States discover true federalism as they approach the World Bank directly for reform-linked aid
IN October 1996, when World Bank president James D. Wolfensohn came to India, Andhra Pradesh chief minister N. Chandrababu Naidu was a prominent member of his visitor's list. The computer-savvy, liberal-thinking Naidu, who was to later impress the Bank with his vision of the future, made a detailed and lengthy presentation on the fiscal mess his state was in. He was quite forthright: Andhra Pradesh was ready for economic reform and restructure and would the Bank help?
A month later, the Andhra Pradesh Agenda for Economic Reform was ready for discussion with the state and Central governments. The World Bank report pointed out clearly that without adjustment, the state's outstanding debt would rise to 32 per cent of gross state domestic product (GSDP) by 2002, revenues would remain constant at 8.1 per cent, and GSDP growth would fall to 3.5 per cent. With reforms, however, the debt ratio would fall to 25.5 per cent, revenues would rise to 11.4 per cent and GSDP growth would be 6.3 per cent.
Back home, Naidu had started using his scissors. The price of subsidised rice was raised and allocations cut, irrigation charges and power tariffs hiked, and steps were being taken to tighten government employment. In May 1997, a $150 million IDA credit for cyclone relief and a $325 million irrigation loan were cleared. Next month, a $350 million six-year loan for development of state highways was approved.
Encouraged by the politically tough decisions taken by Naidu even while facing a disenchanted electorate, the Bank has recently approved a $550-million Economic Restructuring Loan (ESL). The six-part loan will be used for primary education, primary health, irrigation, nutrition, roads and public sector restructuring. Others on the way: a $1-billion power sector loan and a $200-million second loan for Hyderabad water supply. Said Caio Koch Weser, managing director (operations), World Bank, who headed a team to AP to gauge the progress: "The state is going on the right path."
If the Andhra Pradesh reform story so far reads like a Naidu-World Bank mutual cooperation and admiration pact, it's misleading. There's more to the recent shower of World Bank largesse to AP than Naidu's charisma. Andhra Pradesh is just the first off the block from the list of states that are literally queuing up for World Bank aid as it effects a marked shift in its policy of dealing with the states directly, bypassing the all-powerful Central government. It's not that the states are directly borrowing from the World Bank—they cannot under the Indian Constitution. Nor can the World Bank lend to anybody other than its members (countries) under its articles of agreement. So the funds are 'on-lent' to the states from the Centre, the main borrower.
In support of this new strategy, the Bank is undertaking fiscal studies of all the major states either on its own or in collaboration with the National Institute of Public Finance and Policy (NIPFP), a research outfit whose founder-members are states. Says Indira Rajaraman, professor, NIPFP: "The idea is to offer cafeteria solutions so as to help a willing reformer identify the potential benefits of certain policy packages for maximum gain. There's no point in preaching a pie in the sky." Apart from AP, the Bank has taken up Rajasthan, Orissa and Karnataka where substantial reforms are already underway. The NIPFP is studying the reform scenarios for Punjab, Haryana, Assam, Delhi, Tamil Nadu, Kerala, Bihar and Maharashtra. Even the leftist West Bengal is not averse to Bank funds. It is making its own study while UP still seems to be a grey area.
The new strategy is a significant milestone in India. And it has been triggered by simultaneous changes in the economic realities facing India and the Bank. Keen to pursue economic and administrative decentralisation, P. Chidambaram had detailed talks with Wolfensohn on reform-linked loans to states in 1996. It was agreed that the best way to make the states understand the need for a fiscal correction is to let them take the initiative themselves.
Federalism through the back door:Many agree that India's reforms have been floundering since 1995. Reasons: political pressures, lack of visionary policy and, most importantly, a considerably depleted treasury. As a result, funds transfers to states from the Centre, unfair at the best of times, became difficult. More and more states realised that depending on the Centre for resources would be useless. Also, the Centre had much latitude in terms of resources. When things came to a head, it could always approach the RBI or go in for external loans or project-specific aid from multilateral and bilateral agencies. No such manoeuvrability for the states.
Secondly, many states themselves were in a fiscal mess of their own (see chart), created largely by widespread giveaways to nurture votebanks. While expenditures spiralled, incomes dwindled. Efforts to invite private funds failed as the institutions to support such moves were crumbling. Also, with growth slowing, private industry was languishing in the state. As for foreign funds, the fundowners sought guarantees and dedicated returns on investment which the states were in no position to offer. Gross fiscal deficit (GFD) of states widened from 2.6 per cent in 1993-94 to 3.4 per cent in 1995-96. That is, states were borrowing afresh Rs 3.5 out of every Rs 100 they produced every year to run their operations. And interest payments took two-thirds of this debt. Worse, states had begun to borrow about Rs 1.5 to Rs 2 just to pay salaries and wages.
