The Debt & Investment Management Practitioners' Guide

The Debt & Investment ManagementPractitioners’ Guide

USAID/INDIAREFORM PROJECTCOMPENDIUM WITH PRACTITIONERS’ GUIDETo State Fiscal Management Reform

Volume IV

USAID/India REFORM Project Compendium with Practitioners’ Guide To State Fiscal Management Reform

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Authors:Mr. Michael Schaeffer, Bearing Point;Dr. Soumen Bagchi, REFORM Project – Karnataka;Dr. Brijesh Purohit, REFORM Project – Jharkhand; andDr. Mathew Joseph, REFORM Project – Uttarakhand.

Compendium Disclaimer:The REFORM Project Compendium with Practitioners’ Guides is made possible by the support ofthe American People through the United States Agency for International Development (USAID).The contents of this compendium volume are the sole responsibility of the authors and do notnecessarily reflect the views of USAID or the United States Government.

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Volume IV: The Debt & Investment Management Practitioners’ Guide

REFORM Project:Rationale, Objective & Terms of Reference

The REFORM Vision ……"State governments have the necessary organizational structures, analytical toolsand decision-making processes, information sources and trained staff that enablethem to make better informed choices on a transparent and accountable basiswith respect to state public finances. Subsequently, this capacity is institutionalizedinto the mainstream of state government practices to ensure the sustainabilityof the effort."

The Rationale:The starting point of the USAID/India Fiscal Management Reform Project (REFORM) is that the fiscaldistress seen at the state level in early 2000 was, to a large extent, a result of the systemic weaknessesin state fiscal management (Box 1), including within the key departments of finance and planning. Thisprevented forward-looking fiscal decision-making grounded in careful analysis and leading to goodgovernance. In short, the majority of Indian states needed better analytical capacity backed byappropriate institutional infrastructure to formulate and implement good fiscal policy.

Currently, therefore, many Indian states do not have the appropriate capacity1 and the necessarypractices2 to perform relevant, economic and statistical analyses (Box 2).

Box 2: Consequence of Systemic Weaknesses

As a consequence of the systemic weaknesses, most Indian states, for example, have inadequate fiscal managementexpertise and institutional infrastructure to perform revenue and expenditure projections and distributional analysis,assess multiplier and elasticity effects, and run policy simulation and develop alternative policy scenarios. Thisincludes their inability to establish strong links between budgetary outlays and program outcomes for efficient andeffective delivery of results, establish debt and investment frameworks to improve their quality and profile, andconduct rigorous project appraisals to ensure selection of socio-economically viable projects.

1 i.e., fiscal management skill-sets, tools and techniques and organizational structures.2 i.e., consistent, transparent and accountable processes.

Box 1: Systemic Weaknesses in Fiscal Management

The systemic weaknesses found in fiscal management at the state level may be described as "inadequate":

• Technical know-how in modern fiscal management practices.

• Comprehensive, current information databases.

• Robust analytical tools and techniques that correspond to internationally accepted standards.

• Integrated management information systems and systematic approaches to the fiscal decision-making processes.

• Transparent, consistent and institutionalized fiscal practices, reporting systems, and structures that promote thedesired accountability for the effective and efficient mobilization, allocation and utilization of public funds.


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Given increasing decentralization and the continued significance of public finance in India, many stategovernments will be required to assume greater responsibility for the design and implementation oftheir own development strategies. As a result, their ability to strike the right balance between fiscalpolicy, broad-based growth, and financial sustainability will be fundamental to promoting and sustainingdevelopment across every sector of the state economy and, consequently, the nation as a whole,especially in light of the new challenges posed by the opening-up of the Indian economy and statefinances getting substantially linked with market forces.

The Objective:As a response, USAID/India's REFORM project (September 2003-2008) was designed to provide practicalhands-on "how to" skills transferal, based on international best practices, to strengthen fiscal analyticalexpertise, structures and systems of selected Indian states. The objective was to help these states tobetter plan and manage their public finances, especially in the light of the challenges they facedfollowing the 2000-01 fiscal crisis. Jharkhand, Karnataka, and Uttarakhand were identified as the threeREFORM partner states.

The specific objectives of REFORM were:

1) To improve "informed" decision-making within state (sub-national) governments;

2) To ensure that decision-making processes followed consistent and transparent principles, leadingto greater accountability; and

3) To sustain the efforts by institutionalizing and mainstreaming the capacity built.

REFORM, therefore, was not designed to advise or guide Indian state governmentson specific policy decisions but rather to enhance their ability to evaluate and toaddress crucial policy choices and implementation options, based on anunderstanding of the environment - i.e., its potentials, its limits and its perceivedneeds.3

Terms of Reference:Based on discussions with the respective partner states, the REFORM terms of reference were to helpenhance their fiscal management capacity in the following four (4) areas:

• Revenue Management Capacity – To help states undertake detailed analysis of revenue projectionsand the implications of alternative tax policies and revenue choices. Interventions included:Introduction of improved revenue forecasting methodologies, an Input-Output (I-O) frameworkand macro-economic database. A practitioners’ guide was also developed along with hands-ontraining to build state capacity in the above areas.

3 Capacity-building as defined by the United Nations Center for Education and Development, (Agenda 21's definition, Chapter 37,UNCED, 1992).

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• Expenditure Planning and Management Capacity – To help states improve quality and accountabilityof expenditures. Interventions included: Introduction of an outlays to outcomes budgetingmethodology (i.e., program performance budgeting (PPB)) to help states’ prioritize the allocation ofpublic funds, improve program planning, monitoring and evaluation, increase transparency,accountability, and consequently, the quality of public services delivery. A practitioners’ guide withrelated software was developed and delivered. Structured/hands-on training was provided acrossall levels and in almost all departments. Detailed public procurement guidelines were alsodeveloped for two out of the three states.

• Debt and Investment Management Capacity – To help states to better document, track, analyze, andmanage debt, contingent liabilities and investments, in the medium to long term. Interventionsincluded structured and hands-on training as well as introduction of practical guides (with reportingtemplates). Comprehensive debt datasets were developed and migrated into a database using theCommonwealth Secretariat-Debt Recording and Management System (CS-DRMS) software.

• Project Appraisal Capacity – To help states improve appraisal and selection of socio-economicallyviable capital projects. Interventions included: Training in the Harberger project appraisal techniquewhich involves financial, economic, social and stakeholders’ risks analysis. A Project Appraisalpractitioners’ guide with sector-specific guidelines was also developed and introduced to serve asa desk reference.

To sustain and mainstream the above fiscal management reform efforts, four (4) institutional structureswere designed and supported:

• The Fiscal Policy Analysis Cell (FPAC) – To help states institutionalize continuous analysis of theimplications of policies, procedures and regulatory decisions on the fiscal health of the states. Ananalytic unit supported by a team of dedicated and trained staff, with access to relevant and qualitydata, tools and techniques was established.

• The Debt and Investment Management Cell (DMIC) – To help states identify, generate, and analyzedata and support more effective and prudent debt/investment decision-making. Similar to theFPAC, an analytic unit supported by a team of dedicated and trained staff, with access to relevant andquality data, tools and techniques was established.

• Project Unit (PU) – To help states offer a comprehensive range of services from project appraisal andmonitoring, to final end-of-project evaluation, a project unit was designed that would also helppromote public-private partnerships (PPPs).

• Administrative Training Institutes (ATIs) and State Institutes for Rural Development (SIRDs) – To helpstate civil service training institutes (ATIs and SIRDs) train entry level and mid-career state civilservants in fiscal planning and management, training courses; training materials and reference guideswere developed and provided.


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The Final Products:A project Compendium with Practitioners’ Guides was developed under REFORM to assist stategovernments to implement necessary fiscal management practices in the areas of forecasting,budgeting, tracking of debt and investment, and improving project appraisal techniques. Specifically,these Guides were developed to function both as desk references for government officers earliertrained under REFORM as well as training tools for strengthening capacity of new officers. For officersnot earlier exposed to the new fiscal practices, the Guides will need to be supplemented with additionaltechnical support or guidance.

The Compendium also includes a variety of case studies including the experiences of the three REFORMpartner states – Jharkhand, Karnataka, and Uttarakhand – with respect to the implementing the newpractices under REFORM.

“Fiscal Watch”, a virtual resource center, has also been designed and launched to provide a dedicatedsite to promote greater thinking, collaboration, discussions, best practices and, exchange informationand post current data on the fiscal health (and related issues) of Indian states and India. The key featureof “Fiscal Watch” is the dedicated discussion forums to facilitate interaction between fiscal practitioners,both Indian and international (e.g., to provide a platform for finance secretaries, budget officers, revenueofficials, and researchers). In addition, there are numerous hyperlinks to related online resources suchas government websites, professional societies, consultancy opportunities, and training and educationproviders.

The REFORM project may therefore be considered as four-by-four (4x4), consisting of four interventionareas (expenditure, revenue, project appraisal, and debt and investment management) supported byfour institutional structures (FPAC, DMIC, PUs, and ATIs/SIRDs).

Fiscal Policy Analysis Cell (FPAC)Debt & Investment Mgt Cell (DIMC)

Project Units (PU)State Administrative Training Institutes (ATIs)

Improved RevenueManagement:• Revenue Forecasting• Macro-Econ Database• Input-Output Tables• Tax Analysis

Improved ExpenditurePlanning & Management:• Program

Performance Budgets• Procurement

Guidelines

Improved ProjectAppraisal:• Project Appraisal• Project Financing

Improved Debt andInvestment Management:• Management of:

– Debt– Contingent Liability– Investment– Creditworthiness

Guidelines

REFORM: Four-by-Four

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To Conclude:Despite spending large sums of money, governments and donors in many countries have been limitedin their ability to develop successful, sustainable programs due to the inadequacy of fiscal managementexpertise and infrastructure. Such inadequacies prevent the productive absorption of funds. They alsoprevent states from equipping themselves with the necessary fiscal shock absorbers to cushion themagainst unexpected fiscal challenges - some arising out of discretionary, unplanned decision-makingand others as a result of increased globalization. More often than not, these unexpected challenges canand have served as the tipping points, seriously affecting the fiscal condition of even fiscally healthystates, as seen in India especially post 1995-96.

However, given the increasing recognition by state governments of the role of and need for improvedfiscal management capacity in Indian states' development process, and indeed for India as a nation, weare confident that endeavors such REFORM will be sustained and further strengthened.

Madhumita Gupta, Team Leader REFORM, USAID/India

Table of Contents

REFORM Project: Rationale, Objective & Terms of Reference 3

Acronyms and Abbreviations 15

Authors’ Note 17

Why develop this Guidebook? 17What is the Guidebook? 17When to use the Guidebook? 17Who should use the Guidebook? 17How to use the Guidebook? 17

Executive Summary 19

Introduction — Subnational Borrowing 20Nature of Subnational Borrowing 20Indian State Governments to Access Capital Market on their Own 20The Analytical Framework 21

Section I: Review of Indian State Government Borrowing 21Section II: State Debt Management Operations 21Section III: The Importance of Credit Ratings 22Section IV: Mechanisms to Enter Non Statutory Liquidity Ratio (SLR) Bond Market 22Section V: Evaluation and Monitoring Oversight 22Section VI: Guidelines and Recommendations 22

Section I: Review of Indian State Government Borrowing 23

Part 1: Indian State Government Borrowing 25

The Constitutional Provision 25The Role of Central Government and RBI 26State Government Borrowing Profile 26State Government Borrowing and NSSF 27The Banking System and SLR Regulation 28Is a Move from SLR to NonSLR Bond Issuance Foreseen? 28Indian State Government Bond Market: The Future 29

Section II: State Debt Management Operations 31

Part 1: Improving State Finances 33

Current Practices and Shortcomings 33Judging State Performance — Some Parameters 34

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Part 2: Debt and Investment Management Cell (DIMC) 37

The Funding Process 37Organizing the Debt and Investment Management Cell (DIMC) 38

The Front Office — Funding Transactions 39Middle Office Operations — The Analytical Function 40Back Office Operations — The Recording Function 40

Path Toward Effective Debt Management 41

Section III: The Importance of Credit Ratings 43

Part 1: Credit Analysis and Credit Rating 45

How is Credit Risk Measured? 45Subsovereign (State) Ratings 46

The Twelfth Finance Commission and State Borrowing (TFC) 46Subsovereign Borrowing 46Subnational Borrowing: Debt Management Plan 47The Subsovereign Rating Process 48

Subsovereign Rating Factors 48Economic Base, Diversity and Growth 49

Analysis of Outstanding Debt 50Financial Operations 51Administrative Structure, Legal Factors and Political Dynamics 51Sovereign Ceiling 52

General Creditworthiness Standard 52

Part 2: Role of Credit Rating Agencies 54

Ratio Analysis and its Relevance in State Creditworthiness Analysis 55Availability of Credit Enhancements 56

Section IV: Mechanisms to Enter Non StatutoryLiquidity Ratio (SLR) Bond Market 59

Part 1: Structure of Debt Instruments 61

Forms of Securities 61Bond Characteristics: Pledges of Security 61General Obligation Bonds 61Revenue Bonds 62Appropriation Obligation Bonds 62Double-barreled Bonds 62Short-term Financing 63Bond Characteristics: Repayment Features 63

Payment and Maturity 63Redemption 63

Buying and Selling Bonds: The Secondary Market 64

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Part 2: The Marketing Process 65

Method of Sale 65Basis of Award 66Scheduling Issuance 67Issuance Team 68Sales-related Documents 68Rating Agencies 69Sale, Reporting Results, and Closing 69

Part 3: Securing Specialized Services 70

Bond Counsel 70Financial Advisor 70Underwriter 71Trustees and Paying Agents 72Cost of Services 72

Section V: Evaluation and Monitoring Oversight 73

Part 1: Monitoring and Oversight of State Government Debt 75

Overview of the International Experience 75Argentina 75Brazil 76United States (California) 76

Best Practices and Disclosure Standards 76Fund Balance Reserve Policy/Working Capital Reserves 77Multiyear Financial Forecasting 77Monthly or Quarterly Financial Reporting and Monitoring 77

Contingency Planning Policies 77Policies Regarding Nonrecurring Revenues 78Debt Affordability Reviews and Policies 78Superior Debt Disclosure Practices 78Rapid Debt Retirement Policies 79Dealing with Default 79

Section VI: Guidelines and Recommendations 81

Part 1: Concluding Observations and Guidelines 83

Expanding the Playing Field for State Securities 83Financial Market Regulation and Disclosure 83Credit Analysis and Ratings 84Other Issues 84


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Annexures 87

Annexure 1: Financial Market Structure 89Annexure 2: Strategic Benchmarks on State Debt 101Annexure 3: Bank for International Settlements (BIS) Definition of Liquidity 105Annexure 4: Types of Securities 106Annexure 5: Credit Enhancements 109Annexure 6: Government Debt Instruments and Sales Methods 113Annexure 7: Minnesota State Debt Management Policy 114Annexure 8: DIMC and CS-DRMS Implementation Road Map 118Annexure 9: Public Debt Management Links 123Annexure 10: Bibliography 124Annexure 11: Toward Improving Debt and Investment Management at the Indian State

Level: Case Studies of Jharkhand, Karnataka and Uttarakhand 129

Tables

Section II: State Debt Management Operations

Part 2: Debt and Investment Management Cell (DIMC)

Table 2.1: Comparison of Negotiated and Competitive Sales 65Table 2.2: Net Interest Cost versus True Interest Cost 67

Annexures

Annexure 1: Financial Market Structure

Table 1A.1: Debt Market: Selected Indicators 90Table 1A.2: Structure of Indian Debt Market 91Table 1A.3: State Market Borrowing, 2000-01 to 2006-07 96Table 1A.4: Nonrepo Secondary Market Transactions in Government Securities 99Table 1A.5: Secondary Market Transactions in Government Securities (in Percent) 100

Annexure 2: Strategic Benchmarks on State Debt

Table 2A.1: Strategic Benchmarks Country Examples 104

Annexure 11: Toward Improving Debt and Investment Management at the Indian StateLevel: Case Studies of Jharkhand, Karnataka and Uttarakhand

Table 11A1.1: REFORM Project Initiatives, Impact and Leveraging 134

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Figures

Section I: Review of Indian State Government Borrowing

Part 1: Review of Indian State Government Borrowing

Figure 1.1: Financing Pattern of Fiscal Deficit of States 26Figure 1.2: SLR Investments by Scheduled Commercial Banks 29

Part 2: State Debt Management Operations

Figure 2.1: The Funding Process 38Figure 2.2: Organization of a Debt and Investment Management Cell 39

Section IV: Mechanisms to Enter Non Statutory LiquidityRatio (SLR) Bond Market

Part 1: Structure of Debt Instruments

Figure 1.1: General Government Obligation Bonds 61Figure 1.2: Revenue Bonds 63

Annexures

Annexure 1: Financial Market Structure

Figure 1A.1: Indian Debt Market 89

Annexure 4: Types of Securities

Figure 4A.1: Flow of Funds in the Primary Market 106

Annexure 5: Credit Enhancements

Figure 5A.1: Bond Insurance as a Percentage of the Long-term New Issues Market in the U.S. (1980-04) 109Figure 5A.2: The Partial Risk Guarantee Facility 111Figure 5A.3: Establishing a Reserve Account 112

Annexure 7: Minnesota State Debt Management Policy

Figure 7A.1: General Fund Appropriation for Debt Service not to Exceed 3.0% of Nondedicated Revenues 114Figure 7A.2: General Obligation Debt not to Exceed 2.5% of State Personal Income 114Figure 7A.3: State Agency Debt not to Exceed 3.5% of State Personal Income 114Figure 7A.4: Total Amount of State General Obligation Debt, Moral Obligation Debt, State Bond Guarantees,Equipment Capital Leases, and Real Estate Leases not to Exceed 5.0% of State Personal Income 115Figure 7A.5: General Obligation Debt Estimated Outstanding June 30, 2006 115


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Annexure 11: Toward Improving Debt and Investment Management at the Indian StateLevel: Case Studies of Jharkhand, Karnataka and Uttarakhand

