Mumbai, October 30, 2024: Emkay Global Financial Services held a media webinar on the states and Union’s fiscal situation. As per their analysis there are some risks emerging in the convergence path of Centre and States’ fiscal consolidation. The states’ fiscal situation is at a risk of further divergence in FY25. The election-led populist spending by states is unprecedented and increases risk of fiscal slippage in FY25. This may also lead to a higher borrowing by states.

States’ fiscal picture at risk of further divergence in FY25

The centre and states’ fiscal behavior has differed in the way they have achieved consolidation post-Covid. Centre has overachieved on its revenue targets, allowing it to maintain focus on capex while cutting deficits. In contrast, states have consistently missed revenue targets, forcing them to cut expenditure, especially capex, sharply – even as their revex growth has been higher than that of the Centre’s. Indian states’ fiscal consolidation path post-Covid looks like being interrupted in FY25. While the Centre has budgeted a 0.7% reduction in FD/GDP for FY25, States are budgeting a 0.2% higher deficit, after having achieved a similarly higher deficit in FY24P.

Populist push to endanger finances further

The last couple of years have seen an evolution in fiscal behavior around elections, with this shift being far more apparent at the State level. Of the 10 major states that went to polls in 2023 and 2024, nearly every state has introduced new freebie schemes, regardless of party lines. This is not a completely new phenomenon – Emkay Global’s analysis of 19 States over the last 20 years shows that on an average, states’ fiscal deficit/GSDP is 0.5% higher during election years vs the previous year, with revex/GSDP being 0.4% higher, whereas capex/GSDP declined by 0.1%. The worst offenders have been Chhattisgarh, Maharashtra, Bihar, Madhya Pradesh, Odisha, Jharkhand, and Andhra Pradesh – all States that have had or will have elections by end-2025

States’ FY25BE for subsidies has shot up to Rs3.7trn on the back of the freebie wave – this is equivalent to 8.6%/8.7% of aggregate revenue receipts/expenditure (the highest since FY21). Subsidies are budgeted to grow at 26% YoY – while there is a base effect, freebie announcements have led to this rise.

States revenue mobilization to remain a concern?

States’ revenue growth over the last five years has been led by own tax revenue (OTR), which grew at a faster rate than overall revenue receipts (10.4% CAGR vs 8.5% CAGR). OTR currently makes up ~52% of the States’ revenue receipts (FY25BE) — an increase of 4% since FY19, on account of this faster growth. States’ OTR grew just 9% in FY24 (vs Centre’s gross tax revenue growth of 13%) and is budgeted to increase 18% YoY in FY25. However, Centre’s FY25BE tax revenue growth is only ~11%, so States’ OTR estimates look optimistic – while States’ OTR buoyancy has outdone Centre’s tax buoyancy in the past, a similar outperformance is unlikely in FY25 amid slowing GDP growth. SGST (~18% YoY) grew far higher than any other component and is budgeted to rise 18% again in FY25. SGST makes up over 40% of aggregate State OTR, but with all other heads seeing poor growth in FY24P, it will be difficult for overall OTR to grow substantially even if SGST manages to maintain its pace in FY25. States have had to increase reliance on non-tax revenue sources due to slower OTR growth. On aggregate, States are budgeting much higher growth for non-tax revenue (25% vs 13% for FY24P) and non-debt capital receipts (159% vs 66%). With these being volatile revenue sources, overall revenue estimates are at risk in FY25.

Capex improves, but with significant inter-state divergence

FY25BE sees states budgeting strong growth of ~18% for capex. This compares to the Centre which has budgeted 16% YoY growth (ex-capex loan transfers to States). If achieved, this would imply C+S capex/GDP at 5.4%, with States’ capex/GSDP at 2.5% – a multi-year high. This strong growth comes on the back of an encouraging performance by States in FY24P. States mirrored the Centre’s capex behaviour and frontloaded their capex as well, spending Rs6.9tn and achieving 89% of FY24BE – the highest achievement rate in over 10 years. States’ capex/GDP was at 2.3% in FY24P, the highest ratio since FY21. Despite frontloading, March remained a heavy month for capex, with ~20% of FY24P capex (albeit lower than the usual ~25-28%). With the Centre’s capex (ex-capex loans to States) at Rs8.3tn (2.8% of GDP), this meant that total C+S capex/GDP rose to 5.5% – the highest since FY05. Despite the overall rate of achievement, only 4 States overshot their BE, with the most notable ones being Madhya Pradesh, Telangana, & Bihar. On the other hand, 13 States missed their estimates, with the biggest offenders being Punjab, Chhattisgarh, Uttar Pradesh and Andhra Pradesh. This was despite the Centre paying out ~Rs1.1tn through the capex loan program (vs Rs1.3tn budgeted). Centre has budgeted Rs1.5tn for this program for FY25, but stringent conditions (along with delayed disbursement due to the general election) mean that it is unlikely that the entire amount will be utilized.

