size: Over the past decade the size of State
Government budgets have increased sharply, and they now collectively spend
substantially more than the Union Government. Aggregate Expenditure of the state
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governments increased to 30,285.1 billion in 2017-18 (RE) from 12,847.1 billion in
2011-12 and is further expected to increase to ' 33,592.2 billion in 2018-19 (BE).
Growth in their aggregate expenditure has also outpaced that of the Central
Government for each of the years since 2011-12.
Fiscal imbalances are also rising: It is a matter of concern that the finances of State
Governments are showing signs of increasing fiscal imbalance. Reserve Bank in its
'State Finances: A Study of Budgets of 2017-18' observed that the consolidated fiscal
position of states deteriorated during 2015-16 and 2016-17. The GFD-GDP ratio in
2017-18 (RE) is at 3.1 per cent and is above the Fiscal Responsibility and Budget
Management (FRBM) threshold for the third consecutive year. Outstanding liabilities of
State Governments have been registering double digit growth since 2012-13 (2014-15
being an exception). State-wise data reveal that the debt-GSDP ratio increased for 16
states. The downside risks to fiscal position of the states include stress on revenue
expenditure in the run-up to the general elections, implementation of 7th pay
commission recommendations by states, and farm loan waivers in certain states etc.
Fiscal slippages have also been noticed in central finances. In response to the Global
Financial crisis, the FRBM Act was put on hold during 2008-13 and fiscal stimuli
expanded the centre's gross fiscal deficit (GFD) to an average of 5.6 per cent of GDP
during this period. During the period 2013-18, the GFD of the Centre, as a percentage
of GDP averaged 3.9 per cent. The GFD target of 3 per cent of GDP, stipulated in
FRBM Act, now stands deferred to 2020-21. In retrospect, the Central Government has
achieved the target in one year only, i.e., in 2007-08 when the GFD/GDP ratio fell to 2.5
per cent. Growing fiscal imbalance, whether by the Centre or State can derail fiscal
consolidation at the general Government level. General Government deficit of India
rules at a very elevated level amongst the G-20 countries.
States market borrowings have increased: A consequence of large expenditures and
deficits is an increase in market borrowings reflecting rising trend in fiscal imbalance at
States level and increase in outstanding liabilities. The Indian State Governments'
market borrowings, which is the chief source of funding of their gross fiscal deficits,
have risen sharply in recent years, in contrast to the stagnation displayed by the Central
Government's dated market borrowings. The financing of gross fiscal deficit (GFD)
through market borrowings, which constituted small fraction of sources of financing
before 1990, increased significantly to 74.9 per cent in 2017-18 (BE) (Chart 1).
Therefore, it is not surprising to note that gross as well as net market borrowings of
State Governments are budgeted to be similar to that of the Central Government in the
current fiscal year. States have also borrowed significantly to take over the liabilities of
state power utilities under UDAY Scheme. On an aggregate basis, states' gross
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borrowings are budgeted to rise to 5.5 lakh crore or 2.9 per cent of GDP, while net
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borrowings are expected to rise to 4.2 lakh crore or 2.3 per cent of GDP in 2018-19.
States have budgeted to finance nearly 91 per cent of their fiscal deficit through market
borrowings as against around 66 per cent by the central government. Gross borrowings
by State Governments are projected to increase 28.5 per cent year-on-year (y-o-y)
during 2018-19.
Financing Mix has changed: The changes in financing mix of states also contributed
to increased reliance on market borrowings. Pursuant to the recommendation of
Finance Commission-XIV, almost all states have opted out of National Small Savings
Fund (NSSF). As a result, reliance of State Governments on market borrowings has
increased substantially in recent years. Increased redemptions, emanating from higher
market borrowing of 0.5 per cent of GFD consequent to fiscal stimulus provided to the
states in the aftermath of the Global Financial Crisis (GFC) 2007-08, also contributed to
the rise in borrowings2 (Chart 2). This has led to the pace of increase in market
borrowings of State Governments higher than that of the Centre, which is more or less
at stagnant levels over the past couple of years.
