How Covid-19 has affected the finances of state governments?

Context

• The Reserve Bank of India’s study on state governments’ finances, released on Tuesday, indicates that gross fiscal deficits (GFDs) of state governments are set to double in 2020-21.
• With the Covid-19 pandemic having hit the financial position of states hard, the next few years are going to be challenging.

Where are GFDs of states headed?

• In 2020-21, about half the states have budgeted the GFD-to-GSDP (gross state domestic product) ratio at or above the 3% threshold, although most of these budgets were presented prior to the onset of Covid-19, the RBI said.
• The direction of possible revision is evident from the fact that the average for states presenting their budget before the outbreak of the pandemic is 2.4% of GSDP, while it is 4.6% for the remaining states that made their budget presentations after the outbreak.
• Thus, states are grappling with the pandemic with constrained fiscal space.
• In terms of primary balances, most states are incurring primary deficits in 2019-20, as against primary surpluses at the onset of the global financial crisis, the RBI study said.

How long will the stress continue?

• The crisis literature focuses on the operation of ‘scissor effects’ — loss of revenues due to demand slowdown, coupled with higher expenditure associated with the pandemic.
• The duration of stress on state finances will likely be contingent upon factors such as the lockdown tenure and the risk of new waves of infection, all of which make traditional backwards-looking tax buoyancy forecasting models unreliable, according to the RBI study.
• The quality of spending and the credibility of state budgets will assume critical importance.

What will be the impact on states?

• Given the clear inter-linkages between growth and tax revenues and considering the fact that tax revenues fall faster than GDP when growth is negative, tax revenues are likely to be reduced for the next few years, the RBI said.
• Pandemic-related spending, particularly on health and other support measures, are likely to keep these expenditures high, prolonging the ‘scissor effects’.
• In addition, states’ fiscal position is likely to be affected by a surge in contingent liabilities (guarantees).
• In this milieu, state governments may have to face the tough choice of putting investment projects on hold, but, given the multiplier associated with capital spending, this will inevitably entail growth losses in a vicious cycle.

What happened during earlier pandemics?

• An event study analysis using four pandemics in India — the 1896 plague, the 1918 Spanish flu, the 1957 Asian flu and the 1974 smallpox — shows that all of these were associated with a contraction/deceleration in GDP, with the 1918 flu registering the sharpest downturn of about 13%.
• The recovery pattern is similar — a sharp rebound in the immediate subsequent year because of favourable base effects, followed by contraction again, and the GDP growth rate finally returning to pre-pandemic levels in 3-4 years.
• These outbreaks have also depressed per capita economic output, with varying magnitudes.
• The recovery, however, has been observed to be swift and complete within two years of the outbreak, except in the case of the 1918 flu when GDP per capita was restored to pre-outbreak levels only in 1922.

What does the RBI say about the pandemic response in specific states?

• KERALA MODEL: The presence of empowered local governance institutions and community participation helped the Kerala state in effectively reaching out to affected people, the RBI said.
  • With the resurgence in new cases, Kerala is actively roping in the services of local self-governments (LSGs) in its fight against the pandemic.
  • LSGs have been entrusted with the collection of information, spreading awareness, identifying vulnerable sections, ensuring quarantine and lockdown guidelines are being followed, disinfecting public places and ensuring the supply of essential services to those under quarantine.
  • The state managed to contain the spread of the pandemic in the first wave of infections. However, the state witnessed a second wave of infections with the arrival of non-resident Keralites from outside the state and with the easing of restrictions.
• DHARAVI MODEL: The RBI said public-private partnership and community participation played a crucial role in combating Covid-19 in Dharavi.
  • The government tied up with local private doctors, hospitals, NGOs, volunteers and elected representatives and civil society organisations while following a rapid action plan of accessible testing, proactive screening, early detection, contact tracing, timely isolation and putting suspected and high-risk contacts in institutional quarantine facilities in large numbers, the RBI said.
  • Community participation, community kitchens and collective solidarity were the key features that helped contain the spread.
  • Enforcing a strict lockdown and blocking the movement of residents except for essential services controlled the contagion. Dharavi has flattened the curve and is worthy of emulation worldwide (WHO), it said.