States’ borrowings likely to be higher

After a surge in issuance in FY24, FY25E could see a further 8-10% increase in SDL issuance. Emkay Global estimate FY25 gross/net SDLs at Rs11.0trn/Rs7.9trn – ~9% higher than FY24 (assuming mild slippage in FD/GSDP to 3.15%). However, net SDLs will still be lower at ~77% of FD (from 90% in FY24). H1FY25 has so far seen ~35% of est. gross borrowing (Rs3.9tn), implying ~65% in H2FY25 (Rs7.1tn). We note H1FY25 also saw States having healthy cash balances (est. Rs2.5tn in end-Jun’24). Higher issuances in FY24 were largely a Q4 (March) phenomenon, where states misjudged their financing needs, and curbed their capex spends despite borrowing almost ~20% of total in just March alone. This broke the trend of constrained state borrowings seen since FY21. Net borrowing/GFD came off from the highs of >90% in FY20 to <75% in FY23, but this ratio rose back to 90% in FY24 – highest since FY20-24 gross and net borrowing (Rs10.trn/Rs7.2trn) were higher than budgeted (by 10%/11%, resp) as a result, with sharp YoY increase of 33%/38% over FY23.

Sovereign papers to enjoy healthy demand

FY25E general government sovereign supply to fall 2%, with SDL supply likely to accelerate in H2FY25. Demand will stay comfortable despite nearly flattish supply. Long-only investors (pension, PF, insurance) and FPIs will counter the sharp fall in banks’ G-Sec demand vs FY24. RBI will likely be the balancing factor. Any contraction in RBI balance sheet to counter the demand will likely weigh on reserve money growth (We assume NDTL growth of 11.5% and SLR demand by banks of ~28.2% of NDTL for FY25E (vs 26.7% in FY24). We might see a mild structural increase in G-Sec demand from

banks toward Q4FY25 as guidelines on LCR come to the fore in FY26.) Contrary to popular opinion, we believe that there may not be a sudden spurt in G-Sec demand owing to higher estimated HQLA, however, some pockets of banks may still see a higher immediate demand (read foreign banks and small PSBs). Banks may re-assess their risk management profile to see how much they want to align with the new estimated requirements. That said, it is structurally a positive for G-Sec demand and DD-SS balance.

Ms. Madhavi Arora, Chief Economist, Emkay Global Financial Services Ltd., said “While the Centre’s fiscal consolidation path is set to continue in FY25 (with higher tax revenue helping it to possibly even undershoot its budgeted fiscal deficit target of 4.9%), states are likely to diverge, with a higher deficit vs FY24 (FY24P: 2.8%), led by lower-than-budgeted revenue growth and upward pressure on expenditure, mainly due to the increase in populist spending across states. States’ budgeted revenue growth estimates look too optimistic, and the sharp increase in subsidies and freebies will constrain their ability to control expenditure, with capex therefore facing the axe. These factors will lead to states delivering a higher deficit than budgeted (FY25BE: 3.0%), with slippage of 0.1-0.2% of GSDP, for the first time since FY21. States’ capex, which saw healthy growth and achievement in FY24P, will be constrained and could even be lower than last year, as a result of higher committed (esp. subsidy and freebie) expenditure. We reckon states will have to look for innovative avenues to mobilise their revenues better to improve their income profile so that they can spend without straining their balance sheet. The slippage in deficit will also lead to states borrowing heavily in H2FY25 (specifically Q4), especially for those states which are already facing fiscal pressure due to populist spending and revenue growth slowdown (MH, HP etc). However, overall demand for sovereign debt will stay comfortable in FY25E despite nearly flattish supply, due to continued demand from long-only players like insurance, pension and PFs as well as robust FPI flows”.