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A Deep Dive into State Budgets in India

India Policy Forum 2017 New Delhi, India Neelkanth Mishra /+91 22 6777 3716 / neelkanth.mishra@credit-suisse.com Prateek Singh /+91 22 6777 3894 / prateek.singh@credit-suisse.com

Agenda

 Rising Fiscal Importance of the States

− States together now spend 87% more than (net) centre − Central transfers up, and so are states’ own taxes, but scope for improvement − Larger bond market footprint due to higher absolute deficits and borrowing

 Analyzing expenditure trends and patterns

− In under-sized governments revenue expenditure still appears important − Focus on social spending continues − Limited risk of a debt trap − Improvement in the budgeting process can reduce market distortions

Assessing impact of GST, Loan Waivers and FRBM

− GST: fiscal uncertainty greater for the center initially; can it trigger innovation at states? − Loan Waivers: not a one-off development, assessing near-term impact − FRBM Review committee: how easy for the states to comply?

Conclusions

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Rising Fiscal Importance of the States

Expenditure: states now spend 87% more than the centre Receipts: states’ own taxes have grown, but significant scope for improvement Larger bond market footprint

States share of general government spending now 65%

State expenditure growing faster than Centre's States now spend 1.87x the Centre's net spend

Source: RBI, Budget Documents, Credit Suisse Estimates

Growth in aggregate expenditure of state governments has outpaced that of the central government for each of the last seven years From spending 6% more than the centre in FY2011, states are budgeted to spend 87% more than the Centre in FY2018b

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• 5%

0% 5% 10% 15% 20% 25% 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 Central Exp. (Net) Y/Y (%) State Exp. Y/Y (%) 0.9x 1.0x 1.1x 1.2x 1.3x 1.4x 1.5x 1.6x 1.7x 1.8x 1.9x 5 10 15 20 25 30 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018b State Centre (net) Ratio (RHS)

Rs tn

Surge in transfers now over, growth slowing

Total state spend to grow 9% over FY17r Sources of increase in expenditure

Source: RBI, Budget Documents, Credit Suisse Research

Spending is budgeted to grow just 9.3% in FY2018 Smaller increase in central transfers (due to slower tax growth at the centre, slower growth in grants) and a drop in the fiscal deficit Slowdown worse for states more dependent on central transfers

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5% 10% 15% 20% 25% 30% 5 10 15 20 25 30 2009 2010 2011 2012 2013 2014 2015 2016 2017r 2018b Total Expenditure YoY (RHS) ex-UDAY (RHS)

Rs tn

• 1

1 2 3 4 5 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Own Revenues Central Transfer Fiscal Deficit

Rs tn

Own taxes continue to rise: 60% is VAT

States' own taxes have risen as % of GDP

Source: RBI, Budget Documents, Credit Suisse Research

A third of spending increase FY2011 to FY2018b came from own taxes

− Own taxes as % of GDP up from 5.9% in FY2011 to 6.5% now; improvements in JH and TL

VAT is 60% of own taxes; 40% of all VAT is from alcohol and petroleum products 40% of states’ own taxes subsumed by GST

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4.9% 5.3% 5.7% 6.1% 6.5% 0% 5% 10% 15% 20% 25% 30% 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018b Own Taxes YoY (%) As % of GDP (RHS)

VAT is 60% of States’ Own Tax

State Sales Tax 60% Property Taxes 12% State Excise 12% Vehicles 5% CST 4% Electricity 3% Others 4%

Split of Rs10tn Own Taxes in FY17b

Share of Non-VAT taxes steadily declining

Non-VAT taxes are more concentrated

Source: RBI, Budget Documents, Credit Suisse Research

Some non-VAT taxes are more cyclical (e.g. property), but decline has been steady Non-VAT taxes are also more concentrated than population/GDP/VAT

− The top 5 for each of the non-VAT taxes are also different

The perceived loss of freedom with GST may drive more innovation and hard work

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42% 47% 48% 47% 56% 59% 57% 65% 72% 74% 72% 80% 81% 80% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% Population GDP Total Tax VAT State Excise Property CST Top 5 States Top 10 States

Share of non-VAT taxes steadily declining

35% 36% 37% 38% 39% 40% 41% 42% 43% 44% 45% 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Share of non-Sales Taxes in States' Own Tax

Share of non-tax revenues also stagnating

Non-tax receipts have declined in importance Share of non-tax receipts over time

Source: RBI, Budget Documents, Credit Suisse Research

States' non-tax revenues fell from 18% of all revenue receipts in 1995 to 8% now.

