to ensure that state debt will not rise above 35 percent of GSDP. If government liabilities are risk weighted, the contingent liabilities at risk of default will decrease to about 3.4 percent of GSDP.<sup>46</sup> This suggests a smaller required surplus of about 1.1 percent of GSDP.

# **5. Concluding Remarks**

Assessing fiscal sustainability is a complex task as it requires one to form a view about how much fiscal adjustment is politically and socially feasible in the future, and how the outstanding stocks of liabilities are going to evolve over time. These, in turn, depend on macroeconomic and financial market developments that are uncertain by nature.

Debt sustainability at the subnational level is further complicated by the respective legislative mandates of central vis-à-vis subnational governments and the intergovernmental finance system. Unable to issue their own currency, subnationals cannot use seigniorage finance. Subnationals cannot freely adjust their primary balance due to legal constraints on raising own revenue, dependence on central government transfers, and central government influences on key expenditure items such as wages and pensions. In the presence of public sector dominance of subnational lending, lending rates could be subsidized, bank lending to subnational entities could exceed the statutory requirements, and credit risk concerns could be compromised. Many policies that affect the economic growth and the fiscal health of the subnational economy are designed largely or exclusively by the central government. Finally, subnational debt dynamics can change significantly if there are expected bailouts by the central government.

The paper presents a framework for analyzing subnational fiscal sustainability and applies it to the case of Tamil Nadu - an Indian state where fiscal adjustment has been ambitious and politically challenging, but has promised to put state finance on a sustainable path. The analysis suggests that the fiscal adjustment in Tamil Nadu has left fiscal space for increases in infrastructure investment which may be achieved without threatening fiscal sustainability.

Risks to the fiscal outlook include interest rate shocks, fiscal pressures on the primary deficit through wage shocks, subsidy increase, or decline in central revenue transfers. Although individually these shocks may not threaten the fiscal sustainability, their combined effect may have serious consequences for debt sustainability. Contingent liabilities constitute an additional source of concern. Finally, though the state’s efforts to remove constraints to growth, minimize recurrent expenditures, and maximize its revenue potential will be critical for fiscal sustainability and the quality of fiscal adjustment in the long run, national policies feature prominently in subnational fiscal adjustment as they influence wages and pensions, interest rates, tax policy, fiscal transfers and the borrowing regime.

A number of caveats are important. This paper is a first attempt to discuss subnational finance issues and is subject to all the caveats pertaining to fiscal sustainability analysis at

> 46 This is a World Bank estimate based on state government data.

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