'Debts Of States Affect Country's Credit Rating' : AG Tells Supreme Court Defending Centre's Limits On Kerala's Borrowing Power

The AG's note stressed that public finance management is a national issue. "Debt of States affects the credit rating of the country. Moreover, default by any State in debt servicing would create reputational issues and will have domino effect endangering the financial stability of the whole of India," stated the note.

If the State indulges in reckless borrowing to finance unproductive expenditure or poorly targeted subsidies, it will crowd out private borrowing from the market.

“This will lead to increase in the borrowing costs of private industries and adversely impact the production and supply of goods and services in the market. Increases in the State's debt servicing liabilities as a consequence of higher borrowing by it will reduce the availability of funds for development, leading to impoverishment of people and loss of State income, and hence also loss of national income. It may also engender various social and other problems.,” the note added.

States require Centre's permission to borrow from any source

AG Venkataramani stated that all States require permission of the Centre to borrow from any source. While giving this permission, the Centre keeps in mind the overall objectives of macroeconomic stability of the country as a whole and fixes a borrowing limit for the State seeking its permission, under Article 293(4). The borrowing limits of States are fixed in a non-discriminatory and transparent manner guided by the recommendations of the Finance Commission.

In this regard, the note brought attention to the Fiscal Responsibility and Budget Management Act of 2003. This was enacted to ensure that the Centre follows a prudent fiscal policy. The note, underscoring the objective of the Act, added., “It aimed to bring about prudential debt management and fiscal sustainability through limits on Central Government borrowings, debt and deficits, and greater transparency in fiscal operations of the Central Government.”

To understand the background, it may be noted that the Kerala Government, in its suit, has also challenged amendments made to Section 4 of the Act through the Finance Act, 2018. The State has reasoned that the amendment, inter-alia, imposed a Net Borrowing Ceiling on the State by the Union.

In response to this, the Union, in the instant note, has submitted:

“Inclusion of a ceiling of general Government debt in the definition of General Government debt was important amendment in the Act in 2018 because the databases of international financial institutions like the IMF shows the general Government debt for all the countries and credit rating agencies or investors as well as lenders to a country considers not the federal but the general Government debt for their purposes of rating, investment or lending, as it actually indicates the level of risk inherent in an economy.”

Borrowings from Public Accounts, borrowings through State Enterprises- innovative methods adopted by States to hide actual liabilities

The AG mentioned that the States often resorted to "innovative methods" to hide their actual liabilities by making borrowings from the Public Account or through State Owned Enterprises.

"To meet their rising needs for funds, States borrow heavily from their Public Account, which contains all public money received by or on behalf of the Government other than those credited ni its Consolidated Fund. However, the Government is more like a banker as the funds in Public Account, like provident funds, deposits and small savings, do not belong ot the Government and have to be paid back to its rightful owners. There are instances when States have purported to release Central grants to implementing agencies &then credited the amount to public account thus showing utilisation with no additional expense. Therefore, net increase in liabilities is considered a part of fiscal deficit of both the Union and the States."

The AG critically commented on the tendency of States to resort to "off-budget borrowing" as it affects transparency and suppresses actual liabilities.

The note stated that Kerala has resorted to off-budget borrowing of Rs 42,285 crore from 2016-17 to 2021-22 through two state-owned entities (KIIFB and KSSPL) to circumvent the borrowing limits.

“Since these two State Owned Entities (SOEs) have no sources of income and the borrowings are to be repaid not from their revenue resources but from funds transferred from the Consolidated Fund of the State, CAG has termed it as an attempt to bypass targets set in Kerala FRBM Act and Net Borrowing Ceiling (NBC) prescribed by the Centre.,” the note added

“Despite the devolution of substantial resources from Central taxes and duties, highest share of post devolution Revenue Deficit Grant, financial support extended by the Union Government over and above the recommendations of the Finance Commission and substantial transfer of resources to the State Government under the Centrally Sponsored Schemes, any financial stress that the Government of Kerala is facing is purely due to its own financial mismanagement.”

On January 12, 2024, the Division Bench of Justices Surya Kant and KV Viswanathan issued notice to the Union. The suit is posted on February 13 to consider Kerala's prayer for interim relief.

Constitution has given more powers to Union on financial management

Apart from this, the Union, after outlining relevant Articles (of the Indian Constitution) and Statutes, has averred that it has been conferred wider powers to manage the country's finances.

"Study of the division of subjects between the Union and the States, makes it clear that there is an asymmetry between the taxation powers and the functional responsibilities. While the Centre is assigned with taxes with higher revenue potential, States are assigned with more functional responsibilities. By constitutional design, the Union of India is on a different footing and is vested with key powers on financial matters for reasons of monetary stabilization and distribution."

“Athough the institutional structures for managing the finances may look similar for the Union and the States, the architects of the Indian Constitution have consciously granted wider powers to the Union considering its higher responsibilities in promoting macroeconomic stability and mobilizing financial resources..”

Case Title: THE STATE OF KERALA V. UNION OF INDIA, ORGNL.SUIT No. 1/2024