Respected
Dr. Rangarajan, Dr. Raja Chelliah, Dr. Srivastava, Professor Kumar and friends,
I
am thankful to Dr. Srivastava for affording me the opportunity to participate
in the annual day celebrations of the Madras School of Economics. It is an honour
and privilege to be associated with the activities in a distinguished gathering
such as this one.
I
was born in a village in Kadapa (then Cuddapah) district but went to High School
in Chennai (then Madras), studying in Telugu medium. After a two-year stint in
Government Arts College, Anantapur, I was back in Chennai for pursuing my university
level studies in economics. My participation today in the annual day celebrations
of the Madras School of Economics gives me an opportunity to express my gratitude
to (Madras) Chennai which helped me in becoming and being a student of economics.
There
are several reasons for selecting this subject for my address today. First, in
the Indian federal polity, the States, relative to the Centre, have taken the
centre-stage in the reform process since the areas of highest national priority
now fall essentially within the purview of the States. For instance, agriculture,
education, public health, sanitation and much of physical infrastructure belong
primarily to the domain of the State Governments. Second, Dr. Rangarajan and Dr.
Srivastava were Chairman and member, respectively, of the Twelfth Finance Commission,
which made historic contribution to the Centre-State relations. It is also noteworthy
that they addressed the Sixteenth Conference of State Finance Secretaries, held
at the RBI. Third, it was Dr. Rangarajan who, in 1997, initiated the process of
active interface between the Reserve Bank and the State Governments a decade ago,
when he inaugurated, as the Governor of the RBI, the first Conference of State
Finance Secretaries. Finally, there is very little literature available on the
theory or practice of the role of the central banks at the level of sub-national
governments. Hence, there may be some merit in recording our experience in this
regard. I am taking this opportunity to chronicle the unique and productive partnership
between the RBI and the State Governments in securing the progress of our economy,
as part of economic reforms.
On
November 8, 1997, Dr. Rangarajan, the then Governor of the RBI, in his inaugural
address at the First Conference of the State Finance Secretaries convened by RBI,
had flagged the issues that needed to be focussed upon in management of State
finances. These included: alternative methods for borrowing by the States, statutory
ceiling on debt, setting up of consolidated sinking fund and the issuance of State
Government guarantees. I would like to report that most of his expectations have
since been substantively met, as I will enumerate today, a little later.
I
would also like to place on record the high priority that continued to be accorded
to this collaborative process by Dr. Jalan who succeeded Dr. Rangarajan as the
Governor, RBI. For instance, in his inaugural address at the Tenth Conference
of State Finance Secretaries, on June 7, 2002, stressing on the cooperative framework
between the Centre and the States, Dr. Jalan had pointed out that there were lessons
to be learnt from the coordinated approach adopted by some of the large federal
governments in managing their finances successfully in contrast to some of the
Latin American nations. He had noted that although the Centre’s large deficit
had constrained its ability to support the States, the harmonious relations amongst
the States, the Centre and the RBI, which are involved in the management of public
finances in India, had enhanced the stability and integrity of India’s financial
system. He had also reiterated the problems associated with the "automatic
debit mechanism", stating that a State could not manage its finances if such
a mechanism pre-empted a large portion of its available funds.
Mutual
Trust
The
'Reserve Bank of India' and ‘banking’ find a listing in the Seventh Schedule of
the Indian Constitution and hence, fall within the exclusive jurisdiction of the
Central Government. The Reserve Bank of India Act, 1934 provides that the Central
Government shall entrust the RBI with all its money, remittance, exchange
and banking transactions in India and the management of its public debt, and shall
also deposit all its cash balances with the RBI, free of interest. On the other
hand, the RBI may, by agreement with any State Government, take over similar
functions on behalf of that Government. Accordingly, the RBI is the banker to
both the Central Government and all the State Governments, except two, in the
Indian Federation.
The
RBI also manages the open market borrowings of the Central Government and all
the States. The market-borrowing programme of the State Governments
is finalised by the Government of India and the Planning Commission, keeping in
view the provisions of Article 293(3) of the Constitution of India. The Article
stipulates that a State may not, without the consent of the Government of India,
raise any borrowings if it has any loan outstanding, which is repayable to the
Government of India.
The
RBI has, over the years, closely interacted with the State Governments in its
developmental role – particularly in areas of development of agriculture, and
small industries. The RBI was specifically entrusted with an important promotional
role, since its inception, of financing agricultural operations and marketing
of crops. In fact, the Agricultural Credit Department was created simultaneously
with the establishment of the RBI in 1935.
The
Reserve Bank prepares and publishes an annual Study on the State Government Finances.
