Quality control

A deficit in itself is not bad,the quality of deficit is more of a concern.

Indias economic growth,after the initiation of reforms in 1991 in general and from 2003-04 in particular,has migrated to a high growth era. Even during the global economic and financial crisis period of 2008-09 and 2009-10,India’s growth has been exemplary. National economic,taxation and reform policies define the broad contours of economic policy; however,states define their own sectoral policies (for example,tourism policy in states where this is significant or mining policy in states endowed with mineral resources). States derive maximum advantage by aligning these policies with national priorities. Moreover,apart from its economic base,social and infrastructure development play a crucial role in the growth of a state.

While the national economic growth has increased,it has also increased inter-state divergence in per capita income,measured as per capita net state domestic product (NSDP) at 1999-00 prices. The coefficient of variation of per capita NSDP increased from 48.6% in 1999-00 to 54.2% in 2007-08,another measure of economic divergence among states; maximum to minimum income ratio also increased from 7.7 to 8.6 during the same period.

Why do states have a divergent growth pattern? A combination of factors is responsible for this. The initial economic and infrastructural conditions,structure of economy and quality of labour force are some important factors responsible for the varying degree of growth. Governance issues also have a substantial impact on economic growth (the recent growth performance of Bihar is testimony to this). Indian agriculture is passing through a low-growth phase and states with higher concentration of agriculture in their economies are experiencing slower growth (Punjab). Low level of industrialisation (Madhya Pradesh) is another obstacle in achieving high economic growth. However,some states (Gujarat) are able to achieve high agricultural growth by tilting their production structure away from foodgrain in favour of cash crops. States with higher industrial activities (Gujarat,Haryana and Maharashtra) expanded their economies faster than other states.

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The genesis of national and state fiscal consolidation during 2003-04 to 2007-08 has been the strong growth momentum. A rapidly growing economy translates into strong revenue buoyancy,which contributes to fiscal consolidation. Declining deficit levels increase fiscal space available to government,thereby increasing the spending on infrastructure creation. Infrastructure constraints and low endowment of human capital are two other major obstacles for high economic growth. Populous states are not able to reap the demographic dividend due to a low endowment of human resources.

A deficit in itself is not bad,globally all nations borrow to tackle liquidity-revenue-expenditure mismatch. The quality of deficit is more of a concern than deficit per se.

An analysis of fiscal and economic data of Indian states for 1999-00 to 2007-08 reveals:

l a strong negative correlation between average revenue deficit/ GSDP and average capital outlays/ GSDP; and

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l a strong negative correlation between GSDP growth and average fiscal deficit/GSDP.

What do these relationships tell us? A general global phenomenon during fiscal crises is fiscal consolidation at the cost of capital expenditure. It is a bigger problem when a larger portion of current/revenue expenditure is committedadministrative,pension and interest payments cannot be controlled in the short- to medium-term. As the quality of deficit deteriorates (a large portion of deficit is incurred to finance current consumption rather than financing of current expenditure),capital outlays by state governments decline. Declining capital outlays have a long-term growth implication for states,since the quality of both human and physical infrastructure needs improvement; states have to increase capital outlays.

A strong correlation between economic growth and average fiscal deficit is a pointer towards the importance of economic growth in fiscal consolidation in the absence of any expenditure reforms. Considerable fiscal improvement observed in the states of Bihar,Goa,Gujarat,Haryana,Maharashtra and Orissa,during 2000-01 to 2007-08,is testimony to this fact. While some of these states still have high deficit levels compared to others,it is the pace of improvement that will make them converge both on deficit levels and economic growth.

Increasing industrialisation is another factor that can help states achieve high revenue growth. At times,states are not able to take full advantage of centrally sponsored schemes (schemes with fixed share of investment from central government) due to the states inability to generate enough resources to finance their share of expenditure for these schemes.

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West Bengal and Sikkim were unable to take advantage of the debt consolidation and relief facility (DCRF) offered by the Twelfth Finance Commission because they hadnt enacted state fiscal responsibility law. Rest of the states took advantage of DCRF,which helped them not only reduce their debt levels but also consolidate their debt from the central government and reduce the proportion of committed expenditure. However,after the recommendation of Thirteenth Finance Commission,West Bengal enacted a state fiscal responsibility law and is now entitled for benefits under DCRF,which would alleviate some pressure from its finances.

Investment is crucial to sustain growth. While the recent episode of upturn in economic growth in Bihar is largely attributed to improved governance,continuation of this growth momentum will depend on investment in the state both by the government and private sector,which inter alia depend on the quality of physical infrastructure and human capital. Controlling committed expenditure is a key both for fiscal consolidation and improving capital outlays. Bihar,Kerala,Orissa,Punjab and West Bengal have a relatively higher share of committed expenditure. At a time when governments are constrained by resources,private sector focused investment policies and public-private partnerships with strong regulatory environment can help states achieve their desired objective of increasing investment without sacrificing fiscal consolidation.

The author is director,Fitch Ratings India Private Limited. Views are personal