Figure 11A1.1: Vicious Debt and Investment Management Process 132Figure 11A1.2: Virtuous Debt and Investment Management Process 132Figure 11A2.1: State Debt-to-GSDP Ratio (Uttarakhand 2003-04; All Other States 2001-02) 138Figure 11A2.2: Indian State Debt Growth (1991-06) 139Figure 11A2.3: Interest Payments as % of Revenue Receipt (FY 2002-03) 139Figure 11A2.4: Uttarakhand Interest and Principal Debt Repayment Forecast (FY 2002-18) 141

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Acronyms and Abbreviations

BAN Bond Anticipation NotesCAG Comptroller and Auditor GeneralCCIL Clearing Corporation of India LimitedCDs Certificate of DepositsCDS Credit Default SwapsCPs Commercial PapersDS Debt ServiceDvP Delivery Vs. PaymentEBITDA Earnings Before Interest, Taxes,

Depreciation and AmortizationFD Fiscal DeficitFIIs Foreign Institutional InvestorsFRAs Forward Rate AgreementsFRBs Floating Rate BondsFRL Fiscal Responsibility LegislationFRBM Fiscal Responsibility and Budget

ManagementFY Fiscal YearGAAP Generally Accepted Accounting

PracticesGDP Gross Domestic ProductGFD Gross Fiscal DeficitGIC General Insurance CorporationGICs Guaranteed Investment ContractsGoI Government of IndiaGRF Guarantee Redemption FundGSDP Gross State Domestic ProductIAS International Accounting StandardsINR Rupees (Unit of Currency)IP Interest PaymentIRC Irrevocable Revolving Credit

ArrangementsIRS Investment Rate SwapsLIC Life Insurance CorporationMoF Ministry of FinanceNABARD National Bank for Agricultural and

Rural DevelopmentNACSLB National Advisory Council on State

and Local BudgetingNBFCs Non-Banking Financial Companies

NCDC National Cooperative DevelopmentCorporation

NDS Negotiated Dealing SystemNEAT National Stock Exchange for

Automated TradingNSE National Stock ExchangeNSSF National Small Saving FundONTR Own Non Tax RevenueOTC Over the CounterOTR Own Tax RevenuePD Primary DeficitPDO Public Debt OfficePF Provident FundPRB Primary Revenue BalancePRG Partial Risk GuaranteePRI Political Risk InsurancePSE Public Service EnterpriseR-G Rate of Interest minus GrowthRBI Reserve Bank of IndiaRD Revenue DeficitRE Revised EstimateREC Rural Electrification CorporationREPO Buyback TransactionsRRB Regional Rural BanksRR Revenue ReceiptRTGS Real Time Gross Settlement SystemSEBI Securities and Exchange Board of

IndiaSGL Subsidiary General LedgerSLR Statutory Liquidity RatioSO Structured ObligationsSPV Special Purpose VehiclesSTCI Securities and Trading Corporation of

IndiaStP Straight through ProcessingTAN Tax Anticipation NotesTFC Twelfth Finance CommissionTRAN Tax and Revenue Anticipation NotesTRR Total Revenue ReceiptsWDM Wholesale Debt MarketWMA Ways and Means Advances

Why develop this Guidebook?The purpose of this Debt Guidebook is to help an Indian State Government to improve their creditrating as a precursor to entering the debt market to raise capital.

What is the Guidebook?This Debt Guidebook is a supplement to training of those employees who are not familiar with debt,investment or guarantee management. It helps employees of the operating departmentsunderstand public sector debt management by describing international debt management toolsand techniques.

When to use the Guidebook?Once a state government has decided to go to market to raise capital, the state can use the DebtGuidebook as aide in how to improve its credit rating, debt management processes, andorganizational infrastructure.

Who should use the Guidebook?This Debt Guidebook is helpful to: those who will be responsible for maintaining the state creditrating, and portfolio of debts, investments, and guarantees. It is also useful as a reference to otherstate decision-makers who will be considering the assumption of debt.

How to use the Guidebook?The Guidebook serves as a baseline tool to assist state governments to implement necessary fiscalmanagement reform. The compendium includes guidelines for on-the-ground implementation ofinternational best practices by state officials in the areas of forecasting, budgeting, tracking of debtand investment, and improved project appraisal. These guidelines have been developed with theaim of serving both as desk references for government officials already trained in the respectivefiscal competency as well as training tools for structured capacity-strengthening programs. Forofficials not already exposed to the fiscal practices introduced under REFORM, the guidelines willneed to be supplemented with technical support or guidance.

Authors’ Note

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State government market borrowing has largely been limited through the Reserve Bank of India(RBI). However, the Twelfth Finance Commission recommendation to discontinue centralgovernment loans to state governments for plan funding will require Indian states to mobilize largerresources from the market. The challenge to raise funds from the market by state governmentscomes at a time of transition and uncertainty. The central underlying issue in this Guide is statesaccessing the market and the need for improving creditworthiness to facilitate access to market ontheir own.

A critical concern is how to increase the access of state governments to financial markets, broadlydefined as the banking system and the securities market. Credit market access has been approachedfrom various angles in this States Going to Market and Creditworthiness Guide (“Guide”) including:the changing nature of Indian state government borrowing, state debt management operations,mechanisms to enter the nonSLR bond market, and the organization and regulation of the financialmarket. Other areas that are reviewed include the likely investor groups, the need for information toanalyze credit, credit rating and finally, private insurance (or enhancement) of state governmentsecurities.

This Guide explores the market for state government debt in the Indian context and is presented in sixparts. The first five parts establish a framework for understanding the debt market in the Indian contextand the manner in which the current debt market functions, the market structure, operation andregulations, the kinds of security instruments that are available, and the main participants in the market.In these sections, the mechanisms for states going to market on their own, state creditworthiness, andmonitoring of oversight of state debt is brought into focus. The final section provides general guidelinesand recommendations.

While there is no one right way of developing and expanding the Indian state government securitiesmarket, there are ways to facilitate the success of a state government bond market including:

• The financial marketplace should be free to work with state governments to decide on the typesof instruments and associated payment structures to employ;

• Wherever possible, it is best to introduce and promote competition into the state securitiesmarket; and

• Public and timely reporting on the terms, conditions and other provisions of loans and bondofferings is a necessary complement to supporting a competitive state securities market regime.

Information and state government accountability are key factors in the effective operation of statedebt markets. Assessment of risk, crucial for determining the cost of capital, requires stategovernments to produce reliable, complete and timely financial information. Without the disciplineof the hard budget constraint, financial markets and credit assessors have little reason to distinguishamong the various state government credits, and the rationale for market allocation of resources isconsequently lost.

Executive Summary

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Introduction — Subnational BorrowingThe present challenge for Indian state governments to raise funds from the market on their owncomes at a time of transition and uncertainty. The changes in governance and dispersal of fiscaldecision making are increasingly devolving responsibility for meeting capital needs to stategovernments. Concurrently, there is increasing pressure to make government at all levelsaccountable to its citizens and more attuned to the demands of the marketplace.

A critical issue in this transfer of responsibility from the central to state governments is how toincrease the access of subnational (state) governments to financial markets, broadly defined as thebanking system and the securities market. Financial market is simply a system of borrowers andlenders and credit allocation based on pricing decisions that balance supply and demand. Inaddition, a broad-based financial market implies an array of alternatives for accessing capital funds.

Nature of Subnational BorrowingCountries differ in the role that subnational governments have in financial markets and in the natureof their financial markets. Whatever the goals of greater autonomy and capacity at the subnationallevel, subnational governments vary greatly in political power and decision making authority. This, inpart, reflects differences among unitary states, hierarchical federal states and governance systemsthat recognize separate spheres for each level. These differences are embedded in the constitutionsand legal systems that condition the degree to which subnational governments are free to act and tocontrol the resources with which to act.4

The literature pertaining to subnational borrowing or subnational creditworthiness or for thatmatter subnational debt market development in the context of developing countries has tended toremain focused on the problem of municipal debt market development or municipalcreditworthiness. However, the scope of this “States Going to Market and Creditworthiness Guide” isdifferent in the sense that this discussion focuses on the second tier of government, the states inIndia and not the third tier (i.e., the municipal bodies).

Market borrowings by states already exist. However, these market borrowings are undertaken by RBIon behalf of the states. State government bonds are treated as statutory liquidity ratio (SLR)securities, thus providing a captive market for state bond issues. However, in the future, this willchange. Accessing the market by state son their own strength is not easy. This requires stategovernments to build up capacity within each state to assess their own borrowing requirements, tomanage their debt more effectively, and to undertake the actual operation of borrowing byengaging private merchant bankers, and to service creditors. Equally important, this presupposesthe taking up of a series of measures to make the state creditworthy.

4 See Mila Freire and John Peterson (ed.) Subnational Capital Markets in Developing Countries published by the WB and Oxford UniversityPress, Introductory Chapter.

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Indian State Governments to Access Capital Market on their OwnThe central government, based on the recommendation of the Twelfth Finance Commission (TFC)has stopped central loans for plan funding of the states since the Budget 2005-06. TFC has promptedchanges in the manner in which Indian states borrow. Under the newly modified state borrowingenvironment, as the central government ceased lending to state governments, the amount of stategovernment market borrowing will, in all likelihood, increase. By resorting to larger marketborrowings, state governments will now be exposed to market discipline and scrutiny.

The Government of India appointed a technical group under the Chairmanship of Ms. ShyamalaGopinath, Deputy Governor, Reserve Bank of India (RBI) to suggest the transitional arrangements forstate market borrowings. The group has since submitted its report. Based on its recommendations,a Standing Technical Committee is being constituted under the aegis of Finance SecretariesConference with representation from the central and state governments and the RBI to advise on thenext steps in this regard.

The Analytical FrameworkThis “States Going to Market and Creditworthiness Guide” (“Guide”) explores the market for stategovernment debt in the Indian context. This Guide is developed with the following two basicobjectives of (i) guidelines for developing the creditworthiness of the state governments; and(ii) mechanism to approach the market on stand alone strength. Excluding this brief introductorysection, the Guide has six parts. The first five parts establish a framework for understanding the debtmarket in the Indian context and the manner in which the current credit market functions, themarket structure, operation and regulations, the kinds of credit instruments and security instrumentsthat are available, and the main participants in the market. In these sections, the determination ofstate creditworthiness and monitoring of oversight of state debt is brought into focus. Finally, Part 6provides guidelines and recommendations.

Section I: Review of Indian State Government BorrowingCredit needs and market structures vary greatly and depend on the political, fiscal, financial and legalsettings in which they are imbedded. Part 1 provides a review of the current and medium termsystem of borrowing by state governments in India and the current situation of Indian state finances.Recent developments in state government borrowing and the future scenario of state governmentborrowing are also discussed.

Section II: State Debt Management OperationsFiscal capacity and financial acumen of subnational jurisdictions are fundamental considerations indetermining which entities are candidates for borrowing. Although these are not always correlatedwith size, private creditors generally prefer larger jurisdictions because of their bettersophistication, ability to draw on more resources, and ability to spread the fixed costs of debttransactions over larger volumes of borrowing. Part 1 provides a brief overview of current Indianstate government debt management operation practices, looking at shortcomings, and providing

parameters for measuring effectiveness. Part 2 provides a snapshot for establishing a debt, investmentand contingent guarantee monitoring unit (DIMC) within the various Indian state governmentDepartments of Finance. As envisioned, a DIMC could be established at the state government level toensure better recording, transparency and monitoring the state government portfolio of debt,guarantees, and investment operations.

Section III: The Importance of Credit RatingsCredit risk is the risk arising due to uncertainty in a borrower’s ability to meet its obligations. Becausethere are many types of counterparties from individuals to sovereign and subsovereign governmentsand several different types of obligations from personal loans to derivative transactions, credit risk takesmany forms. Part 1 discusses the means, surveillance, analysis and importance of state government debtby credit rating organizations. Part 2 reviews the role of credit rating agencies as states go to market ontheir own. In effect, the information produced by state government credit ratings (and, any subsequentmonitoring program) can be useful to government officials and purchasers of government securities atall institutional and investment levels.

Section IV: Mechanisms to Enter Non Statutory Liquidity Ratio (SLR) Bond MarketBorrowing is at the centre of any economic activity played out in financial markets. Part 1 examines thenature of borrowing instruments (e.g. general obligation bond, revenue bond), their technical design(maturity, payment schemes) and the method by which they are offered to the market. In addition, Part 1 laysthe foundations of the kind of borrowing that may be undertaken by state governments and explore thenature of financial and real (asset) resources that may be pledged to repay indebtedness. Parts 2 and 3provide the structure, operation and the guiding principles of approaching the market by a subsovereignentity. The marketing process for state nonSLR bonds and the nature of required specialized services forentering into the competitive and negotiated path for debt issuance is reviewed.

Section V: Evaluation and Monitoring OversightThe political and financial relationships between central, state and local governments are rich and varied.These relationships are evolving along new lines, many of them unique to a given country’s tradition andposition along the decentralization (and, devolutionary) scale. National government oversight andintervention in state government financial systems vary fundamentally in federal systems, which leaveimportant prerogatives to the states, and in unitary governments, which have strong sovereign centers.Part 1 reviews the various best practice methods available for improving the debt position of subnationalgovernments. The information produced in a good debt monitoring scheme is useful for state officials butalso private lenders. Efforts to regularize and harmonize reporting and improve its content are indispensableto state government debt market development.

Section VI: Guidelines and RecommendationsState government borrowing is not an end in itself. Ideally, it should be used to obtain long-term capitalfor expenditures that provide benefits that stretch into the future. Repaying state government debtrepresents the fulfilling of an intergenerational contract obligating those who benefit from the capitalinvestment to pay their share of the costs. Part 1, therefore, provides guidelines and recommendationsfor developing a more efficient and liquid market for Indian state government securities.


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Review of Indian StateGovernment Borrowing

Section I

In this Part, we discuss the regulatory,institutional and administrative aspects withregard to the current state governmentborrowing as well as its monitoring. This Parthighlights the relevant constitutional provisionsdealing with state government borrowing anddiscusses the current role of the centralgovernment and the Reserve Bank of India (RBI)in facilitating state borrowing. After discussingthe changing pattern of state governmentborrowing, the Part dwells on the possibility ofthe states going in for borrowing throughnonSLR bonds in the future.

The Constitutional ProvisionFor reasons of macroeconomic control,borrowing by subnational governments in anyfederal setting is subordinated to prior approvalby the national government. In India, thissubordination is enshrined under Article 293 ofthe Constitution. As per this provision, states arenot allowed to borrow directly from externalsources and require the central governmentpermission to raise domestic loans so long asthey are indebted to the Centre or takenguarantees from the Centre for loans raised bythem. Box 1.1 presents the relevant details ofthis Article.

In the year, 2001, during the region of the StatesFiscal Reform Facility, the off-budget borrowingsof State Governments through SPVs was alsobrought in the ambit of Article 293(3) of theConstitution. In the wake of rapidly increasinglevel of guarantees by State Governments, GoIwas compelled to issue guidelines to adviseState Governments to obtain prior approvalbefore resorting to SPV borrowing.

States were also advised to obtain credit rating

Box 1.1: Provision under Article 293 ofIndian Constitution

1) Subject to the provisions of this article, theexecutive power of a state extends to borrowingwithin the territory of India upon the security ofthe Consolidated Fund of the state within suchlimits, if any, as may from time to time be fixed bythe Legislature of such state by law and to givingof guarantees within such limits, if any, as may beso fixed.

2) The Government of India may, subject to suchconditions as may be laid down by or under anylaw made by Parliament, make loans to any stateor, so long as any limits fixed under Article 292 arenot exceeded, give guarantees in respect of loansraised by any state, and any sums required for thepurpose of making such loans shall be charged onthe Consolidated Fund of India.

3) A state may not without the consent of theGovernment of India raise any loan if there is stilloutstanding any part of a loan which has beenmade to the state by the Government of India orby its predecessor government, or in respect ofwhich a guarantee has been given by theGovernment of India or by its predecessorgovernment.

4) A consent under clause (3) may be granted subjectto such conditions, if any, as the Government ofIndia may think fit to impose.

Source: Constitution of India.

Part 1:

Indian State Government Borrowing

for SPV borrowing for any new project. Inparallel, RBI also advised banks and financialinstitutions to exercise due diligence whilelending for any specific project of State-ownedPSUs and not to lend solely on the strength ofState Government guarantees. This was the firstconscious step by the GoI to bring theoff-budget borrowings of State Governmentsinto the Constitutional provisions and extendinginitial measures to increase thecreditworthiness of State Governmentborrowing.

25



26

The Role of Central Government and RBICentral Planning Commission determines theannual plan size of each state in consultationwith that state and the central Ministry ofFinance and indicates the financing scheme tothe state. The scheme of finance for the stateincludes borrowing in the form of central loans(which ceased from 2005-06 following TFCrecommendations), securities issued againstNSSF, provident fund, market borrowing,borrowing from central financial institutions(negotiated loans), etc. The Department ofExpenditure under the central Ministry ofFinance accords permission to states for raisingborrowings under the various heads as providedin the annual scheme of financing of the statePlan. As per the present policy of GoI, a StateGovernment has no control over the flow ofborrowing from public account. NSSF proceedsare automatically transferred to the States as perthe prevailing norm.

The Reserve Bank of India acts as the banker/merchant banker and debt manager of states onthe basis of an agreement signed between thestate and the RBI. As per this agreement, the RBIperforms the following functions:

• Advises state governments on its marketborrowing program;

• Undertakes market borrowing for statesthrough tap/auction route;

• Service the debt of state governments bydeducting from state balances with RBI; and

• RBI also provides ways and means advances.

State Government Borrowing ProfileFigure 1.1 provides an idea of the movement ofshares of major sources of loans to the stategovernments. The composition of stateborrowings has undergone significant changes.

Source: Reserve Bank of India Annual Report 2005-06.