This is a unique study since it compiles, consolidates and analyses detailed data
on the budgets of all the State Governments. It also documents the policy initiatives
on State finances and debt management by the State Governments, the Government
of India and the Reserve Bank. The study has been well received by policy makers
and academicians, both in India and abroad, and is an important reference document.
It
is noteworthy that the interface between the RBI and the State Governments arises
not only out of statutorily mandated obligations but also voluntarily, based on
mutual trust. The mechanism of bi-annual conference of the State Finance Secretaries
has formalised and strengthened the process of partnering for progress, based
on mutual respect, through a process of continuing consultations, but with the
States retaining their freedom. Apart from the State Finance Secretaries, senior
functionaries of the Government of India, the Comptroller and Auditor General
of India, the Controller General of Accounts and the Planning Commission as also
heads of select departments of the Reserve Bank are invited to the Conference.
There are occasions when fiscal experts such as Mr. A. Premchand, Mr. M.S. Ahluwalia
from the Planning Commission, leading commercial bankers and representatives of
credit rating agencies are also invited to participate and contribute to the specific
issues on the agenda.
Open
Market Borrowings
The
normal procedure followed for open market borrowings, until the first half of
the nineties, was that the RBI would complete the combined borrowings of all States
in one or two tranches at a predetermined coupon, which was common to all States
and was on par with that of the Central Government. After announcement of the
loan, the RBI would write to the banks indicating the contribution expected from
them, mainly based on their market-share of deposits, with a request to invest
in the State Government bonds. Thus, high statutory pre-emptions in the form of
Statutory Liquidity Ratio (SLR) in respect of the banks and the tying-up of the
loans by the RBI ensured a captive market for these loans amongst the banks and
the successful completion of the allocated borrowing programme.
With
the substantial increase in the market borrowing programme of the Central Government,
progressive reduction in the SLR, increasing sophistication of the Indian debt
markets offering diversified portfolio choices to banks, mark-to-market valuation
norms, changes in risk weighted capital prescriptions and the deteriorating financial
position of the States, it was becoming increasingly difficult to complete the
market borrowings of the States, through the tranche system, at pre-announced
coupon.
To
reflect these new realities, including the market perception of the status of
the State Governments, in 1997, the coupon rate for the entire borrowing programme
for all the States was fixed broadly on the basis of a mark-up (which was initially
25 basis points and later increased to 50 basis points) over the yield of ten-year
stock of the Central Government. Apart from the fact that the banks displayed
an increasing reluctance to voluntarily invest in the State Government paper,
the market had started discriminating amongst the States based on their perceived
strengths and weaknesses; thus adversely affecting completion of the approved
borrowing programme for the States.
The
Central Government had switched over to the auction method for its open market
borrowing programme since 1993 and in view of the experience described above,
it was felt necessary for the State Governments to explore the possibility of
adopting a flexible approach with regard to interest rate, maturity, etc., of
their borrowings. It was also felt that in view of inter-State disparities, a
gradual and cautious approach was necessary. Based on the consensus at the first
Conference of the State Finance Secretaries, an option was made available to the
State Governments to enter the market through a flexible approach, on their own,
to the extent of 5 to 35 per cent of their gross market borrowings. The timing
and volume of issues for auction were to be decided by the RBI, in consultation
with the State Governments, taking into account the market and liquidity conditions.
This dispensation enabled the well-managed States to take advantage of the market
conditions and raise loans at finer rates while the smaller States were able to
protect their interests by substituting a part of their borrowings under the totally
pre-announced coupon approach, with the auction method. The State Governments
were subsequently encouraged to progressively further increase the share of market-borrowings
under the auction route initially to 50 percent and thereafter to cover the entire
market-borrowings.
The
auction system was experimental since the year 1998-99 with one State adopting
the auction route in January 1999. The number of States adopting the auction route
increased gradually in subsequent years.
With
the implementation of the recommendations of the Twelfth Finance Commission (TFC),
the year 2005-06 marked a watershed in the evolution of the finances and the (open
market) debt management operations of the State Governments. Spurred by the moderation
in fiscal imbalances and progressive enactment of Fiscal Responsibility Legislation
by the States – induced in some measure by the incentivised Debt Relief Scheme
recommended by the TFC – the market perception regarding the fiscal position of
the States seemed to have improved considerably. As many as 24 States opted for
the auction route during 2005-06 as compared with only three States in the previous
year. The States raised 48.5 per cent of their total borrowings through the auction
route during 2005-06. The cut-off yields in the auctions were, in general, lower
than the tap issues.
The
market borrowings of the State Governments during 2006-07 and 2007-08 so far have
been raised entirely through the auction route, with a general decline in spreads.
In brief, the migration from the system of administered borrowing programme to
the auction method of borrowing in respect of the States was achieved gradually
and through a consultative process between the States and the RBI.