Impact of higher borrowings:
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Considering the large redemption pressure of around 1.3 trillion, gross market
borrowings are expected to cross ₹6 trillion in FY19, slightly more than Central
Government gross borrowing numbers for the fiscal year. Market share of State
Development Loans (SDL) in outstanding has increased from 16.59 per cent in 2008-09
to 29.06 per cent in 2018-19 as against decrease in share of GoI from 83.41 per cent
(G-Sec & T-Bills) to 70.94 per cent during the same period. Although market borrowings
of the Centre and the State governments have been managed successfully by Reserve
Bank, the increasing reliance on market borrowings by States have raised concerns
both from the supply and demand side and need to be managed so as to minimise any
adverse effects on yields. I would highlight some of these concerns.
i. Hardening of yields: Increased reliance of Centre and States on market borrowings
led to an oversupply of Government paper in the G-Sec market and contributed to
hardening of sovereign yields. This results in a spiral, whereby increased market
borrowings result in increasing redemption pressures which induces further
borrowing to service outstanding debt and accumulated interest burden. Weighted
average yield increased from 7.48 per cent in 2016-17 to 7.60 per cent in 2017-18.
Average spreads of SDL yields over Central Government securities of
corresponding maturity have increased from 38 bps in 2014-15 to 59 bps in 2017-
18 signifying increase in the cost of borrowing for the States. As the investor base
for G-Sec and SDLs are almost same, the continuous and large supply of SDLs
had resulted in hardening of yields of Central Government securities also.
Table: Gross Issuance and Spread of SDLs over Corresponding Tenor of GoI
Securities
Weighted
Gross YoY Gross YoY average YoY
Borrowing Growth Borrowing Growth of SDL Growth
Year
of States of GoI
per per spread per
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(in Cr) cent (in Cr) cent over GoI cent
(bps)
2014-15 240,842 22 5,92,000 5 38 49
2015-16 294,560 22 5,85,000 -1 50 32
2016-17 381,979 30 5,82,000 -1 60 20
2017-18 419,100 10 5,88,000 1 59 -2
ii. Impact on the corporate bond market: An internal study of RBI and CAFRAL had
examined the impact of SDL spreads on corporate bond yields and it was observed that
rise in yields on state government paper end up pushing spreads on corporate bonds.
Unlike Central Government debt which crowds out bank credit, SDL crowds out
corporate borrowings in the bond market by increasing costs. A one percentage point
increase in the ratio of state debt issuance to GDP, results in an 11 per cent decline in
the volume (in Rupees) of corporate bonds issued in FY2016. High rated corporate
bonds and those with longer maturity have a greater propensity for being crowded out
by SDLs which work as substitutes.
iii. Impact on other segments of the financial market: The increased supply and
consequent hardening of yields, especially so in case of the benchmark 10 year
security, has a cascading effect on interest rates in other segments of the financial
market, as pricing of other products are based on the risk-free yield curve. This feeds
into inflation through input costs, further increasing yield levels, thereby creating a
vicious cycle. Since economy is poised for higher growth trajectory, the private sector
demand for domestic funding is expected to significantly accelerate in coming years.
Hence, stake holders would have to be sensitive not only to their own interest expenses
but also to that of the financial sector.
iv. Diminishing demand from banks: Given the large borrowing requirement of Centre
and States, assessment of the institutional demand for government securities is
paramount. Captive funding is diminishing as banks are following the glide path for
reducing the SLR requirements. In a market confronted by reduced pre-emption in the
form of SLR, reduction in HTM and likely adoption of IFRS that will seek to mandate
mark to market (MtM) accounting, the demand for government bonds could be
impacted. Additionally, international capital standards post GFC (Basel III), to which
India is an active participant, proposes to assign credit risk weights to sub-sovereign
borrowings. If and when accepted, this development is likely to impact the cost of
borrowing for State Governments and the attraction to hold SDLs in banks' books, for
reason other than the YTM they offer. Further Basel III capital requirements also seek to
define High Quality Liquid Assets under it's the Liquidity Coverage Ratio(LCR)
framework. As per our extant regulations, SDLs being similar to Government of India
(GOI) securities qualify for inclusion as part of level 1 High Quality Liquid
Assets(HQLA), by virtue of an implicit sovereign guarantee and default free status for its
market borrowings. This may change in the future, in which case banks may have to
begin assigning risk weights to SDLs. State Governments will need to strategize for this
eventuality.