Figure 1.1: Financing Pattern of Fiscal Deficit of States

100%

80%

60%

40%

20%

0%

-20%

1990-91 1995-96 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07(RE) (RE)

Year Ending March

18.8

13.4

2.0

47.1

18.7

23.0

12.1

5.1

36.4

9.4

14.0

18.8

13.2

1.3

53.1

13.6

18.6

8.3

6.5

37.1

11.4

18.0

10.0

7.0

4.8

51.2

27.9

0.9

24.1

5.83.4

16.9

11.5

38.4

11.1

7.4

66.5

30.1

11.5

0.1

4.2

7.9

4.8

65.0

2.3

15.7

6.2

7.8

6.7

53.5

4.8

21.0

Others

Pro. Funds & Small Savings

Loans from Banks & FIs

NSSF

Loans & Advs. from Centre

Market Loans

27


Central government loans which traditionally havedominated state borrowing declined inimportance with the prepayment of over a lakhscrore of high-cost loans during the 2002-05 period(under the so-called “debt swap scheme”).TheNSSF loans have now become the dominantsource of state government debt financingcomprising up to 65 percent of the financing gapof states during 2004-07 (Figure 1.1).

The share of market borrowing through the RBIhad risen considerably during the period of thedebt swap (2002-05) as state governments werepermitted by the centre to go in for additionalmarket borrowing to prepay the high-costcentral loans. Over 2005-07, the share of marketloans remained subdued in the 15 to20 percent range.

Loans from banks and financial institutions(also called “negotiated loans” from centralfinancial institutions) have increased over thelast three years with a share of 5 to 7 percentduring 2005-07.

State provident funds and small savingsconstituted about 7 to 8 percent share during2004-07. The share of other sources of stategovernment borrowings consisting of a mix ofreserve funds, deposits and advances, ways& means advances from RBI, contingencyfunds, etc. have come down drastically from19-24 percent in earlier years to just about4 to 6 percent during 2005-07.

State Government Borrowing and NSSFA quick review of recent state governmentborrowings illustrate that loans from the Centrehave given way to two major borrowing sources:market borrowing and, loans from NSSF. Prior to1999-00, the small savings funds were

transferred as loans from the centralgovernment. However, a separate accountunder the NSSF was created in 1999-00 and100 percent of the funds from this account aredirectly channeled to state governments asloans since 2002-03. In 2006, state governmentsbecame increasingly reluctant to borrow fromthe NSSF because of its high coupon rate of9.5 percent, which were much higher than therate for market borrowing.

The central government is considering reducingthe offtake of NSSF loans to state governmentsto 80 percent rather than existing 100 percent.Moreover, it has taken initiatives to makeinvestments in NSSF less attractive by hiking therates on bank term deposits and bringing themat par with the return on small savings (MonthlyIncome Scheme, Public Provident Fund, NationalSmall Saving Scheme, National SavingsCertificate, etc.). Further, the central governmenthas already brought the bank term depositsunder the investments in tax exemptioncategory under Section 80C of the Income TaxAct. The Government of India has also removedthe 10 percent lump sum bonus on the MonthlyIncome Scheme of Post Offices. This has shownimmediate results. There has been a 30 percentreduction in investments in small savings duringApril to August 2006 compared to the same

The composition of borrowing by Indian stategovernments has undergone significant changesin recent years. There has been significant declinein the share of loans and advances from theCentre from 57.4 percent in end-March 1991 to22.4 percent in end-March 2006. Loans againstsecurities issued to NSSF have become thepredominant source of borrowing by states,financing about two-thirds of gross fiscal deficitduring 2004-05 and 2005-06.


28

period of 2005. The amount of investmentdeclined from INR 31488 crores to INR 21989crores.

The Banking System and SLR RegulationThe SLR Regulation has not only served the roleof a monetary policy instrument for controllingthe liquidity situation within the economy, it hasalso made available funds to the central and thestate governments to finance investments inpriority sectors. However, one of the majorrecommendations of the RBI Working Group onHarmonizing the Role and Operations ofDevelopment Financial Institutions and Banks(1998) has been to phase out SLR in line withinternational practice.5 The Grouprecommended that there is a need to developan alternative mechanism for financing specificsectors which require concessional funds whichcan be provided by specifically targetedsubsidies rather than via statutory obligation onthe entire banking system. Importantly, the Billfor amending the Banking Regulation Actproposes to empower the Reserve Bank of Indiato reduce the SLR from the current 25 percentand the government has introduced anordinance in January 2007 in this regard.

Is a Move from SLR to NonSLR BondIssuance Foreseen?As presented above, the composition ofborrowing by Indian state governments hasundergone significant changes in recent years.There has been significant decline in the shareof loans and advances from the Centre from 57.4percent in end-March 1991 to 22.4 percent inend-March 2006. Loans against securities issuedto NSSF have become the predominant source

of borrowing by states, financing abouttwo-thirds of gross fiscal deficit during 2004-05and 2005-06.

The scenario started changing in 2006-07 with asubstantial decline in the inflow of small savings.This is caused by a number of factors like theremoval of income tax benefits under thesesaving schemes, extension of tax benefits tofixed bank deposits of five years and above,increase of interest rates on bank deposits, andattractive returns from stock market and mutualfunds. Besides, NSSF loans are a high-cost sourceof funds with interest rate at 9.5 percent whilemarket borrowing can be had for below8 percent. Net borrowing under NSSF is boundto decline sharply in the next three to four yearsas the five year moratorium on repayment ofprincipal ending for the large gross inflows inthe past few years.

State government bonds associated with marketborrowing enjoy the status of being statutoryliquidity ratio (SLR) securities. Commercial banksare required to invest a certain portion of theirnet demand and time liabilities (NDTL) in SLRsecurities, which are mainly the central and stategovernment securities. The SLR requirementswere raised in the 1970s and 1980s to supportgovernment’s rising borrowing requirements.The SLR reached the peak level of 38.5 percentby 1992.

As a part of the reform process, SLRrequirements were brought down successivelyto 25 percent by 1997. Nevertheless, bankholdings in government securities continued toremain considerably above the requirements.

5 The Working Group also observed that the need for SLR has declined as a result of stringent asset classification and provisioning normsand Government borrowing at market determined rates.

29


Thus, by early October 2004, scheduledcommercial banks actual holdings ofgovernment securities were around 40 percentof their NDTL as compared to the required 25percent. This is due to the sluggish demand forbank credit from the corporate sector. Thesituation has, however, dramatically changedwith commercial banks holding of governmentsecurities came down to 34.7 percent in October2005 and further down to 29.8 percent in October2006 as the demand for bank credit has surged.This may further decline as the corporate demandfor bank loans is expected to remain strong in theshort- to medium-term (Figure 1.2).

Another source of debt funds for the states is thenegotiated loans from central financialinstitutions such as NABARD, HUDCO, LIC, GIC,REC, PFC and NCDC. These are specific-purposeinstitutions and the scope of large growth ofborrowing from these institutions by states israther limited. While plan loans from the Centrehave stopped (from 2005-06), central loans will

take the form of foreign loans from multilateraland bilateral donors. Although multilateral andbilateral loans have historically been routedthrough the central government, they will nowbe on the same terms and conditions asprescribed by the donors. However, thequantum and share of these loans is notexpected to be large.

In the light of TFC recommendations, all statesexcept the so-called weak and vulnerable statesare to move to the market and borrow on theirown in the near future. They will not have thecomfort of the RBI conducting the borrowing anddebt servicing on their behalf. State governmentdebt will no longer enjoy SLR status.

Indian State Government Bond Market:The FutureThe Twelfth Finance Commission (TFC) hasrecommended that the states should graduateto market borrowing on their own strength.

Figure 1.2: SLR Investments by Scheduled Commercial Banks

Source: Extracted from RBI Mid-term Review 2006-07.

4-A

pr-

03

30-M

ay-0

3

25-J

ul-

03

19-S

ep-0

3

14-N

ov-

03

9-Ja

n-0

4

5-M

ar-0

4

30-A

pr-

04

25-J

un

-04

20-A

ug

-04

15-O

ct-0

4

10-D

ec-0

4

4-Fe

b-0

5

1-A

pr-

05

27-M

ay-0

5

22-J

ul-

05

16-S

ep-0

5

11-N

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05

6-Ja

n-0

6

3-M

ar-0

6

28-A

pr-

06

23-J

un

-06

18-A

ug

-06

13-O

ct-0

6

44

40

36

32

28

Perc

ent o

f ND

TL

Keeping in view the discussions above, it hasbecome imperative for the state governmentsto become creditworthy and get stand-aloneinvestment grade credit rating in the event ofany of the following things happening:

• In the situation of gradual move of RBI as anarranger of state governments “borrowing,”even bond issuance eligible for SLR statusmay be managed by other private fundmanagers;

• Increasing share of market borrowing bystate governments through auction routewhich would mean increasing interest spreadbetween financially strong and less strongstates;

• Accounting contingent liabilities arising outof off-budget borrowing as explicit liabilitiesof the state governments leading to revealingof a poor financial condition for the state;

• Removal of the SLR status of the stategovernment bonds; and

• Further reduction and gradual removal of SLRby the RBI.

The Government of India has emphasized theneed to develop the domestic corporate bondmarket. The R. H. Patil Committee Report hasprovided a plan of action for developing thecorporate bond market. This would clearly helpstate governments to approach the corporatebond market for funds.

With this background the objective of this Guide istwofold:

• Provide a strategy to improve thecreditworthiness of the state governments; and

• To provide a mechanism to approach thebond market for nonSLR bonds.


30

State Debt ManagementOperations

Section II

Fiscal capacity and financial acumen ofsubnational jurisdictions are fundamentalconsiderations in determining which entitiesare candidates for borrowing. Although theseare not always correlated with size, privatecreditors generally prefer larger jurisdictionsbecause of their better sophistication, ability todraw on more resources, and ability to spreadthe fixed costs of debt transactions over largervolumes of borrowing. In most countries threegroups of jurisdictions can be identified interms of the likelihood for the issuance ofsubsovereign debt in private market:6

• Those that already have access to capitalmarket;

• Those with limited or no access to capitalmarkets; and

• Those that cannot generate sufficientrevenue to meet their defined commitmentsand unable to access capital markets.

Jurisdictions in the first two groups have thepotentiality to use private credit resourcesunder a regime in which central governmentassistance to subnational market developmentis accommodative and indirect, focused on lawsand regulations that create an enablingenvironment for subnational governmentborrowing in credit markets. Subnationalgovernments in the third group, the very smalland poorest governments, should not borrow inprivate credit market.

In India, while some state governments have thefinancial capacity to access capital market funds,they are not allowed due to the existingregulatory restrictions by the RBI and the

Part 1:

Improving State FinancesFederal Government. However, stategovernments provide support to utility boardsand special purpose vehicles throughguarantees to facilitate accessing private creditmarket. This is a very common phenomenon.Nevertheless, there are over a dozen exampleswhere urban local bodies (the weakest so far asthe financial capacity is concerned) wereallowed by state governments to go to themarket to fund capital investments in urbanbasic services in India. Most of these urban localbodies issued general obligation bonds throughprivate placements. This Part provides a detailedaccount of some of the shortcomings existing inthe current state finances disclosure norms. As weshall see, these shortcomings make it very difficultto capture the true strength and weaknesses ofstate government financial picture.

Current Practices and ShortcomingsA major issue of concern toward measuring thefiscal and financial performance of the stategovernment is measuring the sustainability ofits financial performance. This would requiregetting into the details of the nature of itsliabilities rather than on its revenue streams(e.g., own sources, intergovernmental transfers)and its sustainability over the period ofborrowing. Computing net worth of asubnational entity may not be very usefulkeeping in view the nature of assets of thegovernment and the assigned roles andresponsibilities. However, there are instanceswhere the property of a state government wasattached due to default in invoking theguarantee issued.

The second concern is the nonavailability of anaccrual based accounting system at the state

6 “Subnational Government as Borrowers” in Mila Freire and John Peterson (ed.) Subnational Capital Markets in Developing Countries.(A co-publication of the World Bank and Oxford University Press).

33



34

level, which fails to provide a clear picture of thefinancial position of the state governments.While the Twelfth Finance Commission (TFC)through its recommendations has tried toreward the better performing states withdebt write-offs. Debt write-off measuresrecommended by the TFC have been relatedto bringing down the revenue deficit to zeroand fiscal deficit below 3 percent over astipulated period.

It would be possible for state governments todefer committed expenditure and generatesurplus on the revenue account to avail thesewrite-offs. This has become possible due to the

provisions often there is no budgetary provisionmade for the guarantees issued by stategovernments. It is very difficult to capture suchinformation in the absence of an accrual basedaccounting system. Having expressed the aboveconcerns, it becomes very important tounderstand how far a true ratio analysis wouldbe useful and relevant in the context of asubnational entity in India.

This issue would be touched upon in this Partand would be discussed in detail subsequentlywhile discussing the credit rating of subnationalentities. A strict sense corporate rating may notbe very useful and relevant for a subsovereignentity. Under such circumstances, it is veryimportant to understand the risks involved insubsovereign borrowings. It is equally importantto know what makes a state government solventand whether solvency does ensures credibility.Solvency may or may not necessarily implycreditworthy. A cash surplus subsovereign entitymay or may not be a sustainable debt repayer. Itwould depend to a large extent on the nature ofexisting responsibilities of the entity and thenature of future commitments.

Judging State Performance — SomeParametersSome of the major parameters that could beconsidered for judging the performance of asubsovereign entity could be the ones thatrelate to measuring their economic structure.For example:

• Strength and weaknesses in terms of diversityand flexibility within the sectors;

• Fiscal performance particularly relating totheir debt profile; and

• Operating performance and cash flow.

Fiscal capacity and financial acumen of subnationaljurisdictions are fundamental considerations indetermining which entities are candidates forborrowing. Although these are not alwayscorrelated with size, private creditors generallyprefer larger jurisdictions because of their bettersophistication, ability to draw on more resources,and ability to spread the fixed costs of debttransactions over larger volumes of borrowing.

existence of a cash based accounting system.Documenting and bringing changes inaccounting policies (e.g., accrual accounting)and disclosure norms by the various stategovernments to the public domain wouldenable most state government bond investorsto be more informed.

The third issue of concern is the lack of detailedinformation pertaining to guarantees issued bystate governments to facilitate borrowings bythe Special Purpose Vehicles (SPVs).

In spite of the GoI’s initiative to bring off-budgetborrowings in the ambit of the Constitutional

35


Moreover, equally important is the aspect ofeconomic management. This refers to theefficiency and effectiveness of its managerialissues. This might include the performance ofthe state public sector undertakings, its planperformance, purpose and efficiency of itsutilization of the ways and means advances,transparency and judiciousness in issuingguarantees for the borrowings by state PSUs,local bodies and cooperative societies.

While looking at the performance of the state interms of diversity and flexibility within theeconomy, it is required to look into the followingsets of indicators:7

• Net State Domestic Product — itscomposition and growth;

• Per Capita Net State Domestic Product andits growth;

• Per capita availability of power, roads,railways and other major physicalinfrastructure;

• Per capita availability of education and healthfacilities;

• Growth of the industrial sector, particularly,manufacturing;

• Per capita sanctions and disbursements bythe Financial Institutions (FIs); and

• Mineral reserves and extent of utilization ofthese mineral reserves, locally and globally.

While looking into the economic performanceof the state, it is equally desirable that the strongeconomy of the state is also reflected in the

states revenue (particularly tax) generationcapacity. Though theoretically explainable in theIndian context, it is worth noticing that there ishardly any correlation between the economicperformance of a state and its revenuemobilization capacity. This issue will be taken upin detail in the later Parts.

The second and the most important of the set ofindicators is the financial performance of stategovernment. However, due to several reasonsdiscussed earlier in this Part, it is very difficult tocapture the true picture of the financialstrengths and weaknesses of a state. It isessential to understand the following:

• Performance of the states revenue earningcapacity — its sustainability as well as itsexpenditure commitments both in therevenue as well as capital account;

• The financing of the plan schemes and itsdependence on the internal and extrabudgetary resources for the financing of theplan schemes;

• Significant dependence on the borrowingsby the state PSUs for plan financing withgovernment guarantee is often not viewed asa positive sign. Such funding with internalresources of the PSUs should be considered aplus for the government;

• While it is important for the government todepend more on its own resources and lesson the transfers from the higher levels ofgovernment, dependence on a single sourceof revenue with less flexibility is often seenas a negative aspect;

7 Various rounds of detailed discussions were conducted with the executives of ICRA Limited to understand the nature of subsovereignrating in India and the parameters used for determination of the rating.


36

• Clearly defined sharing mechanism of fundsbetween different levels of government andnondiscretionary transfers are considered tobe a positive for the subsovereign entity;

• Deficit in the revenue account is oftenconsidered a negative aspect. More so, if it isfunded out of borrowings over a long timeperiod and continuous revenue deficitsleading to accumulation of debt. The situationbecomes further unfavorable in the event ofdeteriorating balance of current revenue;

• Fiscal deficit as such is not bad with marginalor no revenue deficit so far as it is incurred asa result of increased capital outlay subject toquality of investment;

• In other words, a higher share of revenuedeficit in the fiscal deficit is seen as a majordrawback for a subsovereign entity;

• A major concern of a subsovereignparticularly in the Indian context is theamount of its total liability, particularly thoseincurred as a result of the guarantees issuedfor the borrowings of the state PSUs.Outstanding guarantees as a share of the totalliabilities of the state government is animportant component of the states measureof fiscal performance.8

While the financial performance of stategovernments is important, it is equally importantto have a clear idea of economic managementissues. These include state governmentsadherence to the provisions in the various statutes.

It is very much desirable for the subsovereignentities to stick to the requirements and theprovisions of the statutes like the FiscalResponsibility Act, Ceiling of GovernmentGuarantee Act, etc. Moreover, it is desirable on thepart of the subsovereign to try and adhere to thebenchmarks brought out by the Central Bankpertaining to the debt sustainability factors andguarantee related indicators.