Consolidated
Sinking Fund
At
the request of the State Governments, the Reserve Bank had prepared a model Consolidated
Sinking Fund (CSF) Scheme and circulated it amongst them for adoption / consideration
in 1999. By the time of the ninth Conference of the State Finance Secretaries
held in November 2001, 11 States had set up the CSF, which is being administered
by RBI.
The
Twelfth Finance Commission had recommended that the CSF may cover repayments in
respect of all the loans of the State Governments (and not just open market borrowings).
Furthermore, the Bezbaruah Committee on Ways and Means Advances (WMA) to States
had recommended that the States would be entitled to the Special WMA to the extent
of their net incremental annual investment in the CSF, subject to the prescribed
ceilings. Against this backdrop, the Reserve Bank circulated a revised model scheme
of CSF amongst the State Governments in May 2006. As on June 30, 2007, of the
eighteen State Governments that had set up the CSF, 11 had established it as per
the revised CSF scheme. Many more States have intimated their intention to adopt
the revised CSF scheme, as administered by RBI.
Prepayment
of debt
In
the context of build up of cash balances, two States proposed to utilise their
surplus cash to pre-pay a part of their outstanding open market debt. In this
connection, the modalities of buyback auctions were finalised by the Reserve Bank
in consultation with these State Governments and the Government of India. General
issues relating to the pre-payment of debt were discussed at the 18th
conference of the State Finance Secretaries, held in August 2006. The RBI has
conducted two rounds of buyback auctions in February and March 2007.
State
Government Guarantees
Issues
relating to State Government guarantees have also been discussed in almost every
conference of the State Finance Secretaries. Against the imperative of infrastructural
development, the States have been under pressure to provide guarantees for facilitating
the flow of funds to the high-priority sectors, State public sector enterprises,
developmental institutions and local bodies, for commercial as well as non-commercial
activities as also for urban development. The element of risk associated with
such guarantees, transparency with regard to the guarantee policies and the magnitude
of guarantees extended by the State Governments have raised concerns regarding
the optimal or sustainable level of such guarantees. It is well recognised that
while the guarantees, being contingent liabilities, do not form part of the debt,
as conventionally measured, these have, in the eventuality of default, the potential
of straining an apparently sound fiscal system.
At
the first Conference of the State Finance Secretaries held in November 1997, the
issue of government guarantees was deliberated upon at length and the view taken
was that, in the interest of prudent financial management and the credibility
of the guarantees issued, there was a need for a policy on guarantees for each
State Government within certain national parameters. Accordingly, a Technical
Committee was constituted to examine the issue of State Government guarantees,
in all its aspects. The report of the Committee was discussed at the third Conference
of the State Finance Secretaries, held in January 1999, and pursuant to the recommendations
of the Committee, several States have since taken the initiative to fix a ceiling
on guarantees to be issued by them.
The
devolvement probabilities of various guarantees are not identical and consequently,
all guarantees can not be treated uniformly in terms of their fiscal impact. In
order, therefore, to assess the fiscal risk arising out of guarantees in a more
realistic and objective manner, there was a need to evolve a methodology for classifying
guarantees into appropriate categories, with each category reflecting broadly
similar fiscal impact. This, in turn, was expected to facilitate the fixing of
ceiling on guarantees in a non-mechanistic fashion to better capture the risk
inherent in guarantees, and to enable adoption of better provisioning techniques
to cover these contingent liabilities. In this backdrop, it was decided to constitute
a Group of State Finance Secretaries on the Fiscal Risk on State Government Guarantees
to examine the fiscal risk of guarantees extended by the State Governments. The
report of the Group was discussed at the tenth Conference of the State Finance
Secretaries, held in June 2002.
The
general consensus that emerged at the Conference was to place the Report of the
Group in the public domain. It was also agreed to explore the possibility of extending
the scope of the relative RBI circular addressed to the banks, to the financial
institutions also so that they too would undertake due diligence and proper appraisal
in financing of projects rather than merely relying on the State Government guarantees
in their favour. It was also proposed that States could be provided technical
assistance in regard to assigning appropriate risk weights to the guarantees.
The
Reserve Bank organises workshops on the evaluation of fiscal risk of guarantees
for the benefit of State Government officials. Representatives of credit rating
agencies are also invited to give presentations at the workshops. So far, four
such workshops have been organised. It was also decided that the State Governments
would be encouraged to seek, for their internal use, credit ratings from a rating
agency so that they could initiate appropriate measures to improve their financial
performance when they approached the market to mobilise resources.
