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`Black Box' India States Thwart Modi Moves to Lower Debt Costs

  • Nomura sees deficits of major states widening to 3.3% of GDP
  • Worsening finances risk raising borrowing costs across India

Asia’s widest budget deficit is probably worse than it appears.

While Prime Minister Narendra Modi has succeeded in shrinking the federal shortfall, that’s only part of India’s fiscal story. State governments are unlikely to contain their deficits within the 3 percent of gross domestic product target mandated by law, Nomura Holdings Inc. predicts. Higher debt sales would boost borrowing costs as bond issuers compete for funds.

"The risk is very real and quite substantial, at least over the next two years," said Jay Shankar, an economist with Religare Securities Ltd. in New Delhi, referring to fiscal slippage. How states spread out power utility bonds and higher planned spending on staff salaries would be a crucial factor in determining pressure on yields, he said.

Indian bonds have surged after the government’s budget restraint and slower inflation led to anticipation of monetary easing. The benchmark 10-year yield slumped 16 basis points in the debt’s best March performance since 1999. Uttar Pradesh, the nation’s most populous state, sold 10-year notes at 8.02 percent at an April 18 auction, down 56 basis points from that at a March 8 sale.

Tracking the finances of 29 state governments has become more important since Modi gave them more of India’s tax revenues last year -- a record 42 percent. The combined federal and state fiscal situation is a key impediment to a rating upgrade even as Modi pledged to narrow the federal budget gap to a nine-year low of 3.5 percent of GDP this year.

It’s not easy to study state budgets. Unlike the federal government, which publishes monthly data, there’s no similar database for states. Each one presents its budget using different parameters.

For example, several states account for debt taken over from power utilities as capital expenditure, said Sonal Varma, a Mumbai-based economist at Nomura. Even excluding these bonds, the budget shortfall for 16 large Indian states analyzed by Nomura reached an average 3.2 percent of GDP in the year ended March 31 -- 0.4 percentage point more than planned. For the current fiscal year, the brokerage estimates a gap of 3.3 percent of GDP compared with 2.8 percent forecast by the various state governments.

"It’s a black box," Varma said by phone. The power bonds, civil servant pay hikes, over-budgeting of federal tax transfers and spending related to state elections all pose risks to keeping deficits contained, she said.

Higher spending would raise the gross borrowing needs of states by about 20 percent this year to 3.5 trillion rupees, almost as large as last fiscal’s 22 percent increase, Deutsche Bank AG estimates. That would push up India’s overall borrowing to 9.5 trillion rupees, keeping bond supplies high and compelling the central bank to purchase the notes, economist Kaushik Das wrote in an April 12 report.

"Even after factoring in captive demand for bonds from banks, insurance companies, provident funds, mutual funds and foreign institutional investors, there could still be a sizable gap in the demand-supply equation, which would need to be filled in by RBI though open market operations," he wrote.

To manage the debt glut, the Fixed Income and Money Markets Dealers Association -- a private body -- has helped with steps to ensure the bonds don’t enter the market. The notes have been privately placed with certain banks that owe utilities cash and regulations have been eased for such lenders, N.S. Venkatesh, an executive director at IDBI Bank and chairman of FIMMDA, said in a speech on April 19 in London.

One way to improve state finances is by improving the performance of the 849 companies run by state governments, about 30 percent of which are estimated to be incurring losses, said Religare’s Shankar. Failing to do so risks damping the amount of money that can be invested for roads, ports and power plants.

"While state governments have projected higher capex while also aiming for fiscal consolidation, we think this is unlikely to materialize," economists at Standard Chartered Plc, including Saurav Anand in Mumbai, wrote in an April 4 report. "We see downside risks."

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