Government borrowing makes up for a large part of the budgetary shortfalls. Part of this is announced as a part of the Finance Minister’s speech. Often there are further mismatches, not just between revenue collected and expenditure, but exacerbated by events that have an economic impact (the latest being the Covid pandemic) that forces increased expenditure and lower tax collections. This situation applies both to the Centre and States.
The Central government, as the Sovereign, has certain advantages when they have a deficit as it can finance itself by borrowing (through dated Government securities, or G-Secs), monetization (creating, or printing money), raising local taxes and customs duty. The sovereign can never default on its domestic liabilities.
States are not in such a privileged position as the Centre. While they are considered sub-sovereign, some state bonds are as safe as a G-Sec. But this applies only to State Development Loans (SDL) of which the RBI Governor, Dr Das said, “There is an implicit sovereign guarantee in them.” The Centre will not allow these bonds to default. “On the due date of repayment, RBI automatically debits the state government account and makes the repayment…they would not and cannot be considered risky,” Dr. Das had said. While the yield on these bonds is very attractive, the market lot of Rs. 5 crores, same as of G-Secs restrain the retail investor. Smaller lots are traded, but a lot less. The market does not offer much liquidity to the retail investor.
There is another attractive option available to the investor and to Not-for-profit organizations (NPO). The NPOs have a limited set of investment options allowed them under Section 11 of the Income Tax Act, among them being Government guaranteed bonds. State Government guaranteed bonds then become among the most attractive investment options for an NPO seeking higher returns.
State Governments guarantee some bonds issued by their entities. Some bonds that are frequently traded are the Uttar Pradesh Power Corporation (UPPCL), Rajasthan Rajya Vidyut Prasaran Nigam Limited (RRVPNL), Meghalaya Energy Corporation, while Air India, Punjab Industrial Development Corporation and West Bengal Industrial Development Finance are traded less, even while they remain attractive especially when compared against the returns on bank fixed deposits.
A stark aberration in returns is in the comparative returns between 2 UP State bonds – UP Power Corporation Ltd 2026, rated AA(SO) and UP Power Corporation Ltd 2023, rated A+(SO). The former currently offer a yield of about 7.9%, while the latter is at about 10%. The wide difference of about 210 bps (2.1%) would be strange, especially given that the latter matures in 2023, 3 years before the bond offering lower returns. The reason is that the former is linked to the SDL and the Reserve Bank of India will pay for the redemption of the bond out of the Central dues to the state. The latter is paid out of state funds, or out of the state’s balances with the RBI, which are currently nil. This raises the technical prospect of default, reflected in the lower credit rating.
What are the chances of a State Government guaranteed bond defaulting? There have been defaults of Madhya Pradesh, Uttar Pradesh, Bihar, Punjab and Orissa state PSU bonds defaulting early in this millennium (especially during 2000-2002). The bonds have been restructured and subsequently honored, but the chances of defaults occurring again should not be ignored, even if possibility of default is low.
The current financial crunch faced by states is due to revenue stress from delayed payout of their dues from the Centre and substantially lower tax revenues from poor economic activity from the lockdown. The near-term future outlook for state finances depends on the recovery, which could lead to a sharp bounce back, or further deterioration of the fiscal situation.