India’s public debt, at about 80 percent of GDP, is disproportionately high for its per capita income. Yet committed constituencies advocating for smaller or higher quality debt are largely absent. The complacency is because high debt has neither resulted in runaway interest rates or rollover risks nor is it seen to be a drag on growth.

The stability of debt is ascribed to the way it has been financed–domestically, at fixed rates, for long-term,  and in local currency. While foreign investors have been virtually debarred, insulating the debt market from global shocks, domestic institutional investors (banks, provident funds, and insurance companies) are mandated to hold a part of their balance sheets in government papers in the guise of “safe assets”.

Downsides of high public debt— by using up nation’s savings, it crowds out private investments; and interest payments leave inadequate resources for growth enablers such as education, health, R&D, and infrastructure–are hard to establish, resulting in their absence from the discourse.

The complacency has encapsulated the states as well. Collectively, a third of India’s public debt is held by the states, —large than other federal economies. But the states’ debt is perceived to be as safe as that of the Centre, if not more, due to its similar composition and the Centre’s implicit guarantee.

Masked in this safety is the remarkable heterogeneity across states. State debts vary from less than 20 percent of respective state GDPs in Odisha, Maharashtra, and Gujarat to more than 45 percent in Himachal Pradesh and Punjab.

During the last decade, a majority of India’s larger states,  Andhra Pradesh, Bihar, Chhattisgarh, Haryana, Himachal Pradesh, Jharkhand, Kerala, Punjab, Rajasthan, Tamil Nadu, and Telangana, have added more than 10 percentage points to their debt-to-state GDP ratios. Five states — Goa, Assam, Karnataka, Madhya Pradesh, and Uttarakhand — have increased their debt ratios moderately by 3 to 7 percentage points; and the debt ratios of five states — Maharashtra, Gujarat, Odisha, Uttar Pradesh and West Bengal — have fallen or remained flat.

States with larger increases in debt have recorded higher primary deficits and larger contingent liabilities. More indebted states spend larger proportions of their revenues on committed expenditures such as wages, salaries, pensions, subsidies, and interest payments, thereby impairing their growth prospects. Under the business-as-usual scenario, a majority of these states will become even more indebted, further widening their fiscal and developmental gap with the less indebted states.

So, what can be done to strengthen fiscal health of states?

First, states should be mandated to conduct a forensic analysis identifying revenue shortfalls or expenditure over-runs; to orient spending toward investments; and limit contingent liabilities. For strengthening institutional capacity, states should be asked to establish their own independent fiscal councils. These councils should assess the realism of state government forecasts of revenues and expenditures, offer forecasts of their own, and provide analyses of the scope for realization of contingent liabilities. A model for setting up the councils can be proposed by NITI Aayog, while their initial funding can be allocated in the Union Budget.

Second, with many states violating their fiscal rules, it is time to re-assess and overhaul the fiscal rules.

Third, the role of the Finance Commission needs a relook.  Finance Commissions have perversely been mandated to allocate more resources to states with larger revenue deficits. They should instead factor in overall fiscal prudence when recommending allocations; suggest procedures to hold the states accountable for laxity; and ensure credible corrective action.

Fourth, states display little heterogeneity in the rates at which they borrow. Their borrowing rates do not vary with the level of indebtedness, primary deficit, or economic growth. Instead, more indebted states can issue longer tenor securities without having to pay a term premium or a risk premium. For example, Punjab, with a debt-to-GDP ratio of twice as large as that of Gujarat, pays the same interest rate on its securities as Gujarat.

This lack of variation reflects the perceived guarantee of the Centre, resulting in investors’ apathy to discriminate across states. In addition, the Reserve Bank of India ensures that interest rates on state debt remain in a tight range. The policy of defacto capped spreads on the bonds of heavily indebted states should be revisited while allowing market discipline to play a larger role.

Finally, as a last resort, there may be room for a fiscal “grand bargain”, where heavily indebted states receive some debt relief (a portion of their debt is transferred to the balance sheet of the Central Government) in return for them conceding additional Central Government oversight, amending their practices, and even some dilution of fiscal autonomy. Such bargains have worked in other fiscal federations.

A ‘Viksit Bharat’ needs Viksit states; and Viksit States need healthy public finances.