In the world of credit, the biggest risk for a lender is ‘loss to its capital‘. All other form of credit risks like delayed payment risk, political risk , any short term economic risk can be taken care off by charging higher yields. However, the loss of capital is very difficult to cover even by charging abnormally high yield. Of course, there are lenders who have appetite to take such a risky bet but in general the lenders would like to have a borrower where they have reasonable assurance that capital loss is totally or nearly avoidable. Indian states are ‘perfect fit‘ into this situation. Indian states are perpetually in need of funds especially for their developmental activities and thus , generate huge demand for borrowing and interestingly, they are the ones who cannot go bankrupt.

Many may contest that states can go bankrupt and certain Indian states are in precarious financial position. However, Indian constitution ensures that the likelihood of state bankruptcy is near to zero. Article 293 allows central government to cut down states borrowing limit in case it believes that state financial position is precarious. Secondly, it can also impose financial emergency in the state under article 360 of the constitution in case situation is very worse. While borrowing limits have been cut for states like Kerala and Punjab in the past, the financial emergency has never been used in India signaling that existing mechanism of nudging states to reform through borrowing cuts is quite effective in working.

This fact that Indian states can not go bankrupt is further solidified by the fact that all the state development loans are managed by Reserve Bank of India. Also, these loans qualify for maintaining Statutory liquidity ratio for Banks. The result is that all the state government’s state development loans yield the same rate and same spread despite having very different financial situation. For example, currently 10 yr yield for all the state development loans is 34 bps above g-sec of 6.53 percent. This shows that market shows no discrimination between states whether they are fiscally prudent or not .And this material fact that states do not go bankrupt is rejoice for lenders who continue to lend briskly to state governments. This trend is further strengthened by policy measures like UDAY(Ujjwal discom assurance yojna ) which has shifted most of the debt from discoms to state government. This effectively means that all the loans that were earlier with loss making discoms are now to be paid by state government effectively nullifying the risk of losing capital.

However, this does not mean that state governments do face brunt of financial mismanagement. In fact, corporations of states which are well managed are able to raise money at a very reasonable rate compared to financially weak corporations of a financially mismanaged state. For example state PSU’s like Gujarat Petronet , Kerala financial corp are able raise money near MCLR compared to discoms in states like UP and Rajasthan. This is where the credit spread comes into picture and differentiates good financial performance from poor financial performance. However, since state development loans or state guaranteed loans are a major borrowing for states and in that market lender’s do not face much risk , they continue to lend to state and have delightful pie of income from it. Further, lenders are of the view that centre has implicit responsibility of ensuring state’s sound financial condition and thus, policies like UDAY will always come whenever a crisis emerges. Thus, State governments despite being in news for moving towards bankruptcy, continue to borrow easily from banks because banks know that constitutional provisions and practical exigencies can never let Indian states go to bankruptcy.