v. Limited participation of FPIs: As part of the measures to increase the investor base,
attracting Foreign Portfolio Investors (FPIs) towards SDLs would be essential for
meeting the increased borrowing requirements. As per Medium Term Framework
(MTF), the FPI limits were to increase in phases to reach 2 per cent of the outstanding
stock by March 2018. However, the FPI limit utilization of SDLs stood at only 12 per
cent of the limit for the quarter ending March 2018, and lower at 10 per cent of the limit
for the quarter ending June 2018. FPIs have cited lack of information on financial
position of states between two budgets, and opacity of State Government (SG)
operations as one of the main reasons for lackluster interest in SDLs, despite the yields
they have to offer. There is, hence, a need to reach out to investors by introducing
transparency and making accessible high frequency data on State finances in public
domain.
Large cash balances and negative carry: An analysis of surplus cash maintained by
vi.
the States in the past years throws light on the fact that there are States resorting to
market borrowings despite having a surplus invested in ITBs and ATBs with a negative
carry on such investments. If a SG is investing in T-Bills locked in for 182 days and 364
days, there is a need to re-examine states' market borrowing programme. Further,
accumulation of large surplus cash balance by State Governments reduces liquidity in
the market thereby contributing to the pressure on interest rate prevailing in the market.
It is, therefore, necessary for States with large surplus to rationalize their borrowings in
tandem with their surplus cash balance. During 2017-18, seven states had raised less
than 85 per cent of the amount sanctioned for the year reflecting the fact that these
States require lesser than the sanctioned amount. To address these issues, the States
have to devise a mechanism for monitoring their surplus on a continuous basis and
mapping it to their market borrowing programme, with the assistance of external
consultants, if need be. This will reduce the inflow of bonds into the market, reduce the
pressure on yields and have a positive impact on the borrowing cost of both Centre and
other States.
vii. Market microstructure and illiquidity in
SDLs: The SDL market is relatively illiquid,
especially when compared with Central Government bonds. This illiquidity premium is
reflected in spreads. The liquidity of SDLs in the secondary market as reflected from its
share in total G-Sec secondary market, remains significantly low (less than 5 per cent).
The lack of liquidity can be attributed to reasons such as low outstanding stock of
multiple SDLs, market microstructure issues and lack of market makers. SDLs are
almost always new issuances, and hence are fragmented lacking critical mass to
improve trading volumes. In 2017-18, the Central Government had 156 reissuances out
of a total of 159 issuances, while state governments had 43 reissuances out of 411
issuances. Thus, there is a need for reissuance by State Governments.
The SDL market microstructure could also partly explain low liquidity. As on March
2018, more than half of SDLs ownership consisted of insurance companies (33.5 per
cent) and PFs (18.1 per cent) who are largely investors who hold the bonds till maturity.
Even banks investing in SDLs are averse to trading because of the valuation norms
which facilitate nudging up of the price of SDL in banks' books and insulation from
market risks offered by HTM dispensation. With an objective to ensure banks' bond
portfolios reflect their current market valuation, it has been decided that the SDLs
should be valued based on observed prices. This measure could potentially discourage
passive investment by banks and improve trading volumes in SDL. The market is also
devoid of market-makers providing two-way quotes, thereby impacting liquidity.
Risk asymmetry in SDLs
Following the recommendations of the 12th Finance Commission, government
disintermediated from the borrowings of State Governments from FY06 onwards. It was
expected that a rise in the volume of market borrowings would enhance the scrutiny of
the states' fiscal health, and superior fiscal management would be incentivized through
lower borrowing costs.