− From being 2.1% of GDP in 1995, they just add up to 1.2% of GDP in FY2018b

Some of this trend is healthy: Interest income used to be a dominant source of non-tax income, but has come down significantly; industries, power and petroleum are up

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0.9% 1.2% 1.5% 1.8% 2.1%

• 5%

0% 5% 10% 15% 20% 25% 30% 35% 40% 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018b Non Tax Revenue Receipts YoY (%) As % of GDP (RHS) 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 Interest General Social Industries Power Petroleum Others

State deficits are up, but concerns over-stated

General government deficits (Centre + States) State deficits up from lows, but under control

Source: RBI, Budget Documents, Credit Suisse Research

General government deficit trending down (ex-UDAY); FY2011 inappropriate comparison Adjusted for UDAY, aggregate state deficits have been in the 2.5%-2.7% of GDP range in the last five years, and well within the 3% range prescribed for them FRBM vision playing out: centre had been profligate, now shrunk to its promised size

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0% 2% 4% 6% 8% 10% 12% 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 Union Fiscal Deficit (% of GDP) State Fiscal Deficit UDAY 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 1982 1986 1990 1994 1998 2002 2006 2010 2014 2018b State Fiscal Deficit Without UDAY

The bigger footprint of the states: a reset, not a trend

State borrowing vs. Central borrowing YoY growth in bond issuance by states

Source: RBI, Budget Documents, Credit Suisse Research

“Forward looking” warnings mostly come from the bond markets

− The 3% + 3% FRBM rule is now showing up in the bond market, and they did not expect it − Extrapolation (backward looking and somewhat unwarranted) explains some of the panic

Issuance growth to slow in FY2018b as deficit ratio stabilizes

− Share of deficit funded through bonds already at 80%

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0% 10% 20% 30% 40% 50% 60% 70% 80% 1,000 2,000 3,000 4,000 5,000 6,000 7,000 2002 2004 2006 2008 2010 2012 2014 2016 2018 States' Borrowings Centre's Borrowings States/Centre (RHS)

Rs bn

0% 10% 20% 30% 40% 50% 60% 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 2011 2012 2013 2014 2015 2016 2017 2018 States' SDL Borrowings YoY (RHS)

Rs tn

The eco-system has not adjusted to this change

State borrowing is very 2H skewed 1H/2H skew in overall government borrowing

Source: RBI, Credit Suisse Research

The bulk of state government borrowing still happens in the fourth quarter This is skewing the overall government borrowing seasonality

− Against the central government pattern of 60:40 1H:2H, states are 40:60 or worse − Centre sets its issuance calendar to avoid 2H crowding out when private credit picks up − States were much smaller earlier and did not matter as much but now they do

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0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1Q11 1Q12 1Q13 1Q14 1Q15 1Q16 1Q17 SDLs Raised by States Total for FY (RHS)

Rs tn

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% '13 '14 '15 '16 '17 '13 '14 '15 '16 '17 '13 '14 '15 '16 '17 1H 2H

Centre States Aggregate

Share of Borrowings in 1H and 2H

Analyzing expenditure trends and patterns

Revenue expenditure is still dominant (and not all that bad) Social spending continues to get priority Some vicious cycles visible despite redistribution Far from debt trap (mostly)

Revenue expenditure still dominant (and not all that bad)

17% of state spending is on Capex Share of capex across states

Source: RBI, Budget Documents, Credit Suisse Research

Capex is only about 17% of FY2018b state spending: down in the last two years from an all-time high of nearly 20% in FY2016, but still among the highest recorded Significant variation among states: from < 10% in Kerala to ~25% in Telangana

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10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 5 10 15 20 25 30 35 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018b Revenue Ex. Capex Capex Share (RHS)

