Reserve Bank of India shared the report of an Internal Working Group (IWG), which was set up in February to look at, among other things, the impact of farm loan waivers on state finances. The report has shown how farm loan waivers dented state finances and urged governments to avoid resorting to farm loan waivers.

Since 2014-15, many state governments have announced farm loan waivers. This was done for a variety of reasons including relieving distressed farmers struggling with lower incomes in the wake of repeated droughts and demonetisation. Also crucial in this regard was the timing of elections and several observers of the economy including the RBI warned against the use of farm loan waivers.

What has been the impact on state finances?
Chart from the RBI report details the impact on state finances in successive years. Typically, once announced, farm loans waivers are staggered over three to five years. Between 2014-15 and 2018-19, the total farm loan waiver announced by different state governments was Rs 2.36 trillion. Of this, Rs 1.5 trillion has already been waived.

The actual waivers peaked in 2017-18 in the wake of demonetisation and its adverse impact on farm incomes.

What is the impact on economic growth, interest rates and job creation?
In essence, a farm loan waiver by the government implies that the government settles the private debt that a farmer owes to a bank. But doing so eats into the government’s resources, which, in turn, leads to one of following two things: either the concerned government’s fiscal deficit (or, in other words, total borrowing from the market) goes up or it has to cut down its expenditure.

A higher fiscal deficit, even if it is at the state level, implies that the amount of money available for lending to private businesses — both big and small — will be lower. It also means the cost at which this money would be lent (or the interest rate) would be higher. If fresh credit is costly, there will be fewer new companies, and less job creation.

If the state government doesn’t want to borrow the money from the market and wants to stick to its fiscal deficit target, it will be forced to accommodate by cutting expenditure. More often than not, states choose to cut capital expenditure — that is the kind of expenditure which would have led to the creation of productive assets such as more roads, buildings, schools etc — instead of the revenue expenditure, which is in the form of committed expenditure such as staff salaries and pensions. But cutting capital expenditure also undermines the ability to produce and grow in the future.

As such, farm loan waivers are not considered prudent because they hurt overall economic growth apart from ruining the credit culture in the economy since they incentivise defaulters and penalise those who pay back their loans.

How much do state finances matter for India’s macroeconomic stability?
Far too often, analyses of the Indian economy focuses on the Union government’s finances alone. But the ground realities are fast changing. The NIPFP study of state finances reveals that all the states, collectively, now spend 30 per cent more than the central government. Moreover, since 2014, state governments have increasingly borrowed money from the market. In 2016-17, for instance, total net borrowings by all the states were almost equal (roughly 86 per cent) of the amount that the Centre borrowed.

In other words, state-level finances are just as important as the central government finances for India’s macroeconomic stability and future economic growth.

Source: The Indian Express