Three Economic Questions Raised By Government’s GST Compensation PlanBloombergQuintOpinion
After a meeting of the GST Council on Thursday, the central government said that it had presented states with two options:
- States can borrow up to Rs 97,000 crore from the Reserve Bank of India via a special window. The centre would facilitate the mechanism so that states can pick-up this funding at government securities linked rates. This Rs 97,000 crore is the estimated shortfall on account of GST implementation.
- States can borrow a larger amount of Rs 2.35 lakh crore - the entire estimated shortfall in compensation cess for this year. Though it’s not clear yet if the entire amount will be via a special window of the RBI.
While there are no details available, there are a few questions that must be asked as this plan is debated.
Whose Borrowing Is It?
First and foremost, the question must be asked – whose borrowing is this?
The centre is liable to pay the GST compensation to states from the compensation cess collected.
That payment is the liability of the central government.
There could be an argument made that the centre ought to compensate states only for the losses on account of GST implementation. If you buy that argument, you can say the amount due from centre to states is Rs 97,000 crore. If you don’t buy that argument, you could say the amount due to states is the entire Rs 2.35 lakh crore, which is the estimated shortfall in compensation due to states based on the formula agreed upon between the centre and states.
Whichever amount you settle upon, that amount is debt that should go on the central government’s balance sheet. By asking states to borrow from the RBI, will this debt be shifted onto state balance sheets?
Does it matter you may ask?
Investors, rating agencies, and economists look at the general government debt-to-GDP ratio, which includes both central and state government debt. As such, to some of those constituencies this question of ‘whose debt is it’ will seem like semantics.
But it is not. Remember the NK Singh-led FRBM committee had recommended that the general government debt-to-GDP ratio be brought down to 60% by 2023. That included 40% for the centre and 20% for states. The government accepted this but pushed the deadline to 2024-25.
The Covid-19 crisis will mean a spike in the debt to GDP ratios of state and central governments and any additional liabilities will further push that up.
Eventually, those ratios will have to be put on a more sustainable path. Pushing more debt on state balance sheets will mean limiting their borrowing capacity in future years while trying to retain more flexibility for the centre.
Special Window AKA Direct Monetisation?
The second question is on the mechanism.
At present, the RBI lends short-term funds to the central and state governments via the Ways and Means Advances window. These are short term funds used to meet any cash flow mismatches.
Earlier this year, the RBI raised the borrowing limit for the centre and states under this window. However, states used it sparingly. Conversations with state finance ministers at the time had suggested that they didn’t see the short term borrowings as appropriate to deal with the funding requirement brought on by the pandemic.
One option is that the RBI lengthens the term of these borrowings from the current 90 days to a longer period and uses that window for lending to states.
The second option is to open a new window for such borrowings.
If the central government borrowed from the RBI via a direct monetisation window and paid the compensation to the states, the process would have been cleaner. The RBI regularly holds central government securities on its balance sheet and this borrowing would have added to those.
If the RBI lends to states, will the central bank hold state government debt on its balance sheet? It has not done so in the past.
Equally, how will it price these loans? If, as the government suggested, it is priced at a spread above central government g-secs, how will that spread be determined and will it be homogenous across states. As a peripheral issue, if the RBI does take that route and lends at the same rate to all states, it goes back on its long-held dream of creating a differentiated market for state debt based on fiscal parameters.
Liquidity And Inflation
The third question is the liquidity impact and how the RBI will manage that.
Any additional amounts states borrow from the RBI will eventually get spent and add liquidity to the system. With liquidity already in surplus and the spectre of inflation on the horizon, will the RBI be comfortable with this?
To be fair, this dilemma would be equally relevant if the RBI were to directly monetise the central government’s deficit too. Still, it’s a question the RBI must debate if it chooses to go down this route, particularly at a time when Inflation is above the mandated target.
As Suvodeep Rakshit, senior economist at Kotak Institutional Equities said in a report on Thursday, Inflation is not yet a monetary phenomenon. But do we need to worry about it given that money supply growth is already well in excess of output growth?
“In the current cycle, inflation is still not a monetary phenomenon. Most inflationary phases have been linked to money supply growth through high fiscal deficit and credit growth. In the current period, credit growth has been weak. However, fiscal discipline has been slightly inadequate over last few years and it can feed into inflationary pressures if quality of expenditure is not improved through the next 1-2 years,” Rakshit wrote.
The Philosophical View
Beyond the technicalities, if one takes a wider view, it is the sovereign which is the ultimate risk-bearer.
In an unprecedented situation such as the one we are facing, the sovereign will need to step in to provide support. It has shown its willingness to do so for private corporations via schemes such as guarantees offered to small businesses.
As such, the sovereign ought to be willing to step in to support states as well. Should it decide that it is willing to do so, the RBI steps in, in some ways, as the agent of the sovereign. It can then design a special window of support in a way that distortion of market signals is kept to a minimum.
Such special support from the central bank, while technically possible for entities beyond the sovereign, should ideally be restricted to the Government of India to avoid setting a poor precedent.
Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.