Masala Bonds: Financing state expenditure in post-GST era

Like the farm laws which impinge on the constitutionally mandated state list, transforming the indirect taxes to a Goods and Service Tax is fundamentally centralising revenue generation.
For representational purpose.
For representational purpose.

Like the farm laws which impinge on the constitutionally mandated state list, transforming the indirect taxes to a Goods and Service Tax is fundamentally centralising revenue generation. The short-lived experience of transferring GST revenue to states has been marred by controversy, with most states complaining of delays in devolution (transfer of revenue share from the Centre to state governments).

To generate revenues independent of devolution, the Kerala government utilised its Kerala Infrastructure Investment Fund Board (KIIFB) to borrow in the international market by selling rupee-denominated bonds. This frees up resources for the state government to finance its fight against the pandemic without compromising on its infrastructural investments. We analyse at the pros and cons of this financial strategy to understand the ‘new’ Kerala model of development.

What are rupee denominated bonds?
In October 2013, the then chief economic advisor to the finance ministry Raghuram Rajan announced that certain domestic entities (corporate, body corporate and Indian bank) can issue bonds denominated in the Indian Rupee to be sold in international markets. Soon, the International Financial Corporation (IFC) issued bonds worth `10 billion and dubbed it as ‘Masala Bonds’ evoking popular representations of the Indian cuisine.

Kerala’s use of Masala Bonds
On May 1, 2019, the KIIFB floated the first-ever sub-sovereign masala bond at the London Stock Exchange. The KIIFB initially issued `21,500 million in rupee-denominated bonds and managed to raise `23,232.64 million. With the issue of these bonds, the capital provided ensured the capacity to rebuild crucial public infrastructure, which was damaged after the devastating Kerala floods in August 2019. In hindsight, the timing of accessing international markets was spot on.

Reasons for floating Masala Bonds
With the onset of GST in 2017, there were massive revenue shortfalls and reduced space for effective fiscal autonomy – the states had to depend on the GST Council for revenue. To add to troubles, by May 2019, Kerala had witnessed multiple natural disasters – recurring floods and a wave of the Nipah epidemic. KIIFB provided a viable alternative to generate additional revenue. Domestic borrowing for states was costlier than accessing the international market.

For instance, the Indian bond market had securities issued at coupon rates of up to 10.15%. By exploiting the international bonds market even at a rate of 9.72%, KIIFB bonds were accessing cheaper financing options. Despite this, the KIIFB bonds were the 6th highest coupon rate among international currency denominated bonds and the highest ‘Masala’ Bond. So, not only was international borrowing more lucrative, but it also ensured a faster flow of revenue.

Sustainability of debt and other concerns
It appears that these international borrowings could fill the temporary revenue shortfalls and absorb the delays in devolution. However, will these borrowings be sustainable? There are two key factors which could give us some indication of the sustainability of debt. First, past economic performance and projected performance in the coming years. In 2019-20, Kerala’s GDP was estimated to increase by around 12%. If the state improves its performance in line with the aggregate projections, then the size of the cake gets bigger. Does this alone ensure that Kerala could sustain its debt? No.

The second factor is the cost of servicing total debt (old, accumulated debt as well as the new domestic and international borrowings). In 2018- 19, the ratio of its internal debt to total revenue for Kerala was the 5th highest amongst the 29 states for which data was available. However, with borrowings from the international market, the composition of its total debt gets altered and so does its ability to repay based on a lower interest from the international market.

The Kerala ministry of finance explained that their sustainability plans include a strategy for repayment of these bonds. They claim to allocate the petrol cess and up to 50 per cent of the motor vehicle tax towards repayment of the KIIFB bonds. These strategies are likely to maintain investor confidence and ensure that these channels of borrowing could become sources of temporary revenue. If the ‘new’ Kerala model of financing its expenditure becomes a success story, it would usher in a new era of federalism. It would certainly help the states maintain their autonomy and focus on decentralised development. It could potentially pave way for other states to follow suit and fuel their urge to break out of the shackles of centralisation of finances.

Nikhil Damodaran is Assistant Professor of Economics, Shraavan Varma and Aarjav Nair are students at Jindal School of Government and Public Policy.

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