However, the cut-off yields of SDLs issued by states in any given auction remain
narrowly clustered, despite large variations in the state governments' fiscal
performance. A closer look at the data indicates that there has been no significant
difference in inter-state spreads, which on an average have been between 5-7 bps.
States with better fiscal parameters have expressed view that the market is not
providing any incentive for better performance on fiscal front.
The issue pertaining to risk asymmetries across states have been receiving policy
attention as can be seen from observations in two reports viz., The Economic Survey
2016-17 and the FRBM Review Committee Report, 2017 headed by Shri N. K. Singh.
i) The Economic Survey 2016-17 stated that greater market-based discipline on
state government finances is missing, as reflected in the complete lack of
correlation between the spread on state government bonds and their debt or
deficit positions. It was observed that there is a flat relationship between the
spread and the indebtedness of states therefore states are neither rewarded nor
penalized for their debt performance."
ii) The FRBM Review Committee Report titled "Responsible Growth: A Debt and
Fiscal Framework for 21st Century India" published in January 2017 stated that
Despite SDL borrowing rates being market determined, it is felt that risk
asymmetries across states are not adequately reflected in the cost of borrowings.
The report observed that few well managed states with good fiscal performance
have expressed that they are not adequately compensated for better
management of their fiscal and there is some element of cross subsidization by
the financially stronger states of the other states which is akin to financial
repression."
To address this anomaly, RBI has taken several measures. The measures include a)
conducting of weekly auction of SDLs since October 24, 2017 to prevent bunching of
issuances, b) publishing of high frequency data in the RBI Monthly Bulletin relating to
the buffers SGs maintain with RBI, the financial accommodation availed under various
facilities by each SG from the RBI, the market borrowings and the outstanding of SDLs,
so as to add transparency essential for deepening the SDL market. c) The interest rate
on borrowing against the collateral of Consolidated Sinking Fund (CSF) and Guarantee
Redemption Fund (GRF) funds has been lowered to incentivize State Governments to
increase these buffers, which is again an element of comfort to the investors. d) With a
view to incentivising the State Governments to get SDLs rated publically, the cost of RBI
repo facility against the collateral of 'rated' SDLs have been re-calibrated to provide for
lower margins on SDLs3. e) For a fair valuation of SDLs in the books of banks, it has
been decided that the securities issued by each SG will henceforth be valued at the
observed prices in the secondary or primary auctions. Although improvement in debt
sustainability indicators have been witnessed over the years, appropriate pricing of
State Development Loans (SDLs) signaling underlying financial conditions of the states
will have the potential to reinforce fiscal discipline of states. All these measures are part
of the top down approach. The time has come for a bottom up approach, where State
Governments themselves take proactive measures which may include increasing
investor engagement by holding investor meets and promote investment by local as well
as foreign investors.
Way Forward
As the debt manager of the Government, Reserve Bank has to ensure that the financing
needs of the Government is met at low cost over medium/ long-term while avoiding
excessive risk. However, given the quantum increase in market borrowings, it is critical
to develop a strategy by coordinating the market borrowings of Central and State
Governments.
i. Revamping cash management
State Governments will have to relook at their cash management practices and
develop expertise for monitoring and reporting cash flows and using the data to
forecast cash balances with the objective of timing their respective borrowing
programmes.
ii. Inter-state lending borrowing
State Governments have in the past been demanding, and rightly so, greater
avenues to invest their surplus cash balances. Perhaps, the cash surplus SGs
could lend to those in deficit at a rate linked to the market. Of course, this would
need to be budgeted for.
iii. Mandating investment in Consolidated Sinking Find (CSF)/ Guarantee
Redemption Fund (GRF):
Investment in CSF and GRF with RBI, is voluntary at present. These reserves
are intended to provide a cushion to the SGs in meeting the future repayment
obligations. States which maintain these funds are holding different levels of
investments in terms of their outstanding liabilities. There is merit in making
investments in CSF and GRF mandatory for SGs and specify a minimum
threshold in terms of their outstanding liabilities to provide greater comfort to
investors. To further incentivize adequate maintenance of these funds by the
State Governments and to encourage them to increase the corpus of these
funds, Reserve Bank has lowered the rate of interest on Special Drawing Facility
(SDF) from 100 bps below the Repo Rate to 200 bps below the Repo Rate.
