How Increasing Borrowing Limits For States Will Nudge Them Into Biting The Bullet On Much-Needed Reforms

One of the key issues that has been highlighted regularly is the need for state-level reforms, which have been pending for a long time. The expectation was that state governments would recognise the need to attract investments to create adequate jobs, and doing so would put pressure on themselves for reforms.

However, the last few decades have revealed the exact opposite even as the central government initiates reforms across a plethora of sectors, state governments continue to operate without much changes.

A consequence of this is the build-up of pending reforms or low-hanging fruits at the state level. The reason why this happened is the lack of an incentive or any stringent pressure to transform their economies.

Consequently, state governments continue to operate in the pre-1991 mode.

Some peninsular states that did initiate reforms were successful in attracting foreign investments while the rest of the states continued as before.

One needs to simply ask why some states are more industrialised than others to understand the significance of some of these reforms.

Covid-19 has brought an opportunity for reforms and the central government has well recognised this as it finished a major part of the unfinished agenda of reforms over the last two decades.

However, there are several areas where states have to also initiate reforms to be able to attract foreign companies exiting China.

To ensure that states do undertake some of these reforms, the government has decided to increase the borrowing limits for the states by 0.5 per cent unconditionally, while another 1.5 per cent depends on the reforms that are to be done by the state.

Two of the more significant reforms amongst the four that have been linked to the 1.5 per cent are the draft electricity bill and the ‘one nation one card’ proposal. This proposal has been mooted for years, and in 2012 it was presented to the then government which had originally opposed the idea.

Since then, it has been proposed time and again, while some have argued for a complete shift away from the public distribution system (PDS) and towards cash transfers.

The idea behind this reform is to allow anyone to take their food entitlements anywhere across the states using a single PDS card.

This measure is important for efficiency gains for the PDS, however the gains may not be as much as that of a cash transfer programme.

One hopes that the ‘one nation one card’ proposal will ultimately emerge as the backbone for a direct cash transfer food security programme using smart RuPay cards.

The other important reform is to correct the distortions in the electricity pricing across states due to industrial tariffs being higher to compensate for subsidies for residential consumers.

This practice is in contrast with that of East Asia, where residential tariffs are often higher to subsidise industrial units.

The new code is important in overhauling the power distribution and pricing structure, which has often been a major concern for global firms before investing in India.

That state governments have often avoided reforms is well known and this reluctance has come partly due to ignorance and partly due to political compulsions or lack of incentives.

Linking enhanced ability to borrow with these reforms is likely to result in some of these states finally realising the need for genuine reforms.

Most states may need to borrow beyond 0.5 per cent of the gross domestic product (GDP) and this additional credit is therefore a lifeline for them. This makes the move an interesting step in the direction of nudging states to clean up their act.

The difficulty, however, will be for states like Kerala, which have virtually survived on remittances and have effectively little to no industrial clusters compared to other nearby states. The fall in remittances will adversely impact the state and deteriorate their fiscal situation.

It will also expose the hypocrisy of the model, which survived because of capitalism existing outside the state even as they criticised it within. The finance minister of the state has already expressed concerns regarding the linking of borrowing limits to reforms, indicating their reluctance to push for industries to set up operations there.

However, over time, we can witness a far greater divergence between states that industrialise as against states that don’t, and this divergence would in turn act as a political ploy or an incentive for the lagging states to catch up.

While the move to link borrowing limits with reforms may appear to be a trivial one, it has the potential to systematically transform the public finance of various states, create a new dynamic of Centre-state relations and more importantly, do a systemic overhaul of the political executive over a longer period of time.

This is why the political fallout of the reforms will be huge. However, the government must continue with it as this may be the only way to push through some of the much-needed reforms.