Borrowing by India's local and regional governments (LRG) will decline for the second consecutive year in 2006 despite continued high levels of debt. This is the finding of Standard & Poor's Ratings Services and CRISIL Ltd.'s first joint survey of local body and state government borrowings in India, released on February 5, 2006.

Debt issuance by state governments is projected to decline to about Indian rupee Rs1.128 trillion ($26 billion), from Rs1.26 trillion in 2005, Standard & Poor's predicts. This is due to reduced revenue deficits as well as curtailment of capital expenditure, resulting in smaller fiscal deficits. Total debt outstanding could reach Rs7.1 trillion by end-2006. (see Chart 1)

India's debt market is dominated by central government borrowing, but state government issuances are also significant, after central government and corporate bonds. The sale of state government securities is largely on a tap basis, while those by the central government are on an auction basis.

State government debt issuance is largely long-term and in the local currency, as states are not permitted to issue debt in foreign currencies directly. The typical long-term debt is a 25-year fixed-rate loan with a five-year grace period. Two of the main debt types are loans against small savings, which are subscribed by the public, and market loans, which are bought by banks.

One of the key developments affecting state debt issuance is the Twelfth Finance Commission (TFC), a centre-state fiscal review body. The likely consequences of the TFC's main recommendations include greater flexibility for states to decide on the proportion of market borrowings and central government loans, as well as disintermediation in market borrowings. This would enable higher creditworthy states to borrow directly from the money market at lower rates, while fiscally weaker states would continue to depend on the central government in obtaining market loans. Interest rates on state government securities have been on the rise since 2004-05, after eight straight years of decline.

The downward trend in state government deficits and borrowing requirements since 2004 is expected to continue this year due to:

• Reduction in revenue deficits. The devolution of shared taxes from the central government has been increased to 30.5 per cent for 2005 to 2010, from 29.5 per cent between 2000 and 2005. States' own-tax revenue collections are likely to increase on account of higher sales tax/valued-added tax, or VAT, stamp duties, and registration fees. The rise in revenue from sales tax is driven by higher economic growth as well as the introduction of VAT, a more efficient method of tax collection.
  
• Incentives provided by the TFC, although states will have to balance these with their growing need for capital expenditure. TFC incentives involve substantial debt relief to states from 2006 to 2010, subject to their enactment of fiscal responsibility legislation and linked to the amount of reduction in revenue deficit and fiscal deficit.

Besides deficit financing, state governments have also issued debt to honour state guarantees. The combined outstanding contingent liabilities of about $50 billion for 14 major states in 2005 are not likely to decline in the near term, but new contingent liabilities are likely to be curtailed.

The liabilities were largely guarantees for borrowings by financially weak state public enterprises and were eventually realised on the state budget. Pension liabilities of these states also remain high.

"The buoyancy in tax revenues along with TFC incentives-led curtailment of deficits is expected to invigorate finances of the states," elaborates Jyoti, co author of the report. "However, buoyancy or incentive-driven fiscal discipline has its own limitations; the fiscal prudence it induces runs the risk of lasting only as long as triggers last. The real and lasting improvement in state government finances will come about only if fiscal discipline is accompanied by concrete, structural policy measures related to economic management.

"These measures include creating sinking fund outside the consolidated fund, risk-weighted guarantee redemption fund, pension fund and other similar measures. These funds are especially important in the context of the guarantees and pension being off-balance-sheet and unfunded liabilities," he adds.