A more in-depth analysis, based on equation (3) in section 2, identifies the key determinants of state debt in Table 1. Growth in state government liabilities reflected both growth in fiscal deficits and accumulation of interest payments on outstanding debt, while growth and inflation were offsetting factors. The small residual terms – below 1 percent of GSDP in all years except 1998 – suggest that the model in section 2 (equation (3)) captures well the actual debt dynamics in Tamil Nadu.

# **_3.2 India’s subnational borrowing regime_**

The Indian Constitution forbids states from borrowing abroad and requires them to obtain central permission for domestic borrowing. The central government places informal limits on states’ borrowing through the annual discussions with states on financing state development plans. While limiting explosive growth of state debt, the central government has not succeeded in preventing the states’ fiscal deterioration as indicated by high levels of debt and debt service over revenue in many states. Bargaining between the center and the states has often prompted the center to give additional loans or relax borrowing limits. Furthermore, since the late 1990s, many states have circumvented the borrowing limits by accumulating arrears or issuing guarantees to public enterprises’ market borrowing or newly-created special purpose vehicles.

The state borrowing regime in India is complex. There are multiple borrowing channels – each channel with its own rules. The states can obtain market financing, loans from the central government, and financing from employees’ provident fund (Figure 8).<sup>19</sup> Although market borrowing, from the bond market, national small savings fund, and negotiated loans with public-sector financial institutions, has increased in importance, accounting for more than half of subnational borrowing, market discipline is absent. Market loans in India are not pure market-based lending for two reasons. First, market loans are dominated by public commercial banks which have persistently exceeded the statutory requirement of holding government bonds, effectively crowding out private investment. Commercial banks’ holding of government securities grew from 14 percent of combined liabilities of the consolidated government to 25 percent between 1991 and 2004.

Second, interest rates on government bonds are the same for all states independent of creditworthiness. States typically approach the market together, and the Reserve Bank of India (RBI) reportedly pushes creditors to buy a mix of state bonds with the bettermanaged states subsidizing the worse-managing states. In 1999, RBI allowed market borrowing up to 35 percent of a state’s total market borrowing allocation. But in reality, state-specific auctions are declining not increasing (World Bank, 2005b).

> 19 The Provident Fund is a cash balance retirement benefit account operated under the Employees Provident Fund Scheme 1952. All employees of a notified establishment under the Act have to be enrolled as members. Employees and employers contribute to the fund at the rate of 12% of monthly wages payable to employees. A member of a Provident Fund can withdraw the full amount at credit in the Fund on retirement from service or after attaining the age of 55 years.

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