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States would showcase their development activities, enabled by enhanced fiscal space, to argue that they must not be penalised by rating agencies
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In one of the recent State Development Loans (SDL) auctions, the 10-year bond of Uttarakhand had a cut-off yield of 6.74 per cent while that of Rajasthan had 6.70 per cent.
Interestingly, the fiscal deficit ratio of Uttarakhand for FY26 was much lower at 2.9 per cent than Rajasthan’s 4.3 per cent.
For the seven-year bond issued, Himachal Pradesh had a cut-off 6.65 per cent while UP had 6.67 per cent. Yet, the latter’s fiscal deficit and debt-GSDP ratio were much lower at 3 per cent and 29.4 per cent compared with the former’s 4 per cent and 40.5 per cent.
This shows that States’ (sub-sovereign) finances are not linked with the cost of borrowing in the market.
At another level, the AAA corporate bond in FY25 had an average yield of 7.60 per cent compared with 6.87 per cent for the 10-year Gsec, giving a spread of 73 bps. For an AA rated bond it was 8.70 per cent with a spread of 183 bps.
Therefore there is a premium being paid for lower rated corporate bonds. The corporate bond market is very discerning and the credit rating matters. In fact while there is a subtle difference between the creditworthiness between AAA and AA rated companies, the cost can change quite significantly.
Rating States
Now, the status of SDLs can be looked at. There are no ratings as such for these securities. But credit rating agencies evaluate States based on financial parameters besides other behavioural traits before using the proxy rating for state-owned enterprises where there is an irrevocable guarantee provided. Here one of the leading rating agencies, CARE, has given ratings of A (-) for Tamil Nadu, Andhra Pradesh BBB, Karnataka AA (-) and Punjab BB (+).
The rationale here is that States, if evaluated, as standalone independent entities like corporates, would have different credit ratings. Yet, presently all States carry the tag of sub-sovereign with little differentiation when it comes to the market. There are hence anomalies on the cut-off yields at the SDL auctions where some States with better fiscal parameters having to pay more than other States which have less impressive indicators.
This is the starting point of the debate on whether or not State governments need to be rated so that the market can expect States with higher deficits and debt to give a higher return. In fact, this line of argument leads to the conclusion that if this is done, then States would have to ensure better fiscal discipline and hence control their deficits and expenditures. There can be no counter argument here.
But there are some practical issues that hinder the implementation of this new scheme. All State governments are considered to be sub-sovereigns and have an implicit guarantee from the RBI. This means, irrespective of any shortfall on the State’s part, the RBI, being the banker to the government, will honour all payments in the form of interest and principal. Interestingly, this is an implicit guarantee and not an explicit one.
Therefore, to make the ratings effective, the concept of guarantee needs to be reconsidered. This will be tough because State governments are analogous to the Central government when it comes our federal structure.
But then, the counter argument which can be used is that the third level of government, the municipal bodies, do not have such an implicit guarantee and have to borrow money in the market based on their credit rating. So lower ratings of an urban local body will mean higher cost of borrowing. The argument here is, if municipal bodies do not have this implicit guarantee, why should State governments have it?
The deficit factor
Also, the Centre at times allows States to run higher deficits. During the pandemic higher deficits were permitted but it was conditional on reforms being implemented, such as power sector reforms.
Even prior to the pandemic, States with revenue surpluses or an interest-to-revenue ratio within certain limits, were given additional space to run higher deficits of 0.25 per cent of GSDP.
Sometimes States would showcase their development activities, enabled by enhanced fiscal space, to argue that they must not be penalised by rating agencies.
States often argue that being government bodies working for people’s welfare, their finances cannot be compared with that of corporates. Given their development responsibilities, States argue that their spending cannot be looked through a commercial lens.
So to ensure fiscal prudence, States cannot ignore their welfare agenda.
Also direct handouts — cash or goods such as sarees, sewing machines or bicycles have consumption effects and spur economic growth.
In short, if States are to be rated on the basis of fiscal performance, and if they focus on prudence, then development can be jeopardised. There can be some merit in this argument as States vary significantly on the development scale.
So, what is the way out? While it may not be possible to remove the implicit guarantee on loans taken by the State government, State budgets can be rated by the top credit rating agencies such as CARE, CRISIL, ICRA etc. as a matter of routine.
These ratings can be disclosed to the market and the players can decide to use them at the time of bidding in the auctions. This way, the market can decide on how to price the SDLs.
Can the RBI bring in differential weights for investments in SDLs? This can be difficult as long as the implicit guarantee concept remains. Hence, getting in an informal scale to show to the market can be a way out where the credit ratings take into account the development efforts rather than just focus on the fiscal or prudential indicators.
There are no easy solutions here given that there are multiple issues to be considered when a sub-sovereign entity is concerned, as there are disparities in levels of development across States which require differential action by governments.
The writer is Chief Economist, Bank of Baroda. Views expressed are personal
Published on May 22, 2025
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