The
Reserve Bank circulated a draft scheme on Guarantee Redemption Fund (GRF) amongst
the State Governments for voluntary adoption. As an incentive to build up the
Consolidated Sinking Fund (CSF) and GRF, the Bezbaruah Committee (2005) had recommended
that net incremental (i.e., new investment less redemption/liquidation) annual
investment of States in CSF/GRF would be made eligible for availing Special WMA,
but up to a ceiling equivalent to the Normal WMA limit. Keeping this in view,
the Reserve Bank circulated revised draft GRF scheme amongst the State Governments
in May 2006. As on June 30, 2007, eight State Governments had set up the GRF,
of which three had put in place the revised scheme.
Ways
and Means Advances, and cash management
The
Reserve Bank of India (RBI) has been extending Ways and Means Advances (WMA) to
State Governments since 1937 with the objective of covering temporary mismatches
in the cash flows of their receipts and payments.
The
WMA Scheme has been periodically revised, right since the early 1950s, in the
light of the perceived requirements of the State Governments, keeping in view
the evolving fiscal, financial and institutional developments as well as the objectives
of monetary and fiscal management. State-wise limits in respect of Normal and
Special WMA are determined based on certain parameters and have been revised,
periodically, over the years. An overdraft (OD) occurs whenever these limits are
exceeded. Maximum time-period (days) and/or financial limits up to which the State
Governments can remain in overdraft have been specified; these limits have also
been revised periodically. Payments on behalf of the State Governments are suspended
in case the OD limits are breached.
Till
the late 1990s, the Normal and Special WMA limits of State Governments were fixed
in terms of specified multiples of their minimum balances kept with the RBI. Both
the minimum balances and the 'multiples' to obtain the Normal WMA limits, were
revised upwards a number of times (though not necessarily at the same time) over
the years.
There
have been strong demands from several States, from time to time, for upward revision
of the WMA limits. RBI had taken the view that WMA is meant for meeting the temporary
mismatches in the cash flows and hence, any upward revision in the WMA limits
to meet structural deficits of the States is inappropriate. The matter remained
a contentious issue for some time.
The
initiation of the Conference of State Finance Secretaries in 1997 induced a transformation
in the approach to formulating changes in the WMA Scheme. Distinct from the past,
Advisory Committees were periodically constituted by the Reserve Bank to review
the prevailing WMA arrangements and recommend changes, as considered appropriate,
in the light of the evolving circumstances. The involvement of experts from outside
the Reserve Bank in such Advisory Committees helped to strengthen and broad-base
the modalities for effecting appropriate changes in the WMA Scheme. In fact, three
Advisory Committees, that have been constituted so far, have been chaired by experts
from outside the Reserve Bank and have included other 'external' experts apart
from senior functionaries from the Reserve Bank, as members.
The
first informal Advisory Committee on the WMA to State Governments was constituted
in 1998, under the chairmanship of Shri B.P.R. Vithal. As a major break from the
past practices, the Vithal Committee recommended the de-linking of the size of
the Normal WMA limit with the minimum balances held by the States on the grounds
that "fixing the WMA limits as multiples of an unchanged minimum balance,
as in the past, does not capture the differing needs of the States in line with
the different growth in their budgetary transactions. This has resulted in wide
inter-State variations in the WMA limits in relation to the size of the Budget,
and this needs to be corrected." The Vithal Committee instead proposed
linking the normal WMA limit to the cash flows of the State. The recommendations
were implemented in the light of further consultations with the States and the
Centre.
Subsequently,
similar committees (Ramachandran Committee, 2003 and Bezbaruah Committee, 2005)
have refined and improved upon the WMA arrangements. It is noteworthy that WMA
arrangements have ceased to be a contentious matter amongst the Centre, States
and RBI on account of the reliance placed on the advice from the outside experts
and intensive consultations amongst the stakeholders, in finalising the arrangements.
The
upsurge in the surplus cash balances of some of the State Governments since the
middle of 2004-05, in contrast to the liquidity pressures witnessed in the earlier
period, has posed newer challenges to financial and cash management of State Governments.
The issues relating to investment of cash balances of the States were discussed
at the 18th Conference of State Finance Secretaries held in August
2006 and also in the 20th Conference of State Finance Secretaries held
in August 2007. Taking note of the discussions, the Reserve Bank is in the process
of formulating the plans in this regard, in consultation with the Centre and the
States.
Advice
on fiscal management
The
importance of fiscal transparency has got reinforced in the recent years after
Government of India subscribed, in 1997, to the Special Data Dissemination Standards
(SDDS) promulgated by the International Monetary Fund. In the light of this development,
it was decided to constitute a Group of the State Finance Secretaries to suggest
various measures of disclosure, which could be introduced in the budgetary exercise
of the State Governments. It was also decided that the Group could lay down a
model budget for the States, which would enable the Legislature and the public
to enhance their understanding of the State finances. The Group suggested, inter
alia, that it would also be useful if the State Governments could publish
a document akin to the Budget at a Glance of the Union Budget furnishing
the estimated levels of Gross Fiscal Defiit (GFD) and Primary Deficit (PD) of
the State, including their ratio to the State Development Product (SDP). The document
could also incorporate time-series data on important fiscal variables of the State.
