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Consolidating the national debt: India need fresh strategy for new global financial conditions

There are sovereign debt and banking crises in a number of nations, including some in our neighbourhood, Europe, and Africa. G20 Finance Ministers and Central Bank Governors met in Bengaluru on February 24-25, 2023, under India's presidency, to discuss this urgent issue of financial stability that could escalate into a global crisis. For heavily indebted nations, rising interest rates, inflation, and stagnant economies have created unfavourable conditions. Likewise, countries with moderate debt levels, such as India, require a novel strategy to adapt to the new global financial environment.

We argue that the fragmented market for sub-sovereign debt of State Governments in India is inefficient, hinders economic growth, and threatens financial stability. This market should be merged with the requirement for the Government of India's debt to create a single market for the Public Debt in order to improve India's sovereign debt profile. The 'implied sovereign guarantee' leading to mispricing of risk, the small size of the market leading to illiquidity and consequently high transaction costs and low levels of participation, and the lack of transparency regarding the borrowing capacity of each state are the three primary reasons for the inefficiency of the fragmented market for states' debt in India. These three factors have a negative impact on the Indian market for state debt.

The Key Elements

Since Article 293 (3) of the Indian Constitution regulates state borrowing, there is an implied sovereign guarantee for state debt in India. This is reflected in the market by the fact that all state debt paper trades at a modest premium to Government of India bonds (within a range of 40 to 80 basis points), regardless of the financial health of the respective state government. Since the federal government approves each state's annual borrowing limit, the market functions as if all state government bonds are backed by the federal government. In the absence of price discovery for state debt, it is difficult to compare the risk associated with various states' bonds and to evaluate the creditworthiness of a state government.

Second, the relatively small size of each state's debt restricts the market's size and liquidity, which increases transaction costs and tends to reduce market participation. Thirdly, since the borrowing limit of all states was established using the same metric, i.e., as a percentage of their GSDP (gross state domestic product), this has caused some states to fall into a debt quagmire. The 'debt trap' situation of these states is worse than it appears if their future pension liabilities, which have neither been adequately evaluated nor entirely funded to date, are taken into account.

State-Backed Paper Off-budget bending by states is typical. It takes place when a state-owned enterprise (such as a state electricity distribution company) issues'state-guaranteed' bonds. As a result of the state guarantee, purchasers of these bonds neither assign an autonomous risk weight to them nor price them independently.

The fact that many of these bond purchasers are small pension funds or non-banking financial institutions with limited ability to assess the risks associated with these bonds exacerbates the problem.

In addition, even the largest banks have been negligent in subscribing to state-guaranteed papers without evaluating the underlying risk exhaustively. We cannot solely fault market participants for this situation involving rolling guarantees. State paper and State-Owned Enterprises bonds are typically underpriced due to an implied sovereign guarantee and a state guarantee, respectively.

We believe that the 'implied sovereign guarantee' of the Central Government must be eliminated immediately in order to mitigate the six negative consequences outlined above: mispricing of state debt, lack of risk evaluation, high transaction costs, lack of market participation, state government debt traps, and free-riding by state-owned enterprises that issue state-guaranteed paper.

There are two evident solutions to this problem. Allowing each state to borrow independently based on its credit rating, within the limit set by the federal government, is one solution. The alternative is to subsume all state paper into Government of India paper and combine the markets for state debt and central government bonds into one. This latter arrangement will require the federal government to transfer the loans to the respective states back-to-back. We favour the second alternative for the reasons listed below.

First, the national debt will be transparent, allowing for a greater understanding of its size and trends. Moreover, with an explicit sovereign guarantee, the entire public debt will be priced better (at a reduced risk premium), resulting in a reduction in the government's overall borrowing cost and a more efficient use of taxpayer funds.

In addition, a larger and more liquid market will make it less expensive for retail investors to purchase and sell Government of India bonds. This will significantly simplify the regulation of commercial banks, as their portfolio of government bonds (including the required liquidity ratio) will be more homogeneous and transparent. Eventually, this consolidation will assist the central government in developing a deeper market for long-duration bonds of up to 30 years, which will facilitate the growth of several crucial sectors, including insurance, long-term project financing, and long-term risk management.

The first concern can be adequately addressed by the Central Government's assurance that it will transfer funds to each state up to its current borrowing limit. The state will benefit from reduced borrowing costs. The matter may also be considered by the subsequent (16th) Finance Commission, which will make recommendations regarding the distribution of revenues between the centre and the states for the five years from April 2025 to March 2030. Therefore, there will be no financial disadvantage for the states.

Regarding a state government's ability to determine its debt, this is currently limited to determining the schedule and quantity of bonds issued within the Central Government-set annual borrowing limit. This limited degree of autonomy can be maintained in the new regime of the consolidated national debt by the Central Government operating a public debt management office (PDMO) that provides professional advice to all states and organises the timing and amount of each state's debt receipts in accordance with that state's choice.

This new system of consolidated national debt can be designed to ensure no negative consequences for states while simultaneously delivering multiple benefits. It will eliminate the uncertainty surrounding the implied sovereign backing for state government loans, enable the Central Government to operate a single public debt management office, enhance the development of long-term debt markets, improve India's sovereign debt ratings, and result in banks' portfolios becoming more transparent. These developments will increase confidence in our banking system and economy without question.

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