The darker side of UDAY’s light

The Centre’s UDAY scheme has probably been the biggest financial engineering exercise of its kind carried out in the market. Simply put, State governments that accede to this scheme take over 75 per cent of the outstanding debt of State discoms while the balance is restructured by lending institutions. These lenders can also get the backing of a State guarantee.

The condition is that the discom has to meet certain performance metrics with respect to pricing and T&D losses, among others. Future losses of discoms have to be progressively borne by State governments from their budgets. As on date, 26 States have signed up and bonds worth ₹2.32 lakh crore have been issued.

On paper it looks very simple as the entire liability is transferred to the State’s balance sheet and the unit can start on a clean slate. While the notional fiscal deficit increases when debt is taken on by the State government, there is no transfer of funds as such and the States are hence forgiven breaching the 3 per cent mark for FY16 and FY17. All these loans are reissued as non-SLR (statutory liquidity ratio) bonds, which are priced 50 bps above the SDLs (State Development Loans) and serviced for the next 10 years when they are redeemed. The cost comes down and the loans will now be definitely repaid. So, where’s the hitch?

First, by allowing the fiscal deficit number to be breached the entire FRBM (Fiscal Responsibility and Budget Management Act) paradigm is being officially violated. Second, the bonds issued are essentially held by the same entities that had lent funds to the State electricity boards (SEBs). But the interest received is lower by at least 4-6 per cent; this means that there is a loss of income. Intuitively, it can be seen that every ₹1 lakh crore of UDAY bonds issued involves a loss of up to ₹6,000 crore for banks and FIs that have lent money to them.

Third, there is no guarantee that there will not be future losses as there is no retribution if the SEBs choose not to reform. In fact, this has been kept out of the purview of the scheme. By also mandating that State governments have to progressively take over the losses of their SEBs, the Centre has put the onus on the States to deal with the problem.

Fourth, the same money has to be repaid over time and if 75 per cent of the total of around ₹4.3 lakh crore is taken on by the States, the burden will come into effect after 10 years, when States have to generate money to repay this debt. If not, they will run into the usual problem of a debt trap. How will they generate this revenue considering that they are going to run deficits all the time? Clearly they will be borrowing more to service these repayments.

Fifth, the impact on banks would be two-fold. To begin with, the UDAY bonds would give them a lower return. But there is also the lower return on the 25 per cent of debt that is restructured, as it earns just 10 bps above the base rate. As most of these institutions are public sector banks and FIs that are already under pressure from mounting NPAs, this would be a negative for them, even though State government’s guarantee is assured.

Hence this package, as simple and profound as it sounds, will be a nightmare when the loans come up for redemption. Further, the flexibility of a higher fiscal deficit is not provided beyond two years, which means that in future, the 3 per cent figure has to be met.

Therefore, higher payments made as interest on UDAY bonds as well as the future losses of SEBs will come from the budget and will have to be met by cutting down on other discretionary expenditure.

This vexatious issue will only get magnified at the time of redemption. Hypothetically, at 7 per cent average cost, States have to provide for at least 16,000 crore, which can increase to ₹20,000 crore, depending on the exact level of issuance.

Currently, the interest outflow for States is around ₹2.5 lakh crore, according to the FY17 budgeted numbers. An increase of 6-7 per cent would be involved in servicing these bonds. Also, the outstanding debt of the States, which was around ₹26.9 lakh crore (internal debt), would increase by around 9 per cent on this score. While this number may not matter, there is talk of the new FRBM norms restricting the level of overall government debt to GDP at 20 per cent of SDP (State Domestic Product). This would put additional pressure in terms of future debt that can be raised by States.

State governments perforce will have to prune their capex to ensure that they are within the FRBM norm of 3 per cent fiscal deficit mark. While the Centre has been discreet with its spending, States have been more liberal with subsidies, which can range from food and power to distribution of household goods.

While this may be considered improper, governments come to power on the back of these promises and hence cannot renege on them. Add to this the fact that the States have been told to handle their own loan waiver schemes; they will have limited flexibility in making ends meet and would perforce have to cut back on capex, which is not a good sign.

An interesting thought here is also that if UDAY works well for States, why shouldn’t the Centre also take over the debt of the central PSUs — especially of loss-making firms — and get them to start on a clean slate?

The accumulated losses of the central loss-making PSUs is in the region of ₹1-1.2 lakh crore. Ideally the Centre should take over this debt and put conditions for these units for revival so that they become economically viable. The interest cost involved at 7 per cent per annum would be very small at 1.3 per cent of the present interest outflow, while outstanding debt would move up by almost an equivalent amount. Therefore, there is merit in wiping the slate clean and starting over.

Hence, UDAY should be seen more as a scheme that forces SEBs to usher in reforms. States will have a tough time managing their budgets while lenders are clear losers though they have the comfort of dealing with the State government or their guarantees.

The writer is the chief economist at CARE Ratings. The views are personal