The successive Finance Commissions haverecommended setting up of sinking Funds foramortization of debt. The Twelfth FinanceCommission (TFC) specifically recommendedthat all States should set up sinking funds foramortization of all loans including loans frombanks, liabilities on account of NSSF, etc. TheFund should be maintained outside theconsolidated fund of the States and the publicaccount and should not be used for any otherpurpose, except for redemption of loans.Besides, the TFC also recommended that allStates should set up guarantee redemptionfunds through earmarked guarantee fees. Thisshould be preceded by risk weighting ofguarantees. These would improve the creditrating of the States when they apply for loans.

While indicators and benchmarking areimportant, it is essential for the subsovereign toadhere to the recommendations andsuggestions of the Central Bank in terms ofmaintenance of information and regularity inbringing out information required to developinvestors confidence. Many of these issues willbe taken up in subsequent Parts.

8 Various credit rating agencies have indicated that while Guarantees (G)/(Debt (D) + Guarantee (G)) is a very important ration. The ratingagencies analyze the total composition of Debts (D) and Guarantees (G). In addition, the agencies have stated that while Guarantees (G)are important they may not be a critical factor. Credit agencies look at many factors including cash flows, provisions, and reserves.

37


At present, many states do not have a well-defined structure documenting, tracking andassessing the implications of debt, contingentliabilities and investments. Debt data recordingis fragmentary in nature. With regard to stateborrowing from the centre, the Comptroller andAuditor General of India (CAG) maintain recordsfor all state governments. For market borrowing,the Reserve Bank of India keeps the accountsand conducts the debt servicing. Stategovernments which borrow from differentsources do not have a satisfactory mechanism tocompile the entire spectrum of borrowings andthe outstanding debt, and monitor and use themfor their borrowing strategy. Financing of fiscaldeficits in the case of almost all States shows thetotal annual borrowings exceeded the fiscaldeficit thereby inducing financial loss to theStates.

Effective debt management practices suggestthat debt management functions should beconsolidated in one primary location andorganized along functional lines.9

At the operational level of debt management,the responsibilities of the Debt and InvestmentManagement Cell will include contraction ofloans and their debt servicing, and recording,monitoring and analysis of the state level debt.These functions take two forms: passive andactive. The recording and analytical functions are

Part 2:

Debt and Investment ManagementCell (DIMC)

regarded as passive functions in that theirperformance does not imply a change in thestate’s debt profile. In contrast, the functions ofraising and servicing state governmentborrowings are considered active functions inthat they will affect the state’s debt profile.

The Funding ProcessFigure 2.1 presents an overview of the debtmanagement process and the functions thatshould be undertaken by the Debt andInvestment Management Cell (DIMC).10 Thefunding process (see Figure 2.1) indicates that:

• The DOF-Treasury develops a funding plan todetermine how much needs to be borrowed;

• The debt issuance program is established bythe Funding and Resource Mobilization Branch(Front Office). Based on the estimated needs,the office develops a debt issuance programto meet the financing gap;

• The debt is issued and the transaction isrecorded and accounted for as part of theDebt Liability, Investment and Risk AnalysisBranch (Middle Office) operations. The MiddleOffice continuously analyzes the risk to thegovernment’s debt portfolio of certain debtrelated and other indicators (e.g., interestrate, exchange rate movements). This officewould also evaluate the effectiveness of stategovernment (equity) investments and risks

9 DIMC should be established to primarily manage state government debt and guarantees. However, many Indian states should managetheir entire portfolio of assets better. As a result, a DIMC can be established to manage the left hand side of the balance sheet(Investments) and the right hand side of the balance sheet (debt, guarantees). Providing enhanced transparency to state governmentbalance sheets should translated into better credit ratings and, more importantly, lower costs of borrowing.10 A companion "State Government Debt Investment Management Cell (DIMC) Operations and Procedures Guide" to this "State’s Goingto Market and Creditworthiness Guide" is available upon request. The State Government DIMC Operations and Procedures Guidebookprovides greater detail with respect to internal operations and procedures, data collection and recording, and management processeswith respect to DIMC.


38

Figure 2.1: The Funding Process

Activity

Step 2:IssuanceProgram

FrontOffice

Step 4:Risk

Management

MiddleOffice

Step 6:Accounting

AccountingDepartment

Step 1:Funding PlanRequirement

OrganizationalStructure

ForecastDepartment

Step 3:Confirmationand Control

BackOffice

Step 5:Clearing

andSettlement

BackOffice

with respect to state government guarantees;and

• The Debt Recording, MIS and SettlementsBranch (Back Office) clears and settlesissued debt as a component of its operations.This office would also record and keep trackof guarantees and asset in the recordingkeeping of state government investmentrecording in states (where applicable).

The following sections will discuss theorganization and structure of the debtmanagement unit.

Organizing the Debt and InvestmentManagement Cell (DIMC)The following section presents a brief overviewof the organizational structure for the Debt andInvestment Management Cell (DIMC). The DIMCwill be administered under a unit head. TheDIMC is expected to be a relatively small unitand will be structured to allow the employees to

balance specialization in one specific area withacquiring an understanding of the entire debtmanagement process.

The Debt and Investment Management Cell maybe housed within a Fiscal Policy Analysis Cell(FPAC) or outside the FPAC. The DIMC is expectedto be a small unit with some members havingoverlapping skills and functions. A streamlined(multitasking) orientation for the employees of theDebt and Investment Management Cell will leadto greater operational efficiencies.11

One possible scenario for a Debt andInvestment Management Cell structure isprovided in Figure 2.2. The functionalorganization for public debt management that isincreasingly emerging around the globe issimilar to that of an investment institution.

While the agencies responsible for debtmanagement may not be structured as in theseinstitutions, several operational areas may be

11 See Annexure 7: Minnesota State Debt Management Policy for more information regarding a U.S. State government’s policies regardingthe management of state government debt.

39


established within a debt, guarantee andinvestment management unit that correspondsto three categories of the debt, guarantee andinvestment management function, including:

• Funding and Resource MobilizationBranch (Front Office) – This office willundertake borrowing operations based on anapproved borrowing plan. This operationalunit will also take the responsibility forguarantee (and hedging) transactions of thegovernment;

• Debt Liability, Investment and RiskAnalysis Branch (Middle Office) – Thisoffice will focus on developing a debt, riskand investment management strategy,develop borrowing and investment scenariosand compare the emerging debt indicatorswith agreed benchmarks over a period oftime. This would enable sustainable levels ofpublic sector borrowings to be estimated

and a borrowing policy and plan for publicsector borrowing to be prepared; and

• Debt Data Recording, ManagementInformation and Settlements Branch(Back Office) – This office will be responsiblefor making (or integrating with the treasury)debt service payments based on creditorinvoices that are crosschecked with its owndatabase and also be responsible formonitoring loan utilization and thepreparation of accounting and other reportsrequired by creditors and the government.12

The Front Office — Funding TransactionsThe front office is typically responsible for allfunding transactions, including loan negotiationsand issuing government debt. In this process,front office staff seek the most efficient fundingcost, taking into account the risk parametersestablished by senior management and Stategovernment policy. It is the responsibility of the

12 Please see “State Government DIMC Operations and Procedures Guidebook.” The State Government DIMC Operations and ProceduresGuide provides greater detail with respect to internal operations and procedures, data collection and recording, and managementprocesses with respect to DIMC.

Figure 2.2: Organization of a Debt and Investment Management Cell

Funding and ResourceMobilization Branch

(Front Office)Funding Transactions:

Coordinate Relations, Markets, InvestorsNegotiate with Creditors, Enforce

Compliance with Medium/Long DebtStrategy Loan Mobilization

Debt Liability, Investmentand Risk Analysis Branch

(Middle Office)Analysis and Reporting:

Evaluate Concessional (and, otherLoan Alternatives), and Grants

Debt Recording, MIS andSettlements Branch

(Back Office)Debt Recording Function: Registration of

Domestic (International) GovernmentLoans Disbursements/Monitoring of

Disbursements And Registered LoansValidate Debt Data Maintain Debt Data Base

Debt and InvestmentManagement Cell Head

(Head of Office)


40

front office to operate within a legal andregulatory and issuance framework.Furthermore, the front office should maintainwell-informed and coordinated relationsbetween the state government, RBI, the markets,investors, credit rating agencies, andinternational creditors.

The front office should:

• Be able to evaluate funding alternatives andtheir impact on the debt portfolio in terms ofcompliance;

• Be able to negotiate with all externalcreditors and issue the desired amount andtype of borrowing or hedging instruments;

analysis and decision making, utilizing theinformation provided by the recording andcontrol unit (back office). At the aggregatelevel, it involves macroeconomic analysis toexplore the various options available giveneconomic and market conditions and the futurestructure of the state government’s debt (and,investments). The function is necessary in orderto continuously review the impact of variousdebt management options on the state’s budgetand to help with assessing such issues as theappropriate terms for new borrowing.

At the disaggregated level, the analyticalfunction would look at things such as the variousborrowing instruments available, or the choiceof maturities. It could also assist in the analysis ofnew financial techniques such as hedging,swaps, and risk management techniques. If thestate has debt benchmarks to comply with, thisfunction will also measure the performance ofthe State in relation to those benchmarks. All ofthese operations combined are called middleoffice operations.

In brief the middle office operations should:

• Develop a strategy for debt funding;

• Develop a debt profile review; and

• Should evaluate concessional loans in termsof their contribution to debt sustainabilityratios.

Back Office Operations — The RecordingFunctionThe recording function records information.Good debt (and, investment) managementrequires accurate and up to date information.Prompt updating of debt (and, investment) datafiles requires a well-organized and efficientsystem of information flow to the office in

Forecasting and managing a state’s cashrequirements are a prominent aspect of the DIMC.This will ensure that the state manages cashinflows/outflows more efficiently. A majorrequirement of the debt unit is to ensure thatcurrent and future funding needs, arising fromrefinancing maturing debt as well as newgovernment funding, can always be met. Ultimately,the protection of liquidity is one of the most basictasks of the Head of the DIMC.

• The Front Office will be responsible fornonSLR borrowing: going to market, pricingand tenor of the instrument, and, meetingwith investors where appropriate; and

• Be in compliance to the parameters of themedium and long-term debt managementstrategy as recommended by the middleoperations office and approved by policymakers.

Middle Office Operations — The AnalyticalFunctionThe analytical function provides elements for

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charge of the debt registering function. Thisinformation flow is necessary at all levels,including new loans, transactions,disbursements and arrears created. This functionis part of what is referred to as back officeactivities. The primary responsibility of the backoffice includes:

• Registration of state government loans,guaranteed parastatal and local governmentloans and contingent liabilities;

• Monitoring disbursements of the registeredloans for purposes of updating the database;

• Providing timely projects to ensure promptand timely debt servicing;

• Maintaining a debt database; and

• Validating debt data.

Forecasting and managing a state’s cashrequirements are a prominent aspect of theDIMC. This will ensure that the state managescash inflows/outflows more efficiently. A majorrequirement of the debt unit is to ensure thatcurrent and future funding needs, arising fromrefinancing maturing debt as well as newgovernment funding can always be met.Ultimately, the protection of liquidity is one ofthe most basic tasks of the Head of the DIMC.

A key debt recording function, which can beassigned to the DIMC, is the collection, updating,monitoring and reporting on the state debtportfolio. In this connection, use of debtmanagement software is essential. A widelyusedsoftware in the British Commonwealth countriesis the Commonwealth Secretariat Debt Recordingand Management System (CS-DRMS) software.This software is available on a gratis basis for allCommonwealth member states. Training is

provided by the Commonwealth CS-DRMS teamin-country. To date, the Reserve Bank of India(RBI), the Ministry of Finance Department ofEconomic Affairs (DEA) and the states of Assam,Jharkhand, Karnataka and Uttarakhand are usingthe software for daily debt management andrecording.

Path Toward Effective Debt ManagementPoorly performing manual debt recordingsystems, analysis, and debt managementstrategies are often a symptom of broaderorganizational problems, such as inadequatelydefined goals and functions and uncleardecision making authorities andaccountabilities.

In many countries, government debtmanagement skills are often weak because ofdisagreement over roles, decision makingpowers, inadequate systems of checks andbalances, and difficulties in establishingaccountability for quality assurance in suchenvironments. These problems may becompounded by a shortage of well-trained staff.

There is little reason in considering systemsenhancements such as the introduction of acomputerized debt recording system until thedata quality and organizational issues areresolved. An important initial step is toundertake an audit of the quality of the loan dataand to verify why data are unavailable or of poorquality. This requires an examination of thebusiness procedures involved in raising anddisbursing loans, including but not limited toarrangements for borrowing requests,disbursing funds to end users, on-lending, andmaking debt servicing payments and principalrepayments. Procedures for requesting and

approving guarantees (contingent liabilities)should also be reviewed.

In developing an effective debt managementstrategy it is essential to verify the loanaccounting data and to retrieve missinginformation on cash flow obligations. Thisprocess itself can take several months. A

repository for all loan documentation andrecords relating to borrowing, disbursement, on-lending, and guarantees should be centralizedwithin the DIMC in the Department of Finance.

In closing, please see Annexure 8 for arecommended road map for establishing aDIMC and implementing the CS-DRMS software.


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The Importance ofCredit Ratings

Section III

Credit risk is the risk arising due to uncertainty ina borrower’s ability to meet its obligations.Because there are many types of counterpartiesfrom individuals to sovereign and subsovereigngovernments and several different types ofobligations from personal loans to derivativetransactions, credit risk takes many forms.

How is Credit Risk Measured?The primary source of market-based informationon credit risk has been the corporate bondmarket. The margin between the yield oncorporate bonds and that on government bondshas typically been used to measure credit risk.These margins tend to vary with the credit ratingof the borrower and the term to maturity of thebond. The lower the credit rating and the longerthe term to maturity, the higher the creditspread tends to be, since both thecharacteristics increase the possibility of default.Recently, Credit Default Swap (CDS) is beingused for measuring credit risk.13

This situation may not be very strictly applicablein Indian context where there are variousrestrictions operational in the functioning of thebond market and interest spreads may notcapture the risks involved in a strict sense. Inassessing credit risk from a single counterparty’sperspective, an institution normally considersthree issues. These are:

• Default probability. Default probability is thelikelihood that the counterparty will defaulton its obligation either during the life of theobligation or over some specified horizon,such as a year. Default probability computed

Part 1:

Credit Analysis and Credit Ratingfor a one-year horizon is termed as expecteddefault frequency;

• Credit exposure and recovery rate. In theevent of a default, credit exposure is themeasure of the extent of outstandingobligation when the default occurs. Recoveryrate is the fraction of exposure that may berecovered through bankruptcy proceedings orthrough some other form of settlement; and

• Credit quality of an obligation refersgenerally to the counterparty’s ability toperform on the obligation. Credit qualityencompasses both default probability andrecovery rate. Credit quality of an individualor small business is typically assessedthrough a process of credit scoring. Creditscoring for individuals for (say issuance of acredit card or personal loan) may have astandardized structure. This structureincorporates information pertaining to theindividuals annual income, existing debt, etc.and produce a number called the creditscore.14

Things become more complicated when wedeal with larger institutional counterparties orsovereign/subsovereign governments due tothe varied and complicated forms of credit risks.Under such circumstances, credit analysisbecomes more important rather than just creditscoring.

The term credit analysis is used to describe anyprocess for assessing the credit quality of acounter party. While the term can encompasscredit scoring, it is more commonly used to referto processes that entail human judgment.

13 CDS is a bilateral contract between two FIs, in which one agrees to compensate the other in the event that a nominated third partyexperiences an event (say, bankruptcy) (See "New Measures of Credit Risk": Reserve Bank of Australia Bulletin, 2003).14 http://www.riskglossary.com/articles/credit_risk.htm

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46

People providing these judgments based oninformation provided by the issuer are known ascredit analysts. Credit analysts “judgments arebased on review of information of the issuer inthe balance sheet and income statement(known as financial analysis), the performance ofthe issuer in comparison to the industry/sectorin the current economic environment (known asindustry analysis) and the managerial strengthand weaknesses (known as managementanalysis). Based upon this analysis, the creditanalysts assign the counterparty (or the specificobligation) a credit rating, which can be used tomake credit decisions.”

governance is a state subject and the FederalGovernment’s treatment of the stategovernments is not similar to the FederalGovernment’s treatment of the municipalbodies.15

The Twelfth Finance Commission andState Borrowing (TFC)A state government rating was not somethingwhich was considered very important in thecurrent Indian fiscal federalist structure till thereport of the central Twelfth Central FinanceCommission (TFC) came out in November 2004.The TFC is said to have redefined the existingfederal-state fiscal relation. Keeping in view theglobal trend, the TFC recommended discontinuityof the federal government’s loan intermediationrole hitherto existing and subjecting states tomarket discipline. The market borrowing by thestates had remained confined only through theReserve Bank of India (RBI) as discussed earlier. TheTFC recommended that the federal governmentshould not act as an intermediary and the statesshould be allowed to approach the marketdirectly.16

This has necessitated state governments to bemore fiscally disciplined and manage theirfinances prudently. Some of state governmentshave informally approached the credit ratingagencies for rating. However, these ratings havenot been finally publicized for the purpose ofmobilizing resources for the market.

Subsovereign BorrowingBorrowing by subnational governments is apowerful tool of financing, but possess potentialproblems when used, where subnationalgovernments are not subject to hard budget

15 Constitution of India.16 Twelfth Finance Commission Report (2005-10), Ministry of Finance, Government of India.

The primary source of market-based informationon credit risk has been the corporate bond market.The margin between the yield on corporate bondsand that on government bonds has typically beenused to measure credit risk. These margins tend tovary with the credit rating of the borrower and theterm to maturity of the bond. The lower the creditrating and the longer the term to maturity, thehigher the credit spread tends to be, since both thecharacteristics increase the possibility of default.Recently, Credit Default Swap (CDS) is being usedfor measuring credit risk.

Subsovereign (State) RatingsSubsovereign rating in India has remainedlimited to the municipal bodies. Unlike theUnited States, municipal bodies and stategovernments in India should not be treated atpar as subsovereign entities. While states aresubnational entities, municipal bodies aresubstate entities. According to the Constitutionof India (Entry 5 of List II, i.e., Art.246) local

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constraints, capital market fails to impose hardcredit discipline and officials are not fullyaccountable to their constituencies. Apreliminary survey of the financial condition ofsubnational governments show that few havethe degree of creditworthiness needed to accessdomestic capital market. The frequent failure ofinternational on-lending initiatives to buildsustainable local credit markets stems in partfrom lack of clarity as to what elements should asubnational credit market should possess.

