Should states borrow from the RBI?

The proposals put forward to the states by the Finance Minister on August 27, 2020 to which states have seven days to respond are clear indication that the center wants to protect its fiscal space and tilt the balance of power in its favor. It also violates the terms of agreement on initial phases of GST implementation where states are owed compensation for loss of dues. Such turnaround does not bode well for centre state relations in India.

Asking the states to borrow money from the RBI for the compensation that is due to them is essentially saying the following: “I owe you a compensation but I am not going to borrow from RBI to pay it, I will ask you to borrow and repay it back.” This is problematic on several counts. If a private party did that to a lender it would be clear grounds for breach of contract and therefore for a court case! Maintaining the sanctity of a contract by the State is of utmost importance for keeping sanctity of law. Secondly, if states agree to this, the borrowings become the borrowing state’s liability. Given that states have limited capability to raise finances, it means that the borrowing state will have to ask for help from centre if it cannot repay. This puts the borrowing state in a weaker bargaining position and the center can use its superior position to further its agenda.

Additionally, if the states’ borrow from the RBI, the central bank will have to do so by buying the borrowing state’s bonds. The RBI will receive the interest payments on these bonds which will show up as profits on its balance sheet. The centre then can have the central bank to transfer the profits back to it. This way, the centre not only saves on paying the GST compensation, but my making states borrow from RBI, also gets additional funds from them in future. This arguably is worst bargain for states and serious breach of trust on the part of the center.

States should consider this double whammy of loosing bargaining power as well as interest money as they consider the centre’s proposals. Doing so would be in their best interests.

PS: This post has benefitted from a lively discussion on twitter with @Sabya_K, @dugalira, @qfint, and @akshayalladi. All errors are mine.

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