Rs tn

0% 5% 10% 15% 20% 25% 30% 100 200 300 400 500 600 KE HA CG JH WB OR AP GU TN BI KA MP MH TL RJ UP Capex (Rs bn) Capex Share (RHS)

States with low per capita GSDP have fewer employees

Low GSDP/capita states have fewer employees Police density (essential service) across states

Source: Census 2011, MOSPI, RBI, Budget Documents, Credit Suisse Research

In under-sized governments revenue expenditure still appears important

− States with a larger government size, as measured in the number of government employees per unit population, appear to have higher productivity levels − Even on essential services like policing, the weaker states have a much smaller headcount than the larger ones

Only a correlation, but all states with smaller per capita GSDP have smaller governments

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20 40 60 80 100 120 140 160 180 200 5 10 15 20 25 30 35 40 HP UT DL TN PU KA KE HA MH AS RA AP ORGUMP JH CHWBUP BI State Empl. Per '000 People (incl. Quasi) GSDP Per Capita (Rs '000) 40 80 120 160 200 1 2 3 4 5 DL PU HP HA UT AS CH JH MH KE TN KA GU RA OR AP MP UP WB BI Police Personnel per 1000 People GSDP Per Capita (Rs '000, RHS)

Social Spending continues to get priority

States' Education spend as % of GDP over time Social Welfare as % of GDP over time

Source: RBI, Budget Documents, Credit Suisse Research

Aggregate education spending has been climbing steadily as % of GDP A significant part of social welfare spending is also education

− Running schools and hostels for children of deprived classes; scholarships

Questions if any should be on the efficacy of this spending, not necessarily the quantum

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2.0% 2.1% 2.2% 2.3% 2.4% 2.5% 2.6% 2.7% 2.8% 2.9% 3.0% 1,000 2,000 3,000 4,000 5,000 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018b Education Revenue Spend (Rs bn) As % of GDP (RHS) 0.6% 0.8% 1.0% 1.2% 1.4% 1.6% 1.8% 500 1,000 1,500 2,000 2,500 3,000 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018b Social Welfare Revenue Spend (Rs bn) As % of GDP (RHS)

Some vicious cycles clearly visible

Spend on education as % of GSDP Education spending per student (FY2017b)

Source: RBI, Budget Documents, DISE, Credit Suisse Research

Education spend as % of GSDP varies from 1.6% in KA to 5.2% in UP Despite high spend as % of GSDP, per student education spend in Bihar and UP are a fraction of that in the better-off states There are exceptions on both sides: e.g. Chhattisgarh or Gujarat

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0% 1% 2% 3% 4% 5% 6% KA TL GU TN MH HA WB KE AP RJ JH MP OR BI CG UP Education Spend as % of GSDP (FY18b) 5 10 15 20 25 30 BI UP JH WB TL MP RJ GU PU OR KA MH TN CG HA AP KE Education Spend/Student (Rs '000)

Despite systemic redistribution

Poor states have a higher spending ratio Slow growth in some transfer dependent states

Source: RBI, Budget Documents, Credit Suisse Research

The weaker states are “bigger”

− Weaker private sector in these states makes the government more important − Dependent on central transfers

States more dependent on central transfers more affected by recent slowdown

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20 40 60 80 100 120 140 0% 5% 10% 15% 20% 25% 30% GU MH KA HA TN WB KE TL AP RJ JH OR MP BI CG UP Expenditure to GSDP (2017) GSDP Per Capita (Rs'000, 2012 RHS)

• 5%

0% 5% 10% 15% 20% 25% 30% 35% 0% 10% 20% 30% 40% 50% 60% 70% 80% HA GU MH TN KE KA TL RJ IN JH CG AP MP UP OR WB BI Central Transfers Share (FY18b) FY18b Spending YoY (RHS)

Salaries not yet a problem; pensions are becoming one

Salaries are lower as % of total expenses The rising pension burden

Source: RBI, Budget Documents, Credit Suisse Research

Despite periodic pick-up due to pay commission recommendations, salaries as % of total expenses has been trending down

− That said, states adding up to only 18% of salary bill have implemented 7th pay commission so far