A subsovereign’s ability to issue debtsuccessfully is subject to a series of limitationsposed both by the markets and by higher levelsof government. Other limitations andrestrictions are also reflected in the broadersystems and legal frameworks under whichsubsovereigns operate. Some determinants ofsubsovereign borrowing like mode of financingand capital improvement plan, etc., are withinthe jurisdiction of the subsovereign entity.However, the subsovereign entity must alsoaccommodate a series of externally imposedlimitations by the higher levels of government.For example, Art. 293 (3), as discussed earlier ofthe Constitution of India limits the borrowing bythe state governments as follows:

Art.293 (3): “A state may not without the consentof the GoI raise any loan if there is still outstandingany part of a loan which has been made to theState by the GoI………”17

Moreover, state governments access to marketborrowings in India has been limited by theGovernment of India through compulsoryexhaustion of quota of borrowings from the

National Small Saving Fund (NSSF) even after therecommendation of the TFC.18

Subnational Borrowing:Debt Management PlanCapital market borrowing represents just one ofa number of approaches to financing majorgovernment expenditures. If a subnationalgovernment decides to borrow, it is importantthat it develops a Debt Management Plan/Program and carefully evaluate the financialrisks associated with debt obligations prior toentering the capital market. In other words,mobilizing resources through issuance of debtshould not be a stand-alone decision of thesubsovereign rather it should form a part of theoverall capital investment and debtmanagement plan.

A correct debt management policy can providethe conceptual framework and necessary tools toguide the borrowing policies by subsovereignentities. A debt policy is a necessary tool forconsidering how each issuance of debt relatesboth to previous and future issuances and also tolonger-range strategic development andbudgetary goals. One of the key reasons for aseparate capital budget is that decisions toengage in government borrowing should not bemade in a vacuum. In deciding whether to enterthe bond market (or borrow from a bank) asubsovereign must consider not just the best wayto fund a particular project but also how thisfinancing mechanism fits the overall budgetarygoal of the subsovereign. Under mostcircumstances, borrowing by the subnationalgovernments will entail subnational financial riskas the capital markets for subnational debt are

17 Constitution of India.18 "Inter-ministerial Group to look into Debt Cap for States" (Business Standard; 17th June, 2005) and "No Market Access for States till theyhave Access to NSSF Money" (Business Standard; 15th June 2005).


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very underdeveloped and volatile. The debtmanagement policy as a part of the overallbudgetary policy of the subsovereign shouldelaborate on the advantages and disadvantages ofentering the market vis-à-vis other loans and itsshort and long-term impact for financing aparticular project.19

The Subsovereign Rating Process20

If a subnational (state) government issues debtand determines that it needs a credit rating, theissuer will hire a rating agency. The rating agencybegins the process by asking for a presentationfrom the issuer. The issuer takes this opportunityto describe the issue and make a case for itsgood rating. Generally, a rating process involvesthe following:

• Background and history of the issuer;

• Official statement of the issuer;

• Proposed terms, legal covenants and bondindentures for the issue;

• Indentures for the existing bond issues, if any;

• Five years of audited financial statements andannual reports and operating; capitalbudgets; and

• Information about projects in case it is issuedfor a specific project, such as constructionand operating contracts, concessionagreements and other project and legaldocuments.

Each rating agency’s procedures are unique.Moreover, the information provided differs basedon the particular type of bond being issued. With

the completion of the analysis based oninformation provided, the Internal RatingCommittee of the Rating Agency will debate thecredit quality and determine the rating.

The rating is published only if the issuer agreeswith the assigned rating, otherwise, it remainsconfidential. However, the rating agenciespolicies regarding confidentiality differ. Undercertain circumstances, the rating agencypublishes the rating even against the wishes ofthe issuer to protect investor interests. Theissuer-rating agency relationship will continuetill the maturity of the issue. The rating agencyreserves the right to upgrade or downgrade therating based on new credit developments. Theproper antidote to any temptation to shortcutthe objectivity of credit ratings is to requirepublic disclosure of the financial and other datathat should serve as a basis for rating, as well aspublic disclosure of the full rating report.

Subsovereign Rating Factors21

Factors determining rating of an entity issuing aninstrument or simply an instrument is guided bythe type of instrument issued. An instrument’srepayment liability may be from the generalrevenue sources of the issuer, known as ageneral obligation bond. Key aspects of generalobligation bonds include:22

• These are secured by the full faith and creditof issuing governments;

• Relies on taxing ability of the issuinggovernment and the intergovernmentalrevenue transfers;

19 See “Credit Rating and Bond Issuance at the Subnational Level” The World Bank, 1999; pp 2-30.20 Ibid, pp 2-30.21 Discussions with ICRA Officials and World Bank Handbook on Subnational Borrowing.22 Revenue bond debt is serviced through specific project revenues.

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• Typically issued for financing nonrevenuegenerating projects;

• No trustees or debt service reserve fundsrequired; and

• Investor concerned with the underlying fiscalstability of the issuer, good financialmanagement procedures and potentiallikelihood of fiscal reforms.

However, revenue bond debt is financedthrough specific project revenues. A debtservice reserve fund is often a creditenhancement requirement with respect torevenue bonds. A project feasibility study is anessential upfront requirement before a revenuebond can be considered. Strict sense projectrevenue bonds are very rare in India. Forexample, many local urban body infrastructurerevenue bonds use not only the dedicatedrevenue stream of the specified project, butmust also include general budgetary funds tofinance the debt service.

In rating general obligation bond, the ratingagencies generally analyze the followingfive key factors:

• Economic base, diversity and growth;

• Analysis of outstanding debt;

• Financial operations — revenue andexpenditure flexibility;

• Governments administrative structure, legalfactors and political dynamics; and

• Sovereign ceiling.

The above-mentioned factors are explained inthe following sections.

Economic Base, Diversity and GrowthLogically, an economy’s high growth is expectedto be reflected in its high tax revenuegenerating capacity. Economic prosperity anddemographics are significant creditconsiderations. However, in India and in manydeveloping economies, a strict sensecorrespondence does not exist between growthof the economy and tax revenue generation.There are states that have high growth rate ofGSDP with low tax to GSDP ratio and vice versa.

Diversity with no dominant economic sector anda healthy blend of manufacturing, agricultureand services is a positive feature reducing therisk of default as a result of lower revenue fromthe predominant sector. High growth of theeconomy as a result of a sector largely exemptfrom taxation as in case of India (e.g., agriculture)does not necessarily is a positive feature.Nevertheless, a blend of employment in publicand private sector is a positive aspect.

As mentioned earlier, though there is no 1:1correlation between the economy and thefinances of the state governments, some of thefollowing indicators are generally considered bythe rating agencies:

• Real growth of GSDP;

• Real growth of per capita GSDP; and

In India, the rampant issue of guarantee by thestate governments for opting off-budgetborrowings needs reviewing. This could weakenthe issuer’s ability to secure future obligations.States have, however, started coming up with astatutory ceiling on these guarantee issued.


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• Relative shares of various sectors in GSDP.23

It is, however, felt that it would be moreappropriate to consider the growth in revenuefrom taxes on commodities that contributesignificantly to the GSDP. In other words, thesector that contributes significantly to the GSDPis also a major contributor to the tax revenue ofthe state. Computing growth of this sectorwould be more meaningful, rather than theoverall performance of the economy.

subsequent sections. Debt analysis alsoincludes factors such as off-balance sheetproject financing, lease obligations, debtguarantees and contingent liabilities inenterprise funds or other state-ownedentities.

• Exposure to the risk of exchange ratedepreciation for foreign currency debt is also amajor issue to be considered while analyzingdebt profile. This has become an importantcriterion in subsovereign rating only after theTFC recommendation. The TFC recommendedthat the risk of all external agency loan,though intermediated through the federalgovernment would lie with the subsovereign.

• Contingent liability is an important factor inanalyzing debt situation of a subsovereign.

In India, the rampant issue of guarantee by thestate governments for opting off-budgetborrowings needs reviewing. This could weakenthe issuer’s ability to secure future obligations.States have however, started coming up with astatutory ceiling on these guarantee issued.

The following indicators are considered in debtanalysis by rating agencies, including:

• Debt/Consolidated Debt (includingcontingent liabilities) to GSDP Ratio;

• Debt/consolidated Debt (includingcontingent liabilities) to Total RevenueReceipts (TRR) Ratio;

• Interest Payments to TRR Ratio;

In Indian context, it is imperative to understand thefiscal federalist structure including the nature andmechanism of intergovernmental transfers. Inaddition to sovereign support in the form ofexplicit guarantee to subsovereign entities, creditrating agencies also consider the scope of federalgovernment oversight of the activities ofsubnational governments.

Analysis of Outstanding DebtLegal structure, debt profile and burden ofcontingent liability are the three mostimportant factors analyzed under this head. Theobjective of debt analysis is to understand thenature of debt owed (tenure, volume, etc.) andthe purpose for which it has been borrowed andwhat has been pledged to repay the debt.

• Debt is often measured relative to the level ofwealth as well as to the operating revenues.Some of these indicators have been taken upin detail while discussing benchmarking in

23 Credit rating agencies Tax/GSDP analysis emanates from a basic understanding that most state taxes are consumption taxes andhence sectoral gross value added in the economy. As a result, these taxes cannot be segregated for analysis. For example, salestax/manufacturing sector GSDP may not be analytically useful because sales tax is paid on consumption (by all income earners in thestate, not just those from the manufacturing sector). Credit rating agencies such as ICRA use SOTR/GSDP rations under the premise thatGSDP is a reflection of the total consumption in the state (innately assuming common savings rates across states).

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• Debt Growth/Consolidated Debt Growth toRevenue Growth Ratio;

• Outstanding Guarantees to GSDP/RevenueReceipts Ratio;

• Revenue Deficit to Fiscal Deficit Ratio; and

• Fiscal Deficit to Total Revenue Receipts Ratio.

Financial OperationsFinancial analysis begins with an examinationof the issuer’s financial statements. Theagencies financial analysis includes review ofthe budget process, revenue and expenditurestructure and past financial operations. Whilethere is no universal accounting standard thatis practiced in every country, rating agencieswill expect the issuer to explain theaccounting practices used.24

Factors that the rating agencies normally considerinclude:

• Annual operating surpluses or deficit;

• Expectation of the future revenue andexpenditure;

• Inspection of tax revenue and user feerevenue trends including their administrativemechanism;

• Issuer’s budget and capital plan; and

• Flexibility of the subsovereign to raiseadditional revenue or cut expenditure, ifrequired.

Keeping in view the current disclosure normsand existing information maintenance system atthe state level in India, some of the importantindicators (ratios) could be:

• Own Revenue to Total Revenue;

• Share of the Major Tax to Total Own Revenue;

• Nondevelopmental Expenditure to TotalExpenditure;

• Capital Expenditure to Total Expenditure;

• Capital Outlay to Fiscal Deficit;

• Market Borrowing for Financing Fiscal Deficit;

• Budgetary Resources for Plan Funding;

• Tax to GSDP;

• Own Nontax Revenue to Total Own Revenue;and

• Fiscal Transfers to Total Revenue.

Administrative Structure, Legal Factors andPolitical DynamicsOne of the most important rating factors forsubsovereign rating is the regulatory and legalstructures of the country’s executive andlegislative branches of the government, theservices provided by the federal government,state enterprises and administrative agenciesand the relationship among the federal and thesubsovereign governments to help determinethe issuer’s willingness to pay. In addition, therating agencies also need to consider theintergovernmental systems and political andadministrative supportiveness.

In Indian context, it is imperative to understandthe fiscal federalist structure including thenature and mechanism of intergovernmentaltransfers. In addition to sovereign support in theform of explicit guarantee to subsovereignentities, credit rating agencies also consider thescope of federal government oversight of theactivities of subnational governments.

24 Generally Accepted Accounting Practices (GAAP) and International Accounting Standards (IAS) are the two primary accountingstandards used in many countries.


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Analysis of legal and regulatory limitations isalso an important credit factor. This includesconsideration of:

• Details of statutory and constitutionallimitations regarding subnational borrowinglaws;

• Constitutional limitation on taxing authority;

• Bankruptcy and insolvency laws, if any; and

• Summary of pending or proposed legislationthat affects the debt issuance and revenuesources of pledged security of debt.

Sovereign Ceiling25

This represents the upper limit of the rating for aparticular instrument that a subsovereign entityin a given country can have. Even if a financiallystable subnational borrower has the resourcesto pay its foreign currency debt, under thesovereign ceiling of access to foreign exchangeand sovereign control over monetary policy, itcould not do so.

In Indian context, it would apply to both foreigncurrency debt as well as local currency debt ofthe state government as the Constitution ofIndia puts limit to state governmentborrowings. Though it is theoretically possiblebut is not likely that a subnational issuer to havea domestic currency debt rated higher than thatof the sovereign. Higher subsovereign ratingsrepresent conservative financial management,

solid currency reserves and modest futureborrowing requirements.26

General Creditworthiness StandardCreditworthiness is a slippery concept thatcannot be measured objectively. It is often usedas general statement of an entity’s financialhealth that is not tied to a specific transaction.

An issuer might not be “creditworthy” in general,but a specific bond structure may make atransaction creditworthy. It is very difficult to setstandard benchmarks for indicators like debt-GDPratio, interest payments to revenue receipts ratioor outstanding liability to revenue receipts ratioetc. where one can with certainty concludewhether or not an entity is creditworthy.

Generally, an entity (sovereign or subsovereign) isconsidered to be creditworthy if it has the abilityto service debt in time. For a sovereign orsubsovereign entity, the determination ofcreditworthiness largely depends on:

• The existing debt burden;

• Projected deficits both in payments and budgets;

• Future financing arrangements;

• Buildup of the repayment capacity relative todomestic product; and

• Existing repayment liability relative to itsresources.

25 While recommending that the reforms are to be undertaken at the initiatives of the State Governments, the TFC emphasized the needfor imposing hard budget constraints and suggested that the overall borrowing program of a State should be within a prescribed limit,determined annually, taking into account borrowing from all sources. In this context there is a need to ensure that the ceiling of theAnnual borrowing prescribed for each State is: (a) consistent with the fiscal deficit target for all States taken together in view of therestructuring program that has been drawn up taking into account the macro considerations; and (b) that such ceiling are consistent Withsustainability requirements of each State. The TFC also suggested a methodology by which the aggregate fiscal deficit target is translatedinto permissible level of fiscal deficit for individual States.26 Credit rating agencies such as ICRA have pointed out that given the current Indian intergovernmental transfer structure and theessence of Article 293(3), that it is impossible for states to breach the sovereign rating in the Indian context.

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As of May 2006, no state government in India hasyet been rated. Nevertheless, the ratings ofsome of the agencies like the SPVs created forthe irrigation purposes in Karnataka (KBJNL andKNN) which do not have any resource flow areimplicitly the ratings of the Government ofKarnataka.

Norms for debt sustainability of thesubsovereign entities (the state governments)are:

• Debt to GSDP Ratio — 30 percent;

• Debt to Total Revenue Receipts (TRR) Ratio —300 percent for nonspecial category statesand 200 percent for special category states;

• Interest Payments to TRR Ratio— 18 percent20;

• Debt Growth to Revenue Growth Ratio —1.25;

• Revenue Deficit to Fiscal Deficit Ratio —50 percent; and

• Fiscal Deficit to Total Revenue Receipt Ratio— 25 percent.

These criteria could be utilized for the purposesof analysis of “creditworthiness” of stategovernments and could be useful benchmarksfor credit rating purposes.27

Credit rating28 is an independent opinion on thefuture ability, legal obligation and moralcommitment of a borrower to meet its financialobligation of interest and principal in full, in atimely manner. The rating assesses theprobability that the borrower will default on the

security (or a group of securities) before thematurity date. While credit ratings are important,these are not:

• Recommendations to buy, sell or holdsecurity;

• Opinion about general quality of an agency(individual, corporate, sovereign orsubsovereign government);

• Statement about the quality of life in acommunity; and

• Opinion about correctness of a government’spolicy decisions.

Credit ratings are important from both theinvestors and issuers perspectives. They alsoaffect the costs to both sides of buying andselling debt. This occurs because credit ratingsindicate a level of default risk, which is centralingredient for pricing bonds. High credit ratingimplies low default risks leading to low cost ofborrowing and vice versa.

The cost of borrowing is reflected in the spread,which determines the bond’s interest cost.Ratings are intended to equip investors with aconsistent measure of creditworthiness, whichprovides reliable comparisons of debt and debtlike instruments in capital market. Ratings can:

• Expand the number of investors available topurchase the security;

• Make debt more attractive to wide range ofinvestors; and

• Provide a form of free liquidity about asubsovereign’s financial performance.

27 Credit rating agencies have commented that although they consider the Planning Commission norms to be effective financialbenchmarks, agencies such as ICRA have benchmarks that are aligned with their own rating scale.28 Bond Rating Process: A Progress Report by Christopher Mahoney, Senior Managing Director and Chairman, Credit Policy Committee,Moody’s Investors Services, 2002.


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Credit rating agencies have a major role to playtowards successful operation of the capitalmarket of a nation. The main and proper role ofcredit rating agencies is to enhancetransparency and efficiency in debt capitalmarkets by providing an independent opinion ofrelative credit risk, thus reducing theinformation asymmetry between the borrowersand lenders.

In some circumstances, credit ratings areperformed not just by credit rating agencies butalso by national governments or quasi-government agencies that is prescreeningsubnational issuers so as to give the marketgreater faith in their repayment ability. Under suchcircumstances, the national government needs toconsider whether the market will see its rating orprecertification as an implicit national guaranteeof the subsovereign debt issue.