The levels of outstanding debt, guarantees extended, wages and salaries, and subsidies
could also be explicitly indicated. Many States have, in the light of these deliberations,
modified their budget-related documents to enhance fiscal transparency
A
Group was constituted in February 2003 to undertake a study of the pension liabilities
of the State Governments and make suitable recommendations. The Group observed
that if pension payments of the States were to grow at the historical average
growth rate, pension payments alone would pre-empt about 20 per cent of the total
revenue receipts of the States and as much as 30 per cent of the revenue receipts
in the year 2010-11. Thus, purely from the perspective of fiscal sustainability
of the States and the magnitude of the problem, structural alteration in the existing
pension scheme, appeared necessary. The Group recommended introduction of contributory
pension scheme/s for the new employees of the State Governments in lieu of the
existing non-contributory defined-benefit pension scheme. The Group also recommended
three alternative pension models, which are to be acted upon by the States as
they consider appropriate. As per the available information, 19 State Governments
have notified a defined-contribution pension scheme for their new employees.
Recognising
the absence of unanimity about the exact level, composition, and methodology for
compiling the liabilities of the State Governments in India, it was decided in
August 2004, to constitute a working group to evolve a methodology. The Group
recommended that the compilation of data on the budgetary liabilities should be
consistent with those in respect of the Gross Fiscal Deficit and accordingly,
specified the constituent items. The Group also recommended exclusion of the implicit/contingent
liabilities from the definition of budgetary liabilities, reckoning the wide divergence
in views on the various items that should be included under implicit liabilities.
It, however, recommended the disclosure of information on various implicit liabilities
along with the budgetary liabilities. The Group recommended specific formats for
timely release of data on the liabilities in the budget documents of the State
Governments. The Group also recommended that the Reserve Bank should compile and
publish the data on the liabilities of the States in its annual study on the State
budgets; this recommendation has already been implemented.
Fiscal
Responsibility legislation
The
RBI had provided detailed and comprehensive technical inputs to the Government
of India for formulating a Fiscal Responsibility and Budget Management Law, which
culminated in the enactment of the Fiscal Responsibility and Budget Management
(FRBM) Act by the Parliament. In view of this successful outcome, State Finance
Secretaries expressed a desire for similar advice to them from the RBI. Accordingly,
a group was constituted in October 2003 with select State Finance Secretaries
and a representative from the Government of India, Ministry of Finance, as members,
to prepare a model fiscal responsibility legislation for the States. The draft
Report of the Group was discussed at the 14th Conference of the State Finance
Secretaries, held in August, 2004 and the final report was submitted to the Reserve
Bank in January 2005. The Group decided that the model legislation would generally
follow the pattern of the Central FRBM Act, and build upon the State fiscal responsibility
legislations already enacted. The Group also took into account the international
best practices available in the area as well as the recommendations of the various
committees on fiscal transparency and on the issues related to voluntary disclosure
of information by the State Governments. Various dimensions of the fiscal legislative
framework, such as, the choice of targets, the road map for achievement of the
targets, need for a detailed set of illustrative rules, independent evaluation
criteria, prioritisation of capital expenditure, treatment of contingent liabilities
including guarantees, computation of pension liabilities, etc., were deliberated
upon to arrive at a consensus. The Group felt that the model Bill would provide
guidance to the States for enacting their fiscal responsibility legislations with
reference to certain benchmarks.
The
objective of the Group was to design a template for the fiscal responsibility
legislation for the States on the basis of feasibility on pragmatic considerations
and enforceability, taking into account the diverse requirements of various States.
It was considered desirable to allow each State to take a view on the sequencing
of adoption of various provisions of the model Bill, fixing the actual targets,
time frame for implementation thereof and allocating the provisions between the
Act and the Rules, depending on its fiscal capabilities and further refining the
provisions given in the model bill within the overall framework of fiscal prudence
and sustainability.
All
State Governments, except two, have already enacted fiscal responsibility legislation.