Ironically, it is also the system of transfers which made the states complacent. States traditionally get money from the Centre through the recommendations of the fina-nce and the planning commissions. With transfers rising with every new commission, states happily splurged with no thought to income. Investments were made without care for maintenance and cost recovery. Subsidies were offered without targetting and across the board. The worst example was perhaps Punjab. The otherwise agriculturally rich state had abolished all user charges. Says Dr Ashok Lahiri, director, NIPFP, and former economic adviser in the finance ministry: "States have come to realise that there is a linkage between their fiscal stance and GDP growth. So, in terms of reforms, the action is now moving to the states." The third reality is the demand for devolution of more powers to states. If states want to have more power, they must also be made accountable for it.
Explains D.K. Srivastava, professor, NIPFP: "There are three or four triggers to state reforms. Primarily, the new burden caused by the Fifth Pay Commission announcements. For another, thanks to finance commission recommendations, states are also paying out more and more to their local administrative bodies. And if funds have to be sourced from outside, the richer states want more and more say not only in procurement of funds but also a freedom to use it."
Reinventing the Messiah: The emerging reality in India suited the changing goals of the Bank which adopted the Strategic Compact Approach in 1997 to reinvent itself "in a rapidly changing global economy where private capital flows are five times greater than official assistance". Noted its annual report: "As the reforms of the '90s took root in South Asian countries, the Bank supported its clients as they shifted their focus to a second generation of reforms. In India, this involved responding to several requests for assistance at the state level to help evaluate fiscal situations and identify policy options to promote fiscal sustainability." Says its position paper on India: "The Bank Group has reoriented its strategy to focus mainly on those states that have chosen to embark on a comprehensive programme of economic reforms. These include some of the poorer states with the worst social indicators."
SAID senior Bank officials in the capital: "State-level operations are not new to the Bank in India. In the past,however, selection of state projects was done largely on project and sector grounds rather than on overall state policy." Such multi-state projects were complex in many ways: different states had different approaches and different political and economic compulsions. Plus, such projects were mainly in the social sector, where the Bank has the largest exposure. Like the seven-year 11-state District Primary Education Project launched in June 1996 or the countrywide Tuberculosis Control Project started in January 1997.
Adds a Bank official in Washington: "A state in Argentina had also adopted the approach, but its scope was limited. In India, we are picking a few states that show promise to be included in this new strategy and not too many states qualify. Our expectation is that there will be a contagion effect."
However, officials hasten to reassure that there are no frightening conditionalities involved. Senior Bank officials affirm that for reform-linked loans, the states have to take the initiative. And must publicise all that they are doing to their citizens. "The borrower's commitment is the single-most important factor explaining success in Bank Project outcome. And unless the borrower is involved in the long-term sustainability of the project, the aid is meaningless." That, say officials, is the key to ESL.
No pie in the sky: The Bank has devised different approaches for different states. In many states, policy, pricing and institutional reforms of key sectors would bring about the needed fiscal adjustment. Broadly, the reforms suggested are in terms of tax policy—moving forward from excise duty to a VAT regime—and cutting untargetted expenditure and hiking user charges, so as to boot up on infrastructure and social sector investment. In many other states (Maharashtra, Karnataka, Gujarat) a substantial hike in power and irrigation charges would alone bring about a fiscal correction. In others (AP, Rajasthan, Tamil Nadu, West Bengal,
Haryana), more comprehensive reform of public spending is needed. In Haryana, a $60 million loan has just been sanctioned under a $400 million Adaptable Progra-mme Loan for power. The APL has been devised, with major initiative from country director Edwin Lim in India, for states which want some leeway in taking recourse to the finance. That is, it would operate more like a current account for the borrower, to be used when necessary. In more indebted states like Bihar, Orissa and UP, debt refinancing would also be needed.
States like Rajasthan, Haryana and Orissa have been quick to take advantage of the new strategy. Orissa, which received a six-year $350-million power restructure loan in May 1996, has abolished its power board, set up a generating and distributing company and a regulatory commission. Haryana and Rajasthan are following suit. Besides, Rajasthan, where GFD hovered around 5.5 per cent during 1994-97, has effected major fiscal reforms: streamlining sales tax, cutting government role in public sector as also the size of its civil services, strict control on borrowings and public spending.
Many within the Bank and outside are eagerly waiting to see the success of ESL in AP, the pioneer which is bravely walking into uncharted territory. Says the Bank official in Washington: "It's the first state in India and in the world with a comprehensive approach. The world is watching because there are quite a few large countries with important states. So there is keen interest in this sub-national approach to lending and reform." Opposition leaders in Andhra are already protesting that the annual debt servicing burden has touched Rs 2,832 crore, while Naidu claims a saving of around Rs 1,800 crore through his subsidy-cutting measures. The answer should come through by the turn of the century. But the success lies more in getting the states to see sense at the end of the road to reform.