Regulation, however, should not be attemptedto hinder the very objective of the ratingprocess (i.e., to enhance market efficiency,enhance transparency and protect investors’interests). Regulations that are used towardcontrolling the independence and objectivity ofthe rating agencies raise concerns. This issue isvery important particularly when talking aboutthe rating of a subsovereign entity. Moreover,regulation should not prescribe conditions forliability that are inconsistent with the nature ofratings.

As a part of the rating process, the fee of the ratingagency comes from the issuer rather than theinvestors. However, in economies with

Part 2:

Role of Credit Rating Agencies29

developed capital markets as in the US, thereare Investor Associations who appoint ratingagencies to rate issues of some of the issuerswhere the members of this association wishesto invest in. In this case, the rating agency wouldbe more inclined towards protecting theinvestors interests. Ideally, credit rating agenciesshould have their interests aligned with that ofthe investors and not with the issuingcompanies. Further, it is advisable to havecompeting agencies rather than making it amuch regulated business.

Secondly, rating agencies in developingeconomies generally do not bring out regularpublication of company data. In India, thebalance sheet libraries are still governed bylawsand procedures that lay more emphasis onconfidentiality than on meeting the informationneeds of the investors. In the US, for example,Moody’s or Standard and Poor bring outcompany data regularly. Thus, the net result issome degree of opacity, which is not conducivefor investor confidence.

Rating agencies routinely request nonpublicdata in the course of their surveillance activities.Unlike accounting firms, rating agencies have noauthority to demand financial data. Indeed,issuers are under no obligation to provide therequested data. The rating agencies should:

• Publish all information of the issuers used forthe purpose of rating;

• Highlight in greater detail aggressive orpotentially misleading accounting practices;and

29 The Role and Function of Rating Agencies: Evolving Perspectives and the Implications for Regulatory Oversight; Speech by RaymondMcDaniel, President, Moody’s Investors’ Services (2005).

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• Highlight areas in which greater disclosure isdesirable.30

Ratio Analysis and its Relevance in StateCreditworthiness AnalysisRatio analysis is a major component of credit riskanalysis. Several ratios are generally taken intoaccount to have a better understanding of thecreditworthiness of the issuer. However, thefeasibility and relevance of ratio analysis isquestioned in current Indian subsovereigncontext, particularly due to the existence of acash-based accounting system and not anaccrual one. The cash-based accounting systemfails to capture the appropriate profile of thesubsovereign.

Cash accounting records receipts when cash isbanked and payments when cash is paid. Accrualaccounting recognizes events and transactionswhen they occur, regardless of when cashchanges hands. Only a cash flow statement, not abalance sheet, is prepared under cashaccounting. As a result, with cash accounting it isvery difficult to capture the informationpertaining to the total liabilities accrued but notpaid. Hence, the true picture of even thesurplus/deficit is very difficult to determine.Under such circumstances, ratio analysis alonedoes not provide a clear picture of the financialsituation of the entity.

The report of the “Group on Model FiscalResponsibility Legislation at the State Level”31

(“The Group”) in India in addition to providing forthe basic requirements for enacting a fiscal

30 The Indian credit rating agency ICRA has commented that: i) issuers pay rating agency’s fees; ii) ICRA’s rating processes are credible andin line with best practices and ICRA’s ratings are objective opinions; iii) ICRA regularly publishes information on its ratings and ratedinstruments and in addition, ICRA’s analysts are available for discussion; and iv) ICRA publishes rationales for all its rating decisions and isalways open to discuss its views and opinions with all market participants.31 Report of the Group on Model Fiscal Responsibility Legislation at the State Level, RBI, March 2005.

responsibility legislation at the state level alsoprovided for certain disclosure norms for thestate governments. The Group alsorecommended maintenance of the informationon physical as well as financial assets of the stategovernments in India.

If not an accrual accounting system for the stategovernments, the disclosure norms requiredstate governments to maintain informationpertaining to details of assets (physical andfinancial). Moreover, outstanding guaranteeswhich form a significant proportion of theliabilities of state governments were hithertonot captured as a part of the budget of stategovernments. The Group insisted uponmaintenance of information pertaining to otherliabilities in the form of payments due but notmade. It is very difficult to appropriately account

While subnational borrowing itself is in a nascentstage in India, many of these mechanisms wouldneed some time to be put in place. The minimumexperience of subnational borrowing (it could beactually termed as substate borrowing) in India wasby some of the municipal corporations. Most ofthese issues were private placements and for thesethe Securities and Exchange Board of India (SEBI)regulations of financial disclosure and rating werenot mandatory. Moreover, most of these issueswere structured obligations (SO) whereby therepayment mechanism was secured throughopening an escrow account. These escrow accountswere being managed by trustees (usually banks)and issuer lost control over the revenue sourcesescrowed till the maturity of the issue.


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for this information provided the stategovernments do not bring out the details byitself.

Availability of Credit EnhancementsCredit enhancement is a kind of credit supportavailable in addition to credit substitution,which helps develop innovative kind offinancing techniques. In credit substitution, thesubstituting entity’s credit quality is consideredand not that of the issuing entity. Full creditsubstitution isolates investors completely fromthe risks that may be associated with the trueborrower or issuer. The credit substituteprovides protection to the bond holders, even inthe event of issuer default or bankruptcy. Creditsubstitution takes many forms of which bondinsurance and letters of credit are the mostcommon among them.

Credit enhancements are devices and programsthat are meant to mitigate risks in debttransactions that creditors cannot or are notwilling to take. Credit enhancementencompasses a variety of provisions that may beused to reduce the credit risk of an obligation.

There are numerous risks involved generally inlending money. In developing countries, themajor risks will tend to be those associated withfundamental credit (default) risk and inflationand interest rate risk. While the first one isaggravated due to lack of borrower financialinformation, the second one arises due to thinlong-term debt market and thin secondary debtmarket, i.e., lack of liquidity for investments. Lackof political stability also contributes to risks inthe debt market.

The issuer’s own credit quality, however, remainsan important rating criterion in creditenhancement. Credit enhancements do notsubstitute for the issuer’s own credit quality, butcan improve a bond’s rating criteria. Some of thecommonly used credit enhancementmechanisms in Indian context include: (over)collateralization, structured obligation and thirdparty loan guarantees.

Guarantees from the higher levels ofgovernment should normally be the last resortas a credit enhancement mechanism. However,state government support for Special PurposeVehicles (SPVs) is very common in India.Nevertheless, some state governments havebecome conservative in issuing guarantees forthe borrowings of the SPVs and the lower tiergovernments because states they need tomaintain their own credit viability. Stategovernments in many states have resorted toestablishing a cap (ceiling) on the amount ofoutstanding guarantees.

Collateral is assets provided to secure anobligation. Traditionally, banks might requirecorporate borrowers to commit company assetsas security for loans. Today, this lending is calledsecured lending or asset-based lending.Collateral can take the form of inventory,equipment, receivables, etc. Structuredobligation refers to pledging of certain revenuesources in an escrow account to secure therepayment. Guarantees are often given by thehigher levels of governments towardsborrowings of the lower levels of thegovernment to finance their capitalexpenditures.32

32 http://www.riskglossary.com/articles/collateral.htm

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Internationally, irrevocable revolving creditarrangements (IRC) and guaranteed investmentcontracts (GICs) are the major creditenhancement mechanisms in addition torefunding bonds, tax exempt commercialpapers and variable rate demand obligation.

Moreover, partial risk guarantees as well asprivate bond insurance are also significantlyused internationally as credit enhancementmechanisms for subnational borrowings. Theseconcepts have been discussed in detail in theearlier Parts. Many of these mechanisms wouldhowever, need a well developed capital marketto be in place with a strong legal and regulatoryenvironment providing support for a secondarymarket.33

While subnational borrowing itself is in anascent stage in India, many of thesemechanisms would need some time to be put inplace. The minimum experience of subnationalborrowing (it could be actually termed as

substate borrowing) in India was by some of themunicipal corporations. Most of these issueswere private placements and for these theSecurities and Exchange Board of India (SEBI)regulations of financial disclosure and ratingwere not mandatory. Moreover, most of theseissues were structured obligations (SO) wherebythe repayment mechanism was secured throughopening an escrow account. These escrowaccounts were being managed by trustees(usually banks) and issuer lost control over therevenue sources escrowed till the maturity ofthe issue.

Analysis by Bagchi (2001) and Bagchi and Kundu(2003) have provided some details of the escrowaccount for municipal borrowing and constraintsin accessing market funds by subnationalentities in India. However, it would be necessaryto go into a detailed analysis of what forms ofcredit enhancement mechanism would beappropriate for the state governments in Indiain view of the current fiscal federalist structure.

33 The opinion that credit guarantees should be the last resort for credit enhancement should be expanded. The authors believe thatcredit guarantees are a vital part of the lending process. However, the authors believe that there are a number of private marketalternatives that should be explored first, before seeking state government guarantees.

Mechanisms to Enter NonStatutory Liquidity Ratio(SLR) Bond Market

Section IV

An issuer faces numerous structural questionsinvolving the type of security to be used, thematurity structure, issue size, call provisions, andfor limited obligation securities, the design ofthe trust indenture. In addition to these issues,there are questions on the method of sale, thebasis of aware, and the timing of sales. All ofthese issues are considered in the section below.Typically, most state issuers will require outsideassistance in making these decisions, since theyare affected by both legal and marketconsiderations that need expert technicalconsideration.

The structure of the security must be devised insuch a way as to permit prompt repayment ofthe obligation while abiding with legalrequirements and adhering to the adopted debtpolicy. In addition to conforming to the stategovernment’s own policies, the debt obligationmay be structured so as to take advantage of thebond market’s desire for a specific type ofinvestment. In some markets, the obligation canbe designed to attract long-term institutionalinvestor interest. At other times, the design maymake them attractive to individual investors.

Forms of Securities34

State government debt securities can becategorized into two major types, depending onthe nature of funds pledged to their repayment:

• General Obligation Bonds: These securitiesare commonly referred to as full faint andcredit bonds because they are based on thepledge of the state government to levy taxesnecessary to pay the debt. An unconditionalpromise is made to pay interest; and

• Limited Liability or “Revenue” Bonds:

Part 1:

Structure of Debt Instruments

34 See "Annexure D: Types of Securities" for more information.

Funds to pay interest and retire principal onthese securities come only from restrictedrevenues or user fees. These bonds areclassified by what they are not: they are notgenerally backed by the state’s taxing power.

Bond Characteristics: Pledges of SecurityIn general, bonds fall under two broadcategories defined by the security offered fortheir repayment: general obligation andrevenue bonds, respectively. However, there is athird category called appropriation obligationbonds, which include a state commitment topay debt service on bonds through annualappropriation of funding.

General Obligation BondsGeneral obligation bonds are backed by the fullfaith and credit of the issuers for repayment. Thisrepayment pledge is an unconditional promiseby issuers to collect taxes or take whateversteps are necessary to assure repayment.Consequently, general obligation bonds areconsidered to be relatively safe investments andusually carry lower interest rates than revenuebonds, which do not carry this pledge.

General obligation bonds (Figure 1.1) are oftenlimited to constitutionally or statutorily defined

Figure 1.1: General Government ObligationBonds

General Revenues

GeneralObligation

DebtGovernment

Project

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levels and uses. They often are used to supportfacilities such as state office buildings andeducational institutions. General obligationbonds also may be used to fund the constructionof self amortizing facilities (i.e., dormitories). Therevenue generated by these facilities is used tomeet debt service payments.

Revenue BondsRevenue bonds rely on rents or user feescollected from public enterprises or facilities, oron a designated stream of revenues. The incomegenerated by these enterprises or facilities or adesignated revenue stream is the soleguarantee or pledge for repayment from theborrowers. Typical examples of revenue bondsupported undertakings include toll roads,bridges, and water or sewer systems. Revenuebonds generally are not subject to the samedebt limitations as are general obligation bonds.Because revenue bonds are generally securedby project revenues, or a designated revenuestream, they are considered to be of greater riskthan general obligation bonds. As a general rule,revenue bonds carry higher interest rates.

A subclass of revenue bonds is moral obligationrevenue bonds. Like other revenue bonds, moralobligation bonds are secured by revenuesgenerated by the enterprise or facility financed.In addition, these bonds are also secured by apledge to commit funds from tax sources,subject to the legislative appropriation process,if project revenues or the designated revenuestream are insufficient to meet principal andinterest payments.

Because of this pledge, moral obligationrevenue bonds may have interest costs whichare lower than revenue bonds, but higher thangeneral obligation bonds.

Appropriation Obligation BondsIn addition to the general obligation andrevenue bonds, some states have issuedappropriation obligation bonds in order to paythe states unfunded (for example) accrued priorservice (pension) liability. Upon issuance of thebonds, the state will make annual debt servicepayments on the bonds in lieu of each stateagency having to make annual paymentsassociated with these liabilities as part of theirfringe benefit costs.

Because bond repayments are subject toappropriation each year, appropriationobligation bonds are not considered public debtof the state and are not supported by the fullfaith and credit of the state. However, in general,states recognize that they have a moralobligation to fulfill the terms of theseappropriation obligation bonds. The debtservice payments on appropriation obligationbonds are payable from the general purposerevenue appropriations. The following sectionpresents some special feature bonds.

Double-barreled BondsDouble-barreled bonds are bonds that havebeen issued to build or maintain a revenueproducing facility such as a bridge (or tollroadway). The initial debt service is supportedby the user fees generated by the facility.However, the revenue generated by the facilitymay be insufficient to cover the bond’s interestand principal payments. As a result, the interestand principal payments will be supported bythe general tax revenue of the State.

Bonds that are supported by two sources offinancing are called “double-barrel bonds.”Because these bonds are backed by the taxrevenue of the State, the revenue bonds are

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rated and trade like general obligation bonds.35 Payment and MaturityBonds are characterized by their schedules forrepayment of principal. For term bond issues,the entire amount borrowed fall due at the sametime, as much as 20 or 30 years in the future.The individual bonds that comprise the issueshave identical maturity dates and coupon rates.To ensure that repayment funds are availablewhen due, term bonds often provide for sinkingfunds into which borrowers make scheduledperiodic payments.

More common are serial bond issues in whichprincipal is repaid in smaller sums over the lifeof the issues. The individual bonds may havedifferent maturity dates and different couponrates. The principal payments may be equal ineach year of issue, or have different structuresreflecting market conditions at the time of issueor the debt policy of the issues. In addition, theissuers may limit the life of the debt to theuseful life of the facility or equipment the bondfinances. Capital appreciation bonds are termbonds sold at large discounts from face value.Investors receive all principal and interest at thematurity dates. These bonds are attractive tobond funds and institutional buyers who preferlong-term growth over current income.

RedemptionBonds may have call provisions that allow earlypayment; issuers may redeem the debt beforethe regularly scheduled maturity date. Issuersmay exercise this option if they can borrow newmoney at lower interest rates than the bondscarry, or if funds become available to retire thedebt early. When bonds are called, the borrowers

35 See Annexure E: Credit Enhancements for details concerning other credit enhancement opportunities.

Figure 1.2: Revenue Bonds

Revenues (Fees)Government

Debt

Project

Short-term FinancingStates like other issuers need to obtain short-term financing to manage their cash flow andwill generally sell both short-term notes (and, insome cases tax exempt commercial paper).Short-term notes are sold in anticipation ofreceiving other revenue. The types of short-termnotes a state may issue include:

• Tax Anticipation Notes (TANs);

• Revenue Anticipation Notes (RANs);

• Bond Anticipation Notes (BANs); and

• Tax and Revenue Anticipation Notes (TRANs).

A State may also issue tax exempt commercialpaper that matures in 270 days or less and maybe backed by a line of credit at a bank.

Bond Characteristics: RepaymentFeaturesGeneral obligation bonds and revenue bondsgenerally share common payment, maturity,and redemption features.


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often must pay predetermined premiums to thebondholders. Although callable bonds generallyresult in higher borrowing costs for the issuersto compensate investors for increaseduncertainty, the option to call bonds at timeswhen market conditions are favorable forrefinancing is an important debt managementtool.

The inclusion of an optional redemption featureprovides the issuer with additional advantagesbesides the potential for future debt-servicingsavings. The early call enables the issuer to alterthe maturity schedule of outstanding debtobligations more easily. The payment scheduleof outstanding debt may be lengthened tobetter match the stream of revenues pledged torepay the debt or revised to reduce debt servicepayments in those years when pledged revenuestream is not expected to be sufficient.

Additionally, the inclusion of a call provision in theoriginal bond issue may enable the state to relieve

itself of onerous bond covenants. Limitedobligation bonds often curb the issuer’s abilityto sell additional debt unless certain debtservice coverage ratios are satisfied. Forexample, existing bond covenants may restrictthe issuer from selling additional debt, or mayrequire the issuer to raise rates sufficient togenerate a level of net revenues inconsistentwith the state’s financial policies. Once thebonds are redeemed, or legally defeasedthrough an advanced refunding, the issuer canproceed under a new set of covenants.

Buying and Selling Bonds:The Secondary MarketAfter the initial placement of new bond issues,the bonds may be bought and sold many times.The trading occurs in the secondary securitiesmarket. Because of the decentralized trading andthe diversity of the bonds being sold,participants in the secondary trading marketrely heavily on bond ratings and yields whenmaking investment decisions.

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Part 2:

The Marketing ProcessThe marketing of a nonSLR state bond issueentails the coordination of several players totake the required steps and to producedocuments needed for the sale. The method ofsale will dictate which players and process isneeded for bond issuance. The method of bondsale will be taken up first. In general, stategovernments (“Issuers”) will have assembled ateam to assist in various phases of preparing forthe sale and to assist in producing the key sales-related documents. These activities will bediscussed following the method of sale section.The final section contains a discussion withrespect to obtaining specialized legal, financial,and other services to assist the issuer in thedesign and selling of securities.

Method of Sale36

The nonSLR state government bond issuer maysell securities in a couple of ways. Unlike themarket for corporate debt instruments, in whichthe sale of securities through negotiation isalmost universal, nonSLR bonds are often soldthrough competitive bidding. In a competitivebid sale, the bonds are awarded at an auction tothe underwriting firm that provides the issuer

with the best bid for its securities. The biddingparameters are established prior to the saledate and are sued to determine which offer willresult in the lowest effective interest cost.