New
arrangements for borrowings by the States
According
to the TFC, it would be appropriate for the States to take advantage of the prevailing
market rates and avoid the spread charged by the Centre on the assistance provided
by it. The pattern of Central assistance included loan as a major element in respect
of general category States, which was implicitly funded from borrowings by the
Centre and hence, the terms of loans extended to the States reflected the Centre’s
cost of borrowings. To the extent these arrangements prevailed, there was, in
effect, intermediation by the Centre in the provision of loans to the States as
part of the Central assistance. The TFC, therefore, recommended that the Central
Government should not act as an intermediary for future lending and allow the
States to approach the market directly. If some fiscally weak States were unable
to raise funds from the market, the Centre could borrow for the purpose of on-lending
to such States, but the interest rates should remain aligned to the marginal cost
of borrowing for the Centre. This approach was accepted by the Central Government,
in principle, to be implemented in phases, in consultation with the Reserve Bank.
The
new arrangements for ensuring disintermediation of the Centre in respect of States’
borrowings were deliberated upon, at the Conferences of State Finance Secretaries
and by the Monitoring Group on Cash and Debt Management of the Government of India
and RBI. In the light of these discussions and in order to operationalise the
new arrangements, the Government of India constituted a Technical Group, with
Smt. Shyamala Gopinath, Deputy Governor, RBI as chairperson and the officials
of the Government of India, select States and the Reserve Bank, as its members.
The Technical Group submitted its report to the Government of India in December
2005 and made several recommendations.
In
tune with the recommendations of the Group, there has been noticeable progress
in regard to drawing up of calendar of borrowings, re-issuance of securities and
adoption of the auction method for borrowing by the States. In addition, on the
lines of the recommendations of the Working Group on Liquidity of State Government
Securities (Chairman – Shri. V.K.Sharma), 2005, State Development Loans (SDLs)
have been made eligible for repo transactions under the liquidity adjustment facility
of the RBI and it has been decided to introduce the non-competitive bidding facility
in respect of the primary auctions of SDLs. As far as the arrangements for sharing
the corpus of the National Small Savings Fund (NSSF) are concerned, in accordance
with the decision of the National Development Council, the obligatory share of
the States has been reduced to 80 per cent with effect from the year 2007-08.
Loan
Council
The
TFC had also recommended that "…..States, like the Centre, must decide
their annual borrowing programme within the framework of their respective fiscal
responsibility legislations…. The overall limit to their annual borrowings from
all sources should be supervised by an independent body like a Loan Council with
representatives from the Ministry of Finance, Planning Commission, Reserve Bank
of India and the State Governments. The Council may, at the beginning of each
year, announce the annual borrowing limits for each State, taking into account
the sustainability considerations….." (Para 15.7).
It
was, however, felt that setting up of a new institution, like the Loan Council,
would entail additional cost in terms of physical and human resources and would
take time. Moreover, a large majority of States are currently seized with the
task of addressing structural issues in managing government finances which, if
carried on to their logical conclusion, could usher in an era of debt sustainability
over the medium-term of the TFC period. The Loan Council could lose its raison
d’etre once the fiscal situation became tractable, as seems to have been the
case with the Australian Loan Council, which provides the international best practice
in respect of coordinated borrowings by the Federal and State Governments. Against
this backdrop, the Technical Group felt that the objective of securing coordinated
borrowings between the Centre and the States on the one hand, and between the
States on the other, could be best served by the setting up a Standing Technical
Committee (STC) with representation from the Central Government, State Governments
and the RBI.
The
Terms of Reference of the STC are to make annual projections of borrowing requirements
of the State Governments; build alternative scenarios and suggest alternative
strategies and instruments for raising resources of the States; advise on a mechanism
for annual allocation of market borrowings amongst the States; take note of actual
borrowings of the State governments during the year vis-à-vis the budgeted
GFD and develop an appropriate database that would facilitate the monitoring exercise;
assess fiscal risks from issuances of State Government guarantees; and advise
State Governments on various issues relating to their borrowings.
The
first meeting of the STC was held during the 20th Conference of the
State Finance Secretaries held in August 2007.
Management
of Foreign Exchange Risk
The
external assistance by multilateral agencies to the States has traditionally been
routed through the Central Government as part of the Central assistance, with
the Centre bearing the foreign exchange risk. However, as part of the policy of
disintermediation of the Centre in the borrowings by the States, it was decided
by the Central Government that there should be a back-to-back transfer of external
assistance to the States. At the 16th Conference of the State Finance
Secretaries, some of the State Finance Secretaries suggested that the RBI could
play an advisory role in assisting the States in hedging their exchange rate risks
arising from the policy of back-to-back transfer of external assistance.
In
the context of the TFC recommendations and following the discussions at the 19th
Conference of the State Finance Secretaries, held in January 2007, the first workshop
on the management of foreign exchange risk by the States through the financial
markets was organised by the Reserve Bank in May 2007, for the benefit of the
State Government officials.