The rising pension bill is a concern, particularly as it is much harder to project

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0% 5% 10% 15% 20% 25% 30% 35% 40% 1 2 3 4 5 6 1991 1994 1997 2000 2003 2006 2009 2012 2015 Total Wages % of Total 3% 4% 5% 6% 7% 8% 9% 10% 500 1,000 1,500 2,000 2,500 3,000 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018b Pension Spend (Rs bn) % of Total Spending (RHS)

Far from a debt trap (mostly)

Interest cost as % of expenditure

Source: RBI, Budget Documents, Credit Suisse Research

Interest expenditure as a % of total in FY2018b the lowest since 1991

− Even if it is a lagging indicator (by the time it rises, it generally is too late), not flashing red currently

For some states though it is a concern

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0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 0.0 0.5 1.0 1.5 2.0 2.5 3.0 1991 1994 1997 2000 2003 2006 2009 2012 2015 Total Interest (Rs Tn) % of Expenditure

Non-discretionary spend high for some states

20% 30% 40% 50% 60% 70% CG RJ UP JH BI MP KA HA GU OR TL TN AP MH WB KE PU (Interest + Salary + Pension) as % of Total Expenditure (2016)

No differentiation: how do you “discipline” the states?

No change in yield spread between states Debt to GSDP vs. SDL spread over G Secs

Source: RBI, Credit Suisse Research

Yield spread of SDLs of different states issued in the same auction rarely > 20bps Debt to GSDP seems to have no correlation with yield spread over 10 year GSecs Many possible reasons: implicit guarantee, RBI’s escrow,

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10 20 30 40 50 60 Apr-10 Apr-11 Apr-12 Apr-13 Apr-14 Apr-15 Apr-16 Apr-17 Yield range (bps) 50 55 60 65 70 75 80 85 90 95 0% 5% 10% 15% 20% 25% 30% 35% 40% UP WB PU RJ BI KE HA JH MP AP GU TN AS OR MH TL KA CG Debt to GSDP (2017b) 1Y Avg SDL Spread (bps, RHS)

Challenges in the budgeting process can distort markets

Expenditure BE and RE vs. Final Final Deficit nearly always lower than RE

Source: RBI, Budget Documents, Credit Suisse Research

Final state expenditure is generally below budgeted; revised generally higher

− This seems to be partly due to uncertainty on receipts (both own & central transfers), and partly poor execution

Final Deficit was nearly always lower than RE

− The slippage in the last few years driven by UDAY, as well as lower central transfers (mostly FY15 in our view)

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14.0% 14.5% 15.0% 15.5% 16.0% 16.5% 17.0% 17.5% 18.0% 18.5% 2010 2011 2012 2013 2014 2015 2016 2017 2018 Budgeted Revised (RE) Actual

States' Expenditure to GDP

1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Budgeted Revised (RE) Actual

States' Gross Fiscal Deficit - Revisions post budget

Slippage in both central transfers and own tax receipts

Excessive last month skew of tax transfers Own Tax Receipts BE and RE vs. Final

Source: RBI, Budget Documents, Credit Suisse Research

The formulaic transfer of taxes to state governments creates last month volatility

− Standard transfer for the first 11 months and then all adjustments in the final month

Transfers of grants are generally more volatile than direct transfers States have been slipping up on their own revenue targets in the last few years

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20% 22% 24% 26% 28% 30% 32% 34% 36% 38% 40% 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 Apr-11 Dec-11 Aug-12 Apr-13 Dec-13 Aug-14 Apr-15 Dec-15 Aug-16 Tax Devolution State share (1-3Q) Share (4Q)

Rs tn 4Q rate lower than 1-3Q in prior years

5.4% 5.6% 5.8% 6.0% 6.2% 6.4% 6.6% 6.8% 7.0% 2010 2011 2012 2013 2014 2015 2016 2017 2018 Budgeted Revised (RE) Actual

Own Taxes to GDP

Expenditure slippage is surprisingly across the board

MH: most of slippages on revenue expenditure MH: split of unspent funds in FY17r

Source: MH Budget, RBI, Credit Suisse Research

Slippages have been strong in FY2015 and FY2016 (also FY2017, though we lack data) Against common belief of slippages on discretionary expenditure, these are surprisingly across the board