In a negotiated sale, the issuer (state) choosesthe initial buyer of its securities (usually anunderwriter that plans to reoffer them) inadvance of the sale date. The terms of the saleare subject to negotiation between the issuer(state) and the initial purchaser. In manycountries (e.g. Australia, United States), statestatutes often require certain types of bonds,usually general obligation bonds, to be soldthrough competitive bidding process.

Under a negotiated sale process, the inherentprotections afforded by open competition aregenerally absent. Although relieved of someduties, the issuer (state) assumes many otherroles and duties. For example, a state financeofficial must monitor market conditions toassure the receipt of the lowest rates of interest,and also must take a proactive role indetermining the level of compensation for theunderwriter in a negotiated sale (see Table 2.1).37

Table 2.1: Comparison of Negotiated and Competitive Sales38

Positive Negatives

Competitive Sales • Lowest bid wins • Limited flexibility• Transparent sales process works • Many not be available to new issuers

well for established issuers • Underwriting risk built into cost• Flexibility to adjust timing or

structure

Negotiated Sales • Allows presale marketing by • May not result in market priceunderwriter • Potential for corruption

• Appropriate for complex issues

36 See Annexure F: Government Debt Instruments and Sales Methods for additional information.37 When a DIMC structure is established, the monitoring of market conditions would come from a "Front Office" official.38 See World Bank (1999) “Credit Ratings and Bond Issuing at the Subnational Level: Training Manual” Pp 4-25 for more detail.


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Bonds are characterized by their schedules forrepayment of principal. For term bond issues, theentire amount borrowed fall due at the same time, asmuch as 20 or 30 years in the future. The individualbonds that comprise the issues have identicalmaturity dates and coupon rates. To ensure thatrepayment funds are available when due, term bondsoften provide for sinking funds into which borrowersmake scheduled periodic payments.

Several factors should be considered in choosingbetween a competitive sale and negotiation,including:

• Complexity of the nonSLR bond issue.State government securities with complexsecurity features require a greater sales efforton the part of the underwriter. In acompetitive sale, the underwriter does notknow whether it will have bonds to sell untilafter the bids are opened. As a result, itmaybe unwilling to spend much time andeffort on marketing a competitive issue inadvance of the sale date. To offset weaker ormore complex security features of limitedobligation bonds, the issuer may be bestadvised to identify potential bond purchasersearly in the issuance process in order toconvince them to make the investment. As aresult, the negotiated sale can be preferableif the issue requires a stronger market effort;

• Volatility of the bond market. The volatilityof the nonSLR bond market must also beconsidered in the choice of bond salemethod. When state government (nonSLR)securities are subjected to abrupt changes inthe interest rates demanded by investors,state government officials may be morecomfortable using negotiated sales. Whenmarkets are volatile, underwriters may be

reluctant to bid aggressively. As a result,competitive sales can result in the receipt offewer and more conservative bids;

• Familiarity of the underwriters with theissuers (state governments) credithistory. The familiarity of the underwriterwith state government finances,management and credit history has a directimpact on the willingness of underwriters tobid aggressively. General obligationsecurities of infrequent issuers still can besold on a competitive basis, but additionaleffort must be made to familiarize investor’swith issuer’s creditworthiness; and

• Size of the issue. The size of the state’s bondissue is the final consideration with respectto method of sale. The probability ofattracting many bids for a large issue islimited, especially if financial markets arevolatile. A large issue size can induce theformation of bidding syndicates that aresufficiently large as to reduce the number ofpotential bidders to one or two syndicates.For issues of great size, it is unlikely that thecompetitive process results in lower costsof capital.

Basis of AwardIn order to determine which one of thecompeting groups of underwriters is offering topurchase the issuer’s securities for the lowestcost, the issuer must determine the effectiveinterest cost of each bid. There are two methodsfor making this interest cost calculation.

• The first method is a calculation of the bid’seffect upon the net interest cost (NIC) of thebond issue. The net interest cost is theaverage interest cost rate on a bond issuecalculated on the basis of simple interest. The

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aggregate amount of interest payable overthe life of the bonds is divided by theaggregate amount of bonds sold, multipliedby the average life of the issue. Althoughrelatively simple to calculate, the NIC has amajor deficiency in that it treats a rupee ofinterest paid today in the same manner as arupee paid twenty years from now. In effect,this method of calculation does not discountfuture interest payments.

• The preferred method of calculating theeffective interest cost of a bid is thecalculation of true interest cost (TIC). The TICis the rate that will produce a present valueequal to the amount of money received bythe issuers in exchange for the bonds when itis used to discount all future debt servicepayments. The use of the true interest costmethod of calculating the lowest effectiveinterest cost forces the bidder to eliminatehigh interest rates or penalty yields on earlymaturities.

Table 2.2 provides a snapshot of thedifferences between Net Interest Cost (NIC)and True Interest Cost Method of evaluating thebid process.

Table 2.1 illustrates that NIC looks at the averageannual debt cost to the issuer as a percentage ofthe outstanding debt. The problem with thisaverage calculation, is that the bids can have thesame NIC, but cost the issuer different amounts.For example, while the average interestpayments may be identical. One bid mightinvolve higher interest payments in the earlymaturities and lower interest payments in thelater maturities, while a second bid may do thereverse. In this circumstance, the first bid wouldbe more costly to the issuer on a present valuebases as its higher interest payments must bemade sooner.

The True Interest Cost (TIC) takes into accountthis time profile of interest flow.

Scheduling IssuanceThere are numerous considerations to reviewbefore scheduling the sale of debt. In anegotiated sale, the timing becomes less criticalbecause it is much easier to reschedule the saleof bonds until market conditions are morefavorable. However, when the bonds are to besold competitively, the sale date should beselected with great care. Some general rules for

Table 2.2: Net Interest Cost versus True Interest Cost

Years to Maturity Par Value (INR) Issue A (NIC= 5%, TIC=5.04 %) Issue B (NIC=5%, TIC=4.98%)

Coupon Rate Annual Debt Coupon Rate (%) Annual DebtService Service (INR)

1 1,000 12 1,190 2 1,130

2 1,000 3 1,070 5 1,110

3 1,000 4 1,040 6 1,060

Total 3,000

Issue A and B: Total interest payments for each issues = INR 300.Issue B: Coupon payments are made later, TIC=4.98 percent.

Source: Bond Market Association, Fundamentals of Municipal Bonds, 4th ed (New York, PSA, 1990) pp. 181-186; John Mikesell, FiscalAdministration: Analysis and Applications for the Public Sector, 4th ed, (Fort Worth, TX: Harcourt Brace College Publishers, 1995).


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selecting an issuance date, include:

• The choice of date should not conflict withthe scheduled sale of bonds by SPVs, SOEs orother government of large privatecorporations that compete for investors;

• The bond issuance date should not fall on adate when GoI is selling its obligations,because this may distract potential investors;and

• Bond issues in many capital markets are soldin the beginning of the week to permit themarket sufficient time to sell the obligationsbefore any new issues are presented. Ingeneral, Tuesdays are the most popular daysfor issuing bonds.

Bonds are also most frequently issued onMondays and Wednesdays.

Issuance TeamThe heart of a bond issuance team consists ofthe participants that help design, market anddevelop the documents accompanying theoffering. Depending on the markets, the size ofthe issue, the nature of the sale techniqueemployed, the use of proceeds, the players (and,institutions) involved will differ to some extent.However, the primary roles are generally clear.

At a minimum, the debt issuance team consistsof the state government issuer (usuallyrepresented by the Chief Financial Officer, and amember of the Front Office of the DIMC), a bondcounsel (a specialist in securities law), and afinancial advisor (acting in the capacity of afinancial specialist to assist in the transaction). Ifthe sale is negotiated, an underwriter is selectedby the issuer prior to the sale and becomes a

member of the issuance team. An underwriterwill not join the team in a competitive offeringuntil the sale is consummated, but will bepresent during the presale period in anegotiated transaction.

In terms of managing the issuance process andinforming the market of a pending sale, theassignment of duties within a team can bedistributed in a variety of ways. An early step inthe process is an allocation of theresponsibilities among team members and theestablishment of a calendar of activities. Thisallocation and coordination of duties maybedone by the issuer, but more likely will behandled by the financial advisor or, in the case ofa negotiated offering by the bond underwriter.

Sales-related DocumentsA number of important documents and otherinformation items are generated before and atthe time of sale of a newly issued state (bond)security. These sales-related documents include,but are not limited to:

• Notice of Sale is an essential document inthe issuance of bonds by competitive means.It is an official publication by the issuer thatdescribes the terms of a planned newoffering of securities. In most cases the noticeof sale contains the date; time; and, place ofthe sale; the amount of the issue; the natureof the security; information concerning theofficial state and delivery of bonds; and, themethod of delivery;

• Official Statement is a (series of )document(s) that is prepared in conjunctionwith sales of state government securities toprovide information to prospective

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purchasers of the securities. The officialstatement functions as the primarydisclosure documents. Other terms such as“prospectus” or “offering circular” aresometimes used in reference to the officialstatement. The offering circular is not theofficial document of the issuer, but rather aninformational piece that may be put out bythe underwriter or advisor to generateinterest in the proposed financing; and

• Other Information: Once the bonds areawarded, the underwriter supplies additionalinformation, including the yields at which thesecurities are reoffered to the public. Theissuer will incorporate the establishedinterest rates into the draft debt serviceschedules. Once the official statement ismodified in this manner, the document isreferred to as the final official statement andis delivered to the underwriters fordistribution to investors.

Rating Agencies39

Applications for ratings are typically made bythe issuer prior to the sale of new issues. If anapplication is not made and ratings are in effectfor outstanding parity issues, the ratings may bewithdrawn or the new issues may be ratedwithout a request. In the case of all credit ratingagencies, the rating is subject to review bycommittee, communicated to the issuer (or thestate’s advisor), and then released to the generalpublic.

Sale, Reporting Results, and ClosingThe mechanics of the bond sale will dependupon the method of sale used and will bediscussed in the next Part under the subject ofunderwriters. However, once the terms havebeen settled and the transaction agreed to, anumber of additional steps need to beundertaken. For example, the final officialstatement needs to be prepared, and should bemade available to the underwriters within sevendays of the sale.

Also, immediately after the sale, informationabout the bonds, if printed in a certificate form,needs to be submitted to the bond printer. Inthe case of bonds sold in book-entry form(without certificates), the repository must benotified of the results to set up its records.Approximately, three weeks after the sale, theclosing is held, at which time the bonds andother sales documents in final form arepresented to the winning syndicate and fundsare wired to the issuer.

39 The role of the rating agencies are discussed in greater detail in Part 2: Role of Credit Rating Agencies.

The mechanics of the bond sale will depend uponthe method of sale used and will be discussed in thenext Part under the subject of underwriters.However, once the terms have been settled and thetransaction agreed to, a number of additional stepsneed to be undertaken. For example, the finalofficial statement needs to be prepared, and shouldbe made available to the underwriters within sevendays of the sale.


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Most bond issuers retain advisors to assist in thestructuring of the transaction and the provisionof documents. As discussed above, thespecialized services may be limited to theemployment of bond counsel, financial advisor,or consulting engineer. As a practical matter,smaller and infrequent issuers are generallymore reliant on an advisory team to assist themwith the mechanics of issuing debt. The bondcounsel, financial advisor, and in the case of anegotiated transaction, the underwriter and itscounsel are the most common outside advisorsin the debt issuance process. Another importantplayer in a transaction may be the provider of acredit enhancement, which may be representedby its own legal counsel. This section reviews thegeneral roles and activities of the key players inthe state bond issuance process.

Bond CounselIn both negotiated and competitive sales, bondcounsel may perform numerous duties, but itstraditional responsibilities revolve aroundproviding an opinion on the validity of the issue.Bond counsel also prepares and reviews sundrylegal documents such as the form of the bondand the transcript of the sale of the bond. The

Part 3:

Securing Specialized Servicesprimary responsibility and activities of bondcounsel typically are as follows:

• Determining whether there is legal authorityto issue the bonds;

• Drafting the bond ordinance, resolution, or, inthe case of revenue bonds a trust indenture;

• Examining transcripts of proceeding todetermine that bonds were legal offered andsold;

• Determining that bonds were properlyexecuted; and

• Answering any legal questions about thebonds by prospective purchasers.

In negotiated transactions, the bond counsel’s rolemay be supplemented by the underwriter’scounsel, which has primary responsibility for theassembly of the disclosure documents in anegotiated sale and the provision of a disclosureletter that opines on the adequacy of disclosures.The client of the underwriter counsel is theunderwriter. The issuer’s (state government)counsel may be involved in the preparation ofdisclosure information, but the role is largelylimited to opinions regarding the organization andgood standing of the issuer and various proceduralmatters.40

Financial AdvisorThe principal role of a financial advisor to a stategovernment is to provide assistance to issuerson matters relating to the issuance of stategovernment securities. Typically, the nature ofthat assistance depends upon the method ofsale. In a competitive sale, the financial advisor

40 Other counsel may become involved in the transactions, such as that of a credit enhancing entity.

The principal role of a financial advisor to a stategovernment is to provide assistance to issuers onmatters relating to the issuance of stategovernment securities. Typically, the nature of thatassistance depends upon the method of sale. In acompetitive sale, the financial advisor assists theissuer in designing the debt structure, preparationof the official statement, and marketing of thesecurities to potential investors.

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assists the issuer in designing the debt structure,preparation of the official statement, andmarketing of the securities to potentialinvestors.

The nature of the financial advisor differs whenstate government bonds are being sold throughnegotiation. In a negotiated sale, the advisor actsas an advocate for the client government toassure that the underwriter is treating the stategovernment fairly. An important duty of thefinancial advisor may be to assist the stategovernment in the selection of the underwriter.In negotiated transactions, the bonds arestructured by the underwriter, whose ownmarketing staff contacts institutional and retailinvestors directly.

During the pricing of the bonds, the financialadvisor may be used by state governmentofficials to provide assurances that the interestrate scale for the proposed bond issue isreasonable in light of existing marketconditions.

UnderwriterThe role of the underwriter (“the banker”) is topurchase the bonds from the issuer and to sell(reoffer) them to investors. The exact nature ofthe underwriter’s role depends upon whetherthe issue is negotiated or sold competitively. Ifthe issue is negotiated, the underwriter mayperform many of the consultative and supportroles performed by the financial advisor, such asstructuring the issue, preparing the disclosureinformation, and obtaining ratings from therating agencies.

On most large issues, the managing underwriterwill form a syndicate that will offer the issuer aprice at the sale date. Other members of the

syndicate will be securities firms or banks that,depending on the nature of the underwritingagreement, will have the opportunity to reofferthe bonds, but will also assume responsibilitythat the sale will raise the needed funds on atimely basis.

In a negotiated sale, the syndicate knows that itwill get the bonds and therefore will be able todiscuss the issue before their offering withpotential investors, feeding back information,and in some cases influencing the design of thebond issue to meet market specifications. Thefinal purchase price is decided upon when afirm’s bond purchase agreement is submitted tothe issuer. A major advantage with respect tonegotiated sales is that of timing, since the salesdate is flexible and can be decided quickly.

In a competitive sale, the underwriters orsyndicates bid against one another. Generally,the underwriters decide on bids by reviewinghow comparable issues are doing, canvassingpotential purchasers, noting the overall supplyof bonds on the market, and making a judgmentabout the level of competition for the offering.Key to an underwriting by competition are therules, established in the notice of sale and thebid form, that are to be used in comparing bids(basis of sale), restrictions carried on the couponrates, and whether the bonds can be sold atdiscount.

Underwriters are generally compensated fortheir efforts in different ways. In a negotiatedsale, the underwriter receives a gross spread ordiscount that is a percentage of the face amountof the bonds and may be expressed, forexample, as 1 percent per 100 Rupee bond. In acompetitive sale, the compensation may comeeither from buying the bonds at discount or

from buying them at par and reoffering them ata premium. In either case, the lead underwriterwill be paid more, in the form of a managementfee, than other members of the syndicate tocompensate for its management services and willalso be reimbursed for issue-related expenses.Other members of the syndicate will receive salescommissions (takedowns), as will dealers thatassist in the sales efforts (concessions).

Trustees and Paying Agents41

The function of trustees and paying agents willvary in many countries depending on their legalauthority. In some circumstances, trusts areestablished as independent legal bodies thatinsure that all parties involved in a financingplan comply with the terms and conditions ofthe legal documents prepared for thetransaction. In other cases, a trust provides aguarantee for debt service payments and/or itcollects and distributes the revenues used to

make interest and principal bond payments.Trustees can retain collateral used to securea transaction.

The paying agent is responsible for distributingpayments on issued bonds from the issuer to thebond holders. It also maintains records ofbondholders. The paying agent is in most casesa bank.42

Cost of ServicesThe use of specialized services entails costs that,in conjunction with a bond sale, are termedcosts of issuance. In addition to the majoradvisors listed above, other activities includingprinting and professional services (e.g.accounting) are carried out in support of a bondissuance and may be capitalized into the issueand paid from bond proceeds. In general,the largest component of costs is that paid tothe underwriter.

41 See World Bank (1999) “Credit Ratings and Bond Issuing at the Subnational Level: Training Manual” Pp 4-19 for more detail.42 Ibid Pp 4-19.


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Evaluation andMonitoring Oversight

Section V

The decentralization of governments throughoutthe world has brought new prerogatives andresponsibilities to state and local governmentsas service providers to their local constituents.The decentralization of government finances hasprompted increasing reliance on financialmarkets, private provision of many activitiesformerly carried out by governments, and anincreasing emphasis on using private capitalmarkets as an efficient allocator of credit. Stateand local governments are being required to domore things and to be more self-reliant inraising revenues. Hard-pressed budgets haveconstrained the ability of central governmentsto provide for the needs of state and localgovernments.