The
States have also proposed alternative mechanisms for providing for foreign exchange
risk by setting aside funds in their budgets, where the Reserve Bank is expected
to play a role in managing these funds on the lines of the CSF. These proposals
were discussed at the 20th Conference of the State Finance Secretaries,
held in August 2007.
Selective
broadening and deepening of relationship
There are many areas in which there has been close coordination between the RBI
and the States. For some of the important areas of the RBI’s responsibilities,
there are standing institutional mechanisms at the State level, with which the
Regional Offices of the RBI and the concerned officials of the State Governments
are associated. The more important areas of close coordination relate to the provision
of overall physical security for the banking system, matters relating to coins
and currency and responses to natural calamities.
Considerable decentralisation of powers and responsibilities to Regional Offices
of the RBI has been brought about to facilitate locally relevant solutions to
the problems, as they arise. The empowerment of Regional Offices has been combined
with promoting State-specific initiatives, both in policy and implementation.
The Regional Offices play a facilitating role in bringing together the contending
parties when some tensions arise, that affect the financial system. One of the
examples relates to resolution of stand-off between a State Government and the
microfinance institutions on the terms of loans granted and methods for recovery
of dues employed by the microfinance institutions. Similarly, considerable latitude
is provided, to suit the local conditions, in the deliberations of State Level
Bankers’ Committees, and there are many instances of the State Finance Ministers
and Chief Ministers presiding over such meetings.
In
the broad area of banking, an innovative mechanism has been designed to resolve
the issue of dual control in regard to the urban cooperative banks. Several States,
together accounting for over seventy percent of urban banking activity, have signed
Memorandum of Understanding with the RBI to constitute in each State a Task Force
on Urban Co-operative Banks (TAFCUB) to ensure co-ordinated actions to revive
and strengthen this sector. This has been, by all accounts, an outstanding success.
Similarly, Empowered Committees have been constituted in all the States to reorganise,
strengthen and expand the Regional Rural Banks. In the matters relating to revival
of rural cooperatives also, State-specific packages are considered. Special plans
for coordinated actions for select States, where the spread and depth of banking
services are poor, have been mounted, the examples being the north-eastern States,
Uttarakhand and Bihar.
More
recently, a vigorous programme of financial inclusion has been initiated to ensure
the offer of banking services to the whole population. The RBI plays the lead
role in each State, while the State Government participates in the movement, for
operationalising the approach. The States have particular interest in this programme
to ensure efficient and inexpensive disbursal of funds under several social security
related and rural employment programmes. The recent developments in technology
are facilitating this process. Simultaneously, some States have shown enthusiasm
for extending financial literacy and RBI is encouraging its Regional Offices to
respond, preferably in the local language, and the RBI website attempts to disseminate
information in several of these languages.
We
do recognise that while we should avoid overstretching our resources, we should
be willing to interact and respond positively to the genuine demands of the State
Governments that are legitimate concerns of the RBI. No doubt, the State-specific
considerations would govern State-specific responses, within the overall policy
framework of the RBI. There are many areas, which are perhaps of greater relevance
to the Central Government than to the RBI, in which the States seek the RBI’s
involvement but we are constrained to carefully distance ourselves. Some time
ago, there was a strong appeal from several States that the RBI should award a
rating to the quality of fiscal management of all the States, which would carry
greater weight and foster better response from the political leadership of the
States concerned. The RBI had to politely decline the request since, as an institution,
it should not appear to be ranking the States or passing judgments on their fiscal
performance.
Outcomes
and Challenges
Having
delineated the efforts and the processes of collaboration between the States and
the RBI, it is only appropriate to briefly enumerate the outcomes and to recognise
the critical challenges that lie ahead for the State finances and the RBI.
First,
the progressive enactment of Fiscal Responsibility Legislations (FRLs) by as many
as 26 State governments has indeed strengthened the fiscal consolidation initiatives
at the State level.
Second,
the gross fiscal deficit of States, which had increased from an average of 2.8
per cent of GDP in the first half of the 1990s to an average of over 4 per cent
of GDP in the first half of the present decade, was placed at 2.5 per cent of
GDP in 2005-06 and is expected to be brought down to 2.4 per cent in the budget
estimates for 2007-08. The revenue deficit, which had increased to an average
of 2.2 per cent of GDP in the first half of the present decade, has remained at
less than 0.1 per cent since 2005-06. In fact, an aggregate revenue surplus (of
0.4 per cent of GDP) has been budgeted for 2007-08. All States, except eight,
have budgeted for a revenue surplus during 2007-08.
Third,
open market borrowings of the State Governments have been conducted entirely through
the auction route during 2006-07 and 2007-08 (so far). The spreads for almost
all the States, over the yields of Central Government securities of comparable
maturity during 2006-07 and 2007-08 so far, has remained well below 50 basis points
(spread fixed in the case of tap issuances), reflecting favourable market perception.
