After Union govt, states obfuscating budgets. India needs true bond market more than CAG audits

As seen with the fall of the Liz Truss govt in the UK, a well-functioning bond market can sometimes be more brutal and more effective in taming government profligacy.

26 October 2022
The Print

It has been reported that the Comptroller and Auditor General of India is considering ways to take a more holistic view of the financial sustainability of state budgets. The Liz Truss government in the United Kingdom fell owing to fiscal concerns. A CAG audit is a step in the right direction. However, as seen in the UK, a well-functioning bond market can sometimes be more brutal and effective in taming government profligacy.

Caring about the fisc

It takes money for a government to function. Salaries and electricity bills have to be paid. Capital expenditures have to be incurred on building assets in the hope that they will bring economic growth. All of this is largely financed through taxes and other revenues. If they fall short, as they usually do, the government has to borrow. It is possible that the debt becomes so large that most revenues get spent on servicing it and not on incurring developmental expenditure. Excessive debt can further dampen economic growth and lead to higher taxes in the future and inflation. This is why we worry about government finances and insist that the spending is in line with revenues. In 2003, India enacted the Fiscal Responsibility and Budget Management (FRBM) Act, which came into effect in 2004. The Act required the Union government to keep its revenue and fiscal deficits below certain thresholds. By 2010, all states had also enacted their own FRBM Acts.

CAG audits and off-balance sheet exposures

Under the Constitution of India, the CAG is authorised to conduct an audit of the finances of the government(s). It studies where governments spend money, how they manage debt, and whether or not constitutional provisions relating to budgetary management are being adhered to. Evaluating if fiscal deficits are within thresholds specified under the FRBM Act is another objective of the CAG audits. The findings of the CAG tell the legislature whether money is being spent as it was meant to, whether deficits are contained, and if not, where the gaps are. It is a way for the legislature to get a report card of the executive.

The CAG audit of Union accounts for 2017-18 and 2018-19 found gaps in some accounting practices. It showed that the Union government had been undertaking spending from “extra budgetary resources” that do not show up in the standard fiscal calculations. For example, the debt is raised by a State-owned enterprise so it doesn’t show up on the government’s balance sheet. But since it is expenditure incurred by the government, ultimately, it has similar fiscal implications. Such obfuscation also dampens the credibility of the government.

The true fiscal burden

It seems that now it is the turn of the state governments who are raising loans through their own enterprises and mortgaging state assets. Off balance sheet borrowings have reached a high of 4.5 per cent of gross state domestic product (GSDP), so much so that the Union government had to exhort them to come clean and allow for further borrowings only after full disclosures of their off balance sheet liabilities.

The discussion so far has only been on explicit borrowings by the state. However, governments often make promises of payments deep into the future, such as their pension obligations. They also provide implicit guarantees to certain institutions — if these fail, then governments are likely to step in and bail them out. Other examples include the wage indexed pension promises for the armed forces, health insurance promises through government-funded programmes, or the cost of recapitalising banks should they get in trouble. If one were to correctly measure state finances, then these liabilities need to be taken into account.

The State and the market

The CAG reports do not penalise governments for fiscal irresponsibility. They can, at best, shine light on the functioning of the executive. It is only when the government has to go to the market to borrow for its expenditures that it has to bear the cost of its excesses. If you are deep in debt and unable to even service your earlier obligations, you can expect that the only people who will lend to you will do so at a higher interest rate. This is, in some sense, the penalty that Liz Truss had to pay for being reckless about the impact of her policies on the budget. The bond markets went for a spin, and the Bank of England had to step in to calm the waters.

Why do our bond markets not penalise the government? This is because we don’t have a true market. We force our financial institutions to purchase government bonds, making them a captive audience for the government. If an insurance firm or pension funds investment guidelines require that contributions be largely invested in government bonds, then there is not much scope for these institutions to walk away. The government has to make no effort to persuade investors to lend to it. It just forces them. Until we reform our bond markets, we will have to rely solely on mechanisms like the CAG to point to the problems and hope that it persuades us to do things carefully.

eSign can do to land markets what demat did to equity if centre and state come together

Land markets are more challenging than equity markets, especially because substantive reforms mostly lie in the domain of states.

12 October, 2022
ThePrint

The Ministry of Electronics and Information Technology released a notification on 26 September through which eSign or Digital Signature Certificates can now be used for all property transaction documents such as sale, lease, and mortgages. A few weeks before this notification, demat accounts in Indian equity markets crossed 100 million. On the surface, these two developments seem disconnected. However, they are the same phenomenon at work—dematerialiation of securities is an example of the remarkable reforms that India began in the mid-to-late 1990s. The eSign notification takes us one step closer to a more vibrant market for immovable property.

Why does this matter?

An asset’s value is unlocked if there is a clear title to it and if there are minimum frictions in its sale and purchase. Electronic records through the dematerialisation of shares and the rationalisation of stamp duty made a substantial difference to equity markets.

Frictions, however, continue to exist in land markets. Restrictions on the transfer of land and poor ecosystem of land records are some of the factors that have held back market growth. Transfer restrictions imply that there is no liquidity in land markets as land of one type and designated for a specific use, cannot be easily sold for another purpose. Keeping the land locked into one use dilutes its value.

It also leads to rent-seeking as entities scramble to change land use. If one doesn’t have a conclusive title to the property, it becomes a hurdle in sale transactions. A buyer needs to make considerable investments just to check the sanctity of land records. This increases the cost of each transaction.

Poor records also have downstream effects on the ability to get credit, as the land cannot be easily used as collateral. Finally, the requirement of signatures on physical documents increases the cost of maintaining such records and transacting in land. It is, therefore, no surprise that even though real estate accounts for a large chunk of household portfolio in India, monetization of land is still very low.

Slow but steady reforms

In India, the story of equity reforms has been led by well-drafted legislation, institutional depth and extremely high-quality human capital that was not afraid of taking risks. Equity reforms did not fall prey to the usual “jaldbaazi” or the haste of the policy process in India. It followed the policy pipeline that is required so that the reforms do not fall down like a pack of cards, or laws and policies have to be constantly tweaked because the foundations have not been laid down ahead of time.

Even though a start has been made, this confluence of factors has yet to come together in the space of land markets.

Of course, the political economy in land is more complicated than in equity. A significant step towards reform was taken by the Digital India Land Records Modernization Programme (DILRMP) (the erstwhile National Land Records Modernization Programme). The goal was to achieve more accurate land title records so that disputes on land titles could be resolved and ultimately reduced to a bare minimum. While progress has been made, there are still gaps, and variation across states.

With e-signatures now allowed for immovable property, it should help lower transaction costs in the home-loan and loan against property markets. With electronic records and e-signatures, the number of friction points have come down. But we still have a long way to go in the way land-use laws are framed. The process of registration of property still requires physical presence at the office of the sub-registrar. There may be important reasons for physical presence clause because it is a better guarantee of neither party being coerced into the transaction. But in a digital world, we need to find better mechanisms that ensure consent for transfer of property.

Policy reform pipeline

Dematerialisation of shares began in 1995. It was in 2019 that the final amendment that led to a neutral stamp duty regime for all securities across the country fell into place. The policy process has led to various improvements in the intervening years, and one hopes that it will continue to do so.

There are important lessons that land markets can draw from the equity market reform story and from human capital inside institutions such as SEBI, Ministry of Finance, and the National Stock Exchange (NSE). Land markets are more challenging, especially because substantive reforms mostly lie in the domain of states, and the Union and state governments have to work together, making it even more important to continuously chip in at the policy reform pipeline.