Profligate State-Level Spending Could Derail Modi's Reform Plans

Even as New Delhi's deficit narrows, state level deficits are widening
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  • Central government has made progress on the fiscal deficit
  • Gains may be lost as populist state governments spend up big
Photographer: Dhiraj Singh/Bloomberg

India’s national government has finally got its finances under control. Too bad about the states.

With populations as large as 200 million people, India’s states are massive. They also wield enormous budgets.

But while New Delhi has slowly wrestled its fiscal deficit to 3.5 percent of GDP from 5 percent a few years ago, the deficits are actually widening at the state level -- leaving India’s financial position essentially unchanged from 2012, before Prime Minister Narendra Modi even took power. What’s more, the problem is likely to get worse as populist farm waivers and other spending sprees pick up ahead of the general election in 2019.

Capital Economics

"There’s definitely reason to be concerned over the way things are going," says Shilan Shah, the Singapore-based India economist for Capital Economics, who tackled the subject in a recent note. 

It means borrowing costs for Indian companies could rise as state-owned banks are forced to buy state-issued bonds, "crowding out" companies hoping to raise debt. That could hit already-anemic private sector investment, which has been holding back faster GDP growth and prevented India from generating the millions of jobs needed to meaningfully employ its young population.

It also means India may not get a ratings upgrade that could improve global investor confidence. In the past, India’s top officials have complained about ratings agencies keeping India at their lowest investment grade, saying they have "inconsistent standards" for assessing Asia’s third-largest economy.

More broadly, Shah said, it means Modi’s reform agenda at the center is being undermined by the country’s various states.

But Modi and his Bharatiya Janata Party are not entirely without blame. 

In the euphoria following the BJP’s election victory in India’s most populous state, Uttar Pradesh, the new state government -- run by a Hindu priest -- eagerly turned on the money taps for a huge loan waiver for the state’s farmers. 

That has set off a domino effect as the waiver puts pressure on other other Indian states. BJP-led Maharashtra, Karnataka and Punjab have already announced loan waivers. Farmers in Gujarat, Madhya Pradesh, Haryana and Tamil Nadu are asking for waivers that would cost many hundreds of billions of rupees more.

To give a sense of scale, the Uttar Pradesh waiver will cost 2.6 percent of state GDP -- and the government is already running a 3 percent deficit. In Maharashtra, the state’s 2.7 percent deficit will be hit by a $5.2 billion waiver affecting nearly 9 million farmers.

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India’s central bank governor Urjit Patel has warned writing off loans for millions of farmers encourages others not to repay and risks pushing up inflation. Fitch Ratings has already said that waivers will lead to "further fiscal slippage," noting the last widespread waiver program for 43 million farmers in 2008 cost around 1.3 percent of GDP. CLSA India Pvt. has predicted these loans could swell to $30 billion over five years. 

These are big numbers. And it’s not as simple as saying economists are heartless: Reports suggest needy farmers are sometimes skipped over, while even-poorer landless agricultural laborers don’t benefit at all. 

But Shah notes it’s not just loan waivers causing the uptick in state spending. 

Weaker economic growth has hurt tax revenues, while spending on wages has gone up. Importantly, however, Shah said it’s concerning that most of the spending is on rising public sector wages and subsidies, rather than on more productive investments such as infrastructure that could boost growth and raise living standards over time.

"Markets could forgive an infrastructure spend," Shah said. "They’re less likely to forgive spending on wages."

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