The political and financial relationshipsbetween central, state and local governmentsare rich and varied. These relationships areevolving along new lines, many of them uniqueto a given country’s tradition and position alongthe decentralization (and devolutionary) scale.National government oversight and interventionin state (and local) government financial systemsvary fundamentally:

• In federal systems important prerogativesare left to the states (and their localgovernments); and

• Unitary governments have strong sovereigncenters.

Overview of the International ExperienceThe United States, Canada and many LatinAmerican countries, for example, have a federal

Part 1:

Monitoring and Oversight ofState Government Debt

43 This discussion has been obtained from Mila Freire and John Peterson “Subnational Capital Markets in Developing Countries: FromTheory to Practice” World Bank, 2004, pp 159-161.

system of government with specific powers andprerogatives reserved for each level of thegovernment. Although often possessing somedegree of independence, local governments aresubordinated to state and provincialgovernments. In unitary systems, all powers ofthe state are derived from the centralgovernment, which has oversight overstate andlocal governments. Rather than a prescribed,singular approach to monitoring ofsubsovereign financial conditions, there aremany different approaches that have beenutilized by various political systems.A nonexclusive list of international experiencesis given below:

Argentina43

Historically, Argentina has a highly decentralizedsystem of government with significant powersgiven to provincial governments. Much like theU.S. and Canadian systems, the provincialgovernments are the parents of localgovernments. The central government raisestaxes, most of which it then transfers to theprovincial level to provide services.

The financial structure places substantialemphasis on the intergovernmental transfermechanism. All three levels of government arepermitted free rein to borrow. Many subnationalgovernments have borrowed funds to coveroperating deficits. In the 1990s, the centralgovernment stepped in to bail out theprovinces and cities by replacing subnationaldebt with national debt. The nationalgovernment closed the window on provincialbank lending to provincial governments.

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However, the provinces have continued toborrow from private banks and to pledge futureintergovernmental transfers. A recurringproblem has been a lack of discipline inborrowing to cover current deficits. Since theprovinces (and municipalities) have a highdegree of independence, the centralgovernment’s ability to control (and monitor)their behavior is limited. In anew approach, thefederal government and the provinces haveentered into numerous agreements intended tocontrol provincial spending and borrowing.

Brazil44

Brazil’s constitution provides nominally equalstatus to all three levels of government. As inArgentina, the lack of effective control by thecentral government lead to increasing levels ofindebtedness by the states and the two largestcities, followed by widespread defaults in the1980s. The debts were rescheduled by thecentral government to convert short-term tolong-term debt.

A major problem was that the nationalgovernment had no effective control over theamount of debt incurred by subnationalgovernments. As in Argentina, negotiationsbetween the state and central government areongoing. However, since 1998 and the passageof the Fiscal Responsibility Act, the centralgovernment has curbed imprudent state (andlocal) government level fiscal behavior andestablished tight conditions for subnationalgovernment borrowings.

United States (California)The United States has a federal system of

government with specific powers assigned toeach level. Even though many localgovernments possess some degree ofindependence, they are subordinated to stategovernments. Oversight and intervention by thestates in the affairs of local governments varygreatly in the United States. However, in thecase of state-level fiscal distress, the states arelargely left on their own to resolve theirbudgetary issues.

For example, California is weathering a fiscalcrisis largely created by increases in operationalspending combined with a general reduction ingovernment revenues. This has forced the stateto impose spending controls, and refinancing itscurrent debt obligations. These actions werelargely undertaken without the intervention ofthe central (federal) government.

Best Practices and Disclosure Standards45

The following section presents best practicereporting and disclosure standards to assiststates and local governments in more effectivedebt management practices. Best practices thatpromote efficiency in government reportingand solvency have been promoted by theGovernment Finance Officers Association(GFOA-US) and the National Advisory Council onState and Local Budgeting (NACSLB). These bestpractices include the following:

• Fund balance reserve policy/working capitalreserves;

• Multiyear financial forecasting;

• Monthly or quarterly financial reportingand monitoring;

44 For more detail see Mila Freire and John Peterson “Subnational Capital Markets in Developing Countries: From Theory to Practice”World Bank, 2004, p 161.45 The following section(s) largely paraphrases Fitch Ratings “The 12 Habits of Highly Successful Finance Officers” November 21, 2002,pp 3-7.

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• Contingency planning policies;

• Policies regarding nonrecurring revenues;

• Debt affordability reviews and policies;

• Superior debt disclosure practices; and

• Rapid debt retirement policies (greater than65 percent in 10 years).46

According to Fitch Ratings, the above-mentioned list of positive financialmanagement practices had the most beneficialeffect on creditworthiness. A number of itemson this list touch on greater disclosure, such asan issuer’s receipt of awards for excellence onfinancial reporting and budgeting. We examinethe list in more detail below:

Fund Balance Reserve Policy/WorkingCapital ReservesMaintaining an operating reserve fund isconsidered perhaps the most effective practicean issuer can use to enhance (protect) its creditrating. It is also the most frequentlyimplemented practice, adopted by both largeand small government issuers. The capitalreserve fund provides a defense against deficitspending and helps maintain liquidity whenbudgeted drawdowns become inevitable. Theappropriate size of such a reserve largelydepends on the variability of the revenues andexpenses, as well as the working cash needs ofthe government entity to handle seasonality ofrevenues/expenditures.

Multiyear Financial ForecastingThe practice of forecasting operating revenuesand expenditures over several years has

developed from issuers experiencing fiscalstress. However, multiyear financial forecastinghas had beneficial effects long after a financialcrisis has passed. A multiyear plan allowslegislators and executives to anticipatepotential budget stress that may result fromprojected revenue and expenditure imbalances,allowing them to take corrective action longbefore budgetary gaps develop into a crisis.

Monthly or Quarterly Financial Reportingand MonitoringInterim financial reporting can block theprogress of impending fiscal stress if thefinancial management system is calibratedproperly. The best interim reports providedetails on the issuer’s major tax and revenuesources, with variance analysis that shows thefactors that are affecting revenue inflow. Inaddition, interim reports that present currentmonth spending, for the year to date, and incomparison with the budget are also essential.

Contingency Planning PoliciesDemonstration by an issuer of foresight andplanning against unforeseen events is viewedpositively. Many future challenges can beanticipated. Each year, in a number of U.S. states,voter initiatives are presented that proposerevenue limits or reductions that can potentially(and dramatically) change an issuers financialflexibility. Issuers should have meaningfulcontingency plans against the possibility ofsuch changes. In addition, governments shouldconsider establishing contingency plans inthe event that budget assumptionsprove erroneous.

46 See Fitch Ratings “The 12 Habits of Highly Successful Finance Officers” November 21, 2002.


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Policies RegardingNonrecurring RevenuesOver reliance on nonrecurring revenues topaying ongoing and recurring expenses is acredit concern, since it frequently contributes tobudgetary stress and fiscal structuralimbalances. Nonrecurring revenues can be salesof fixed assets, budgetary savings from a debtrefinancing, or tax collection windfalls. From acredit perspective, nonrecurring revenuesare best used for onetime or discretionaryspending that will not entail spending pressuresin future years.

Debt Affordability Reviews and PoliciesStrong debt management practices areevidenced by comprehensive debt policystatements that discuss the types and methodsof financing employed by an issuer. These shouldinclude an issuer’s policies regarding off-balancesheet financing (i.e., lease debt) as well as bondanticipation notes and tax and revenueanticipation notes. Policy statements should alsoset forth any self-imposed debt limitations.47

Related to debt affordability, an issuer shouldconsider its overall exposure between investedassets and external debt issuance. Increasingly,government issuers are balancing short-,medium- and long-term investments with a mixof short- and long- term debt. A stategovernment should engage in a proactive assetliability management policy that includes, but isnot limited to:

• Identification of debt and investmentmanagement products that are acceptable tothe debt issuer;

• Expected benefits of selected financialproducts in light of potential interest ratevolatility;

• Sources of funds available for potential swaptermination payments;

• Designation of individuals responsible fornegotiating, monitoring, and reportingmarket conditions, and their impact onvariable and fixed rate debt, investments;and

• Any other financial products underconsideration.

Superior Debt Disclosure PracticesSuperior debt disclosure practices go beyondthe documentation required to successfullyundertake a new issuance in bonds or notes.Some examples of superior disclosure that arenot standard items in a financial report include:

• Delineation of financial managementpolicies;

• Specific history of pledged tax or revenuestreams that back revenue bonds;

• Charts depicting required and actual revenuebond coverage (calculated per the bondindenture formulas);

• Compliance with key indenture items, suchas covenants, reserve funds, and/or renewaland replacement funds;

• Use and performance of interest rate swaps,including market-to-market value; and

• Annual updates of operating data forenterprises, such as fees, customer trends andservice volume.

47 The State of Maryland (U.S.A.) has established a debt affordability policy.

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Rapid Debt Retirement PoliciesOne tenet in effective debt management is thatthe life of debt should not exceed the useful lifeof the asset or the project being financed.However, useful life should not be the onlybenchmark considered when structuring thematurity of an issuer’s debt. For example, anissuer that frequently sells 30-year debt orcontinually extends existing maturities of itsdebt through refinancing and restructuring maystill manage to match debt and useful life.However, from a credit perspective, an issuerthat pays off its debt rapidly (65 percent or moreof principal in 10 years) will be reviewed morefavorably than a similar issuer that retires only50 percent of its debt over 10 years.

Issuers that stretch out their debt throughascending debt service maturities or heavy useof capital appreciation bonds reduce theirfinancial flexibility. For example, a number oflocal governments in the U.S. restrict the finalmaturities on tax supported debt to 15 years,resulting in a debt amortization rate of89 percent over 10 years.48

Dealing with DefaultThe international experience with respect todealing with default varies significantly.Some government have institutionalizeddefault procedures within the constitution(e.g., Hungary and South Africa) while othershave developed a number of laws dealing withdefault remedy procedures.

What is default? Default is defined as a missed ordelayed payment by an issuer in breach of theagreed terms of the issue. In general, all credit

rating agencies and financial institutions usesimilar definitions of default.

For most subnational (state and local)governments, the development of early andaccurate detection of problems is the bestremedy to stave off default. Further, ratingagencies and lenders view the adoption of astate-level debt monitoring procedures as animportant element in managing debt andavoiding default. Once problems are accuratelydetected and their underlying causes diagnosed,the swift and effective correction of thoseproblems requires the development of credibleplans specifying one or several series ofcorrection measures and allocating authorityand responsibility for carrying out these plans,within agreed upon time frames.

State governments should determine whowould be the primary point person thatcreditors should deal with on a day to day basisin the event of a potential debt default. Further, astate level financial recovery plan must beaimed at securing the state’s ability to meet itsobligations to provide basic services or itsfinancial commitments, and such a plan,whether mandatory or discretionaryintervention, must:

• Identify the financial problem;

• Be designed to place the state in a soundand sustainable financial condition as soonas possible;

• State the principal strategic objectives ofthe plan, and ways and means for achievingthese objectives;

48 ICRA responded to this section on rapid debt retirement polices by stating that shorter average loan maturity may not necessarily bepositive from the credit perspective at all times. Rapid debt retirement practices must be seen in context of various other practicesincluding the pattern of regular cash flows, available financing options and investment plans.

• Set out a specific strategy for addressing thefinancial problems, including a strategy forreducing unnecessary expenditure andincreasing the collection of revenue (as maybe necessary);

• Identify the human and financial resourcesneeded to assist in resolving financialproblems, and where those resources areproposed to come from; and

• Describe the anticipated time frame forfinancial recovery, and milestones tobe achieved.

In addition, the recovery plan must be able to:

• Provide for the liquidation of specific assets,excluding those needed for the provision ofthe minimum level of services;

• Provide for debt restructuring or debt relief;

• Provide for special measures to preventunauthorized and/or wasteful expendituresand other losses; and

• Identify any actual and potential revenuesources.

Furthermore, a financial recovery plan must:

• Set spending limits and revenue targets;

• Provide budget parameters which bind thegovernment for a specified period or untilstated conditions have been met; and

• Identify specific revenue raising measuresthat are necessary for financial recovery,including the rate at which taxes and tariffsmust be set to achieve financial recovery.


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Guidelines andRecommendations

Section VI

State government market borrowing has largelybeen limited through the Reserve Bank of India(RBI). However, the Twelfth Finance Commission’srecommendation to discontinue loans to stategovernments for plan funding will require Indianstates to mobilize larger resources from themarket. State government borrowing is not an endin itself. Ideally, it should be used to obtain long-term capital for expenditures that providebenefits that stretch into the future. Repaying stategovernment debt represents the fulfilling of anintergenerational contract obligating those whobenefit from the capital investment to pay theirshare of the costs. Successfully incurring andrepaying debt is an affirmation that stategovernments are capable of planning for thefuture and fulfilling their obligations.

Credit market access has been approached fromvarious angles in this Guide including: thepotential needs of state government borrowers,the organization and regulation of the financialmarket, the likely investor groups, the need forinformation to analyze credit, credit rating andhow state’s can go to market under acompetitive versus negotiated sales method.This section provides some concludingobservations and general guidelines withrespect to improving the Indian stategovernment securities market.

Expanding the Playing Field for StateSecuritiesIn promoting the Indian state governmentsecurities market, the governing laws andregulations should make clear the legal statusand remedies available to investors in stategovernment obligations. The security andenforcement process should be explicit and

Part 1:

Concluding Observations and Guidelineseasy to call on. However, in designing thesecurity and enforcement procedures, theregulators must be somewhat flexible inestablishing the boundaries of prudentialbehavior. In addition to developing securityprovisions to meet general requirements,parties to state debt transactions should be ableto design security provisions to meet specificneeds and circumstances. Other elements thatare essential for expanding the demand for statesecurities include:

• The financial marketplace should be free towork with state governments to decide onthe types of instruments and associatedpayment structures to employ;

• Wherever possible, it is best to introduce andpromote competition into the statesecurities market; and

• Public and timely reporting on the terms,conditions and other provisions of loans andbond offerings is a necessary complement tosupporting a competitive state securitiesmarket regime.

Even in places where the securities market isnot fully developed, and effective competition islimited, the bidding process and full disclosureof transactions should encourage participationin the debt market.

Financial Market Regulation andDisclosureA key concern in securities market regulation isproper financial disclosure. State governmentsecurities should be subject to disclosurestandards that require both information at thetime of the initial offering and regular reporting

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to investors subsequently. State governmentfinancial information needs to be promptlydisclosed after the close of the fiscal period inclear, consistent formats. For debt monitoringpurposes, reporting on a modified accrual basisis essential (as are cash flow statements).

A central repository (e.g., DIMC) of financialinformation on government borrowings is anessential tool in promoting efficient disclosure.The repository should have current data on debtoutstanding and information on security pledgesand liens.

The following measures are recommended forimproving the financial disclosure (and, hencethe creditworthiness) of the state governments:

• The FRL should provide for a mandatory DebtManagement Plan to be prepared over aperiod of three-five years to ensureachievement of the various targets forprudent debt management;

• There should be a detailed capital budgetproviding for all capital expenditure forecastsfor the state governments;

• The debt sustainability norm as put forth bythe GoI should be strictly adhered to. Thisshould be established in the form of aGovernment Order (GO);

• State governments should ensure that theyhave details of all information pertaining totheir assets, particularly financial assets andliabilities; and

• There should be a system ensured through arule under a statute for maintainingcomplete detail of all loans guaranteed bythe government as well as all loans for whichthe repayment liability falls on thegovernment.

Credit Analysis and RatingsCredit analysis is a product of the credit market’sneed to assess state government financial risk,whereas, credit ratings are the leading form ofinstitutionalized credit analysis. Credit analysisand ratings play an important role in expandingstate government securities instruments. Creditratings focus on credit risk (risk of paymentdefault) which then is used to help determineoverall risk and reward. A financial market onlybecomes viable when there is a variety ofcompeting investors, and investments withdifferent risk and reward characteristics.

Credit ratings have the benefit of ranking stategovernments on their perceived ability andwillingness to pay their debts and avoid financialstress. Credit ratings are relatively easy tounderstand, hence their popular appeal withinstitutional investors in the capital market. Thebroad based appeal of credit ratings representsa catalyst for state governments, providing anincentive to upgrade their credit rating.

Other IssuesA regular and universal reporting system forstate governments founded on an accountingsystem (modified accrual) relevant to theinformation needs of investors and prepared byproperly trained officials is a prerequisite formarket development. Most important is theability to report direct and contingent debtsoutstanding, current state debt servicerequirements and cash funds available to meetthese demands as well as baseline operatingexpenses. While the ability to support manyother measures of performance and conditionsis desirable, reliable baseline data on pendingstate debt obligations and reporting needs areindispensable to developing the state debtsecurities market.

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The following Annexures provide greater detailon the organization and operation of DebtReform:

• Annexure 1 describes the Financial MarketStructure;

• Annexure 2 discusses Strategic Benchmarks onState Debt;

• Annexure 3 defines the Liquidity according tothe Bank for International Settlements;

• Annexure 4 describes the Types of Securitiesavailable to state governments;

• Annexure 5 discusses the ways to enhancecredit;

• Annexure 6 contains a Table summarizingGovernment Debt Instruments and SalesMethods;

• Annexure 7 discusses the Minnesota StateDebt Management Policy;

• Annexure 8 provides a road map on how toset up a Debt and Investment ManagementCell and implement the CS-DRMS software;

• Annexure 9 provides a list of virtual links toWeb sites related to Public Debt Management;

• Annexure 10 contains a Bibliography; and

• Annexure 11 contains a detailed report on theREFORM Project and Investment Managementexperiences in Jharkhand, Karnataka, andUttarakhand.

Annexures

This Annexure focuses on the guiding principlesof approaching the market by a subsovereignentity in India. Moreover, this Part detailsdifferent types of subsovereign borrowing inIndia. Government securities have contributedto the development and functioning of financialmarkets around the world in part because oftheir liquidity.49 In highly developed markets(e.g., the United States) examples of theirimportance include:

• Government debt forms part of bankregulatory capital and in many countriesguidelines or direct quantitative regulationsof private pension funds specify minimumcompulsory investment shares ingovernment securities;

• Governments (reflecting their taxationpower