iv. Rating of SDLs by rating agency on a standalone basis
SDLs carry no credit risk, as they are sovereign and have power to impose taxes
under constitution. This absence of credit risk can be seen from the fact that the
risk weight assigned to holdings of SDLs by commercial banks is zero in the
calculation of their CRARs under the Basel III capital regulations, similar to GOI
bonds. There is no default history to assess probability of default. The states also
maintain a consolidated sinking fund (CSF) with RBI to provide a cushion for
amortization of market borrowing/liabilities. Having CSF and GRF gives states
and investors comfort that SDL payments will be made in all circumstances. On
the other hand, risk needs to be looked into in its totality. An index measuring
debt sustainability and fiscal prudence performance indicators could be
attempted to measure state government performance. Fiscally strong SGs can
take the initiative to get themselves rated on such parameters from approved
standalone rating agencies and make them public. This may help them to get
better rates in auctions of their bonds. Such exercise would act as an incentive
for states to perform better. To incentivize adoption of public ratings by the State
Governments for SDLs, recently the Reserve Bank has decided that the initial
margin requirement under LAF for rated SDLs shall be set at 1.0 per cent lower
than that of other SDLs for the same maturity buckets. The public disclosure of
SG ratings may also help in price differentiation of SDLs.
V. Robust calendar
While the Central Government is known to adhere to the borrowing calendar
published every half year (HY), the SGs do not adhere to their quarterly
calendars. Such deviations leave the market to second guess their market
borrowing. Communication to the market as well as predictability is critical for
credibility of the borrowing programme.
vi. Consolidation of debt
The maturity pattern of SDLs indicates that the redemption pressure would start
increasing from 2022-23 and would continue to do so till 2026-27. The upsurge in
redemption necessitates consolidation of debt. Each State Government will have
to plan reissuances, buyback and switches based on their respective maturity
profiles and cash flows. This will help create volumes, facilitate trading in the
secondary market and benefit SGs by lowering yields. Additionally, it will also
even out redemption pressures and elongate the residual maturity of securities.
Due to efforts of Reserve Bank, several states have started reissuing SDL. We
are also working with states on debt buy-backs and will take this process forward.
vii. Improved and timely disclosure of information:
FRBM legislations have significantly improved budget reporting, debt and fiscal
data of states is not readily available. With a view to improve transparency and
facilitate investors in taking informed investment decisions, there is a need to
provide high frequency data on State finances in public domain. Transparency
includes having an independent audit of sub-national financial accounts, making
periodic public disclosures of key fiscal data, exposing hidden liabilities, and
moving off-budget liabilities on budget.
Conclusion:
Development and reforms are a continuous process. During the new millennium, State
Governments have taken several steps to improve fiscal and debt management. All the
State Governments have enacted their Fiscal Responsibility Legislations incorporating
the fiscal consolidation path. Therefore, an institutional commitment to fiscal prudence
exists. The traditional debt sustainability indicators are on a reasonably strong footing.
There may not be any significant systemic risk on account of states' public debt.
However, during the recent past there are indications of fiscal slippage. Rising deficits
and borrowings of states with low liquidity and shallow investor base have macro-
economic implications. Hence, it is important for all the stake holders to take measures
as discussed above. I would urge market participants to utilize the SDL data being
published by RBI to take informed investment decision and also encourage participation
of other investors including FPIs in SDLs. Economic and social welfare of citizens is
dependent on effective fiscal and debt management by the states. Building robust SDL
markets and augmenting debt management systems in states to take care of emergent
risks, is both imperative and urgent. Reserve Bank has been working actively with State
Governments to achieve this objective. I would urge market participants also to play an
active role in this endeavour.
Thank You.