− Staff salaries often get pushed out to meet fiscal targets

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• 12%
• 10%
• 8%
• 6%
• 4%
• 2%

0%

• 250
• 200
• 150
• 100
• 50

2011 2012 2013 2014 2015 2016 Revenue Capital % of Total (RHS) INR bn Difference between Revised and Final Expenditure R - Welfare 14% R - Education 12% R - Urban Dev. 11% R - Health 8% R - Police 6% R - Pensions 5% R - Agriculture 4% R - Roads 3% Other Revenue 12% C - Agriculture 9% C - Welfare 3% C - Roads 2% C - Irrigation 2% Other Capital 9%

The one-offs

GST: Uncertainty more for the centre than the states for now Loan Waivers: a structural issue, but near-term impact less than feared FRBM: hard to get ratios down

GST: the uncertainty is much higher with the centre

The "beat" slowed sharply after FY2013 Variation by states

Source: RBI, Budget Documents, Credit Suisse Research

The compensation formula is rather generous, given recent tax growth for states

− Assumes 2% buoyancy, i.e. tax growth above GSDP growth, but not achieved in recent years

The redistribution between states so far has been assessed only on CST basis, but there are several complexities

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• 2%

0% 2% 4% 6% 8% 10%

• 6%

0% 6% 12% 18% 24% 30% 2011 2012 2013 2014 2015 2016 2017r Taxes YoY Nominal GDP YoY

• Diff. (RHS)
• 3%
• 2%
• 1%

0% 1% 2% 3% 4% MH WB BI HA OR UT JH JK RJ UP PB CG KA KE GU TN AP

Services GDP Share - Sales Tax Share

Loan Waivers: A structural risk, fiscal impact spread out

Agri output still weak due to weak pricing

Source: MOSPI, CAG, Credit Suisse Research

The problem is structural, and may not go away soon Loan waivers are easy to announce, but harder to implement Fiscal impact to be spread over several years

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• 5%

0% 5% 10% 15% 20% 25% 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014

Agri GDP Deflator Growth Continues to be weak

2008 waiver took 2.5 years to execute

50 100 150 200 250 Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12

Rs bn Amount Released to Banks under Central Government Debt Waiver Scheme

Scheme Announced in Budget Scheme Approved by Cabinet

Total Disbursed Rs525bn, 27% lower than Rs717bn announced

FRBM Review targets: Fiscal consolidation will be needed

Aggregate government debt to GDP State ratio on FRBM committee guided path

Source: FRBM Review Committee, Credit Suisse Research

The FRBM Review Committee presents various scenarios for the states' debt to GDP trajectory beginning at 21% in FY2017 If central and state deficits are similar, debt ratios are likely to converge as well

− For states, to reach 20%, deficits must decline by 0.18pp per year from the 2.5% ratio budgeted for FY2018b

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0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1981 1985 1989 1993 1997 2001 2005 2009 2013 2017b Centre Debt/GDP State Debt/GDP Overall Debt/GDP 1.5% 1.7% 1.9% 2.1% 2.3% 2.5% 2.7% 19.0% 19.5% 20.0% 20.5% 21.0% 21.5% 22.0% 2017b 2018 2019 2020 2021 2022 2023 States' Debt to GDP ex-NSSF Fiscal Deficit Assumed (RHS)

Forecast

Conclusions

State governments’ larger fiscal footprint

− More fiscal power now: control 65% of all government spending − The larger bond market footprint is as envisaged in first FRBM targets: the centre had been in breach thus far − FRBM Review Committee target of 20% arithmetically inconsistent with the earlier 3% deficit target: state and central debt ratios must converge if deficits are similar − Far from a debt trap, but disciplining the states can be a challenge: markets cannot

States need to be more creative and work harder on taxation

− Can GST be the catalyst?

Spending Patterns: some vicious cycle at play despite redistribution

− UP/Bihar spend on education: PPP adjustments needed?

Capex vs. Revenue prioritization

− Government size much smaller in states with below average per capita GSDP − Pensions can be a problem, salaries not yet

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