Indian States Face Unfair Borrowing Costs Without Credit Ratings

Source: The post Indian States Face Unfair Borrowing Costs Without Credit Ratings has been created, based on the article “Complexities in rating States’ debt” published in “Businessline” on 23 May 2025. Indian States Face Unfair Borrowing Costs Without Credit Ratings.

UPSC Syllabus Topic: GS Paper2- Polity-issues and challenges pertaining to the federal structure, devolution of powers and finances up to local levels and challenges therein.

Context: A recent auction of State Development Loans (SDLs) has reignited debate over whether Indian States should be rated individually like corporate entities. Despite similar or better fiscal indicators, some States face higher borrowing costs. This inconsistency questions the fairness and transparency of current borrowing frameworks under RBI’s implicit guarantees.

For detailed information on Issues with borrowing powers of States read this article here

Mismatch Between State Finances and Borrowing Costs

1. Unlinked Yields and Fiscal Health: The SDL auction revealed that States with stronger fiscal indicators sometimes faced higher yields. For example, Uttarakhand, with a 2.9% fiscal deficit, had to pay more than Rajasthan, which had a 4.3% deficit. Similar anomalies were noted between Himachal Pradesh and Uttar Pradesh.
2. Corporate Bond Market Contrast: In the corporate space, yields vary significantly based on credit ratings. AAA bonds yield 7.60%, while AA bonds yield 8.70%, reflecting a clear risk-based premium. This contrast shows the financial market values credit ratings for corporates but not for States.
3. Anomalies in SDL Auctions: Currently, SDLs do not carry individual ratings. This creates irregularities where fiscally prudent States are penalized, while less disciplined ones benefit. The absence of a rating mechanism distorts price discovery in the bond market.

Credit Ratings and Their Absence in SDLs

1. Proxy Ratings by Agencies: Credit rating agencies evaluate States primarily when rating state-owned enterprises backed by government guarantees. CARE, for instance, rated Karnataka AA(-), Tamil Nadu A(-), Andhra Pradesh BBB, and Punjab BB(+), indicating wide disparities in fiscal health.
2. Sub-Sovereign Status Limitation: Despite different credit profiles, all States are treated similarly in the market due to their sub-sovereign status. This lack of differentiation in pricing mechanisms weakens the incentive for fiscal discipline.
3. Rationale for State Ratings: If States were rated like corporates, it would promote fiscal responsibility and provide better signals to the market. Higher deficits would lead to higher borrowing costs, nudging States toward prudent spending.

Challenges in Implementing State Ratings

1. RBI’s Implicit Guarantee: States enjoy an implicit guarantee from the RBI, ensuring repayment regardless of fiscal performance. This undermines the effectiveness of a rating system and discourages market-based pricing.
2. Federal Structure Constraints: State governments, being part of a federal structure, are seen as extensions of the Centre. Removing or altering the implicit guarantee would face legal and constitutional challenges.
3. Municipal Body Comparison: Unlike States, municipal bodies do not have implicit guarantees and are rated independently. This sets a precedent for differentiated borrowing costs based on creditworthiness, raising questions on fairness in treatment.

Fiscal Flexibility and Welfare Priorities

1. Centre’s Conditional Relaxation:The central government sometimes permits higher deficits for States under conditions, such as implementing power sector reforms. This allows some leeway but does not reflect in borrowing costs.
2. Development Justification: States argue that their welfare-driven spending should not be judged by commercial metrics. Welfare schemes, including direct handouts, drive consumption and growth, justifying higher spending in some cases.
3. Risk of Undermining Development: If ratings lead to pressure for fiscal tightening, States fear their development goals may suffer. This is crucial as States are at varying stages of development, requiring tailored spending strategies.

Toward a Balanced Rating Framework

1. Proposal for Routine Budget Ratings: To bridge the gap, budgets can be routinely rated by agencies like CARE, CRISIL, or ICRA. These ratings could be disclosed to aid market participants during SDL auctions.
2. Market-Driven Price Discovery: While removing RBI’s implicit guarantee may be difficult, informal ratings could guide investors. This hybrid approach balances fiscal prudence with developmental needs.
3. Limitations Remain: Differential SDL weights or formal enforcement remains unlikely under the current guarantee regime. However, informal ratings can still inject transparency and encourage responsible fiscal behavior.

Question for practice:

Examine whether the absence of individual credit ratings for Indian States affects fair price discovery in SDL auctions.