Fourth,
as far as the State Government guarantees are concerned, the volume is on a declining
path: guarantees were placed at 6.5 per cent of GDP as of end-March 2005 as compared
with 8.0 per cent as at end-March 2001. Many States have imposed administrative/
legislative ceilings on guarantees. Eight States have set up Guarantee Redemption
Funds to provide for the possible invocation of guarantees.
Fifth,
18 States have set up Consolidated Sinking Funds to provide for orderly repayments
of their open market borrowings. Of these, 11 States have adopted the revised
CSF scheme which provides for repayments of all liabilities (and not just open
market loans). Many more States have proposed to set up the revised CSF.
Sixth,
the cash management of the State Governments has shown a marked improvement in
recent years. The daily average utilisation of Normal WMA, Special WMA and overdrafts
by the State Governments declined during 2006-07. During 2006-07, eight States
availed WMA as against 12 States in the previous year. Only two States resorted
to overdrafts during 2006-07 as against eight States in the previous year.
Notwithstanding
the positive developments and prospects, there would remain a few areas of concern.
There
are certain risks to the process of fiscal consolidation such as the expected
increase in expenditure from the revision of pay scales of the State Government
employees, pursuant to the implementation of the ensuing recommendations of the
Sixth Pay Commission. In this connection, State Governments would need to make
their budgets robust enough to enable them to steadfastly adhere to the provisions
of their Fiscal Responsibility Legislations. Fiscal empowerment through revenue
augmentation holds the key to address such fiscal risks.
Initiatives
by the States would be needed to develop a calendar for open market borrowings
by the States, on the lines issued by the Government of India. This would enhance
transparency, reduce uncertainty for the market participants and thereby help
to further smoothen market-borrowing operations. Re-issuance of State Government
securities would also help to build up a critical minimum size of securities,
which would, in turn, help to enhance their liquidity.
The
Reserve Bank continues to receive complaints from the banks and financial institutions
regarding defaults in honouring of obligations under the State Government guaranteed
bonds. Such issues need to be addressed by the State Governments as this would
impact on their credibility and market perception of their financial position.
At
the same time, issues relating to the insistence of certain (re-financing) institutions
for provision of State Government guarantees, irrespective of the financial viability
of projects, perhaps on account of legal requirements, also need to be addressed
at an appropriate forum.
The
State Government expenditures on education and health remain low at around 2.5
per cent and 0.7 per cent of GDP, respectively. These expenditures may need to
be enhanced to make a long-term impact on the level of human development in the
country, within the framework of Fiscal Responsibility Legislation. At the same
time, issues relating to the quality and timeliness of providing such social sector
services need to be expeditiously addressed. From the Reserve Bank’s standpoint,
initiatives relating to credit culture, financial literacy, financial inclusion
and priority sector lending would continue to remain high on the policy agenda.
Concluding
Remarks
RBI
has considerable professional skills and the States recognise and value them better
when we are willing to consider State-specific orientation to our broader analysis.
The RBI, like most of the central banks, commands considerable credibility and
good public image and as a public institution is considered relatively apolitical
in viewing the vertical relations between the Centre and the States and horizontal
ones amongst the States. The bi-annual Conference of the State Finance Secretaries
sponsored by the RBI has proved to be an excellent forum for wide-ranging discussions.
The Technical Committees or Groups that are formed, have membership entirely from
the States, though Centre may occasionally be associated, but RBI provides secretarial
and technical support. The Centre and each State concerned decides the appropriate
course of actions. The fact that some of the States have adopted a few but not
all the recommendations of the Committees and Groups, demonstrates the shift away
from the perceived centralisation of the past towards a participative process.
I
am happy to submit that all the States, though with varying degrees of enthusiasm,
fully endorse the immense contribution of the process of partnering between RBI
and the States in the cause of better financial sector and fiscal empowerment
in the States.
Let
me conclude with profuse thanks to the Madras School of Economics for provoking
me to think aloud on this subject and share the thoughts with wider audience.
The
School came into existence in 1995, but very soon, it could obtain `A’ Grade from
the National Assessment & Accreditation Council. The Ministry of Environment
and Forests has also designated the school as a Centre of Excellence in Environmental
Economics.
I
have no doubt that the School would emerge to be an internationally recognised
Centre of Excellence in economic studies attracting the best of students and teachers
from different parts of the country as well as other countries.
On
our part, we in the RBI are in close touch with the School with a view to obtaining
their expertise in the process of monetary policy formulation.
Thank
you.
Address
by Dr. Y.V.Reddy, Governor, Reserve Bank of India at the Madras School of Economics,
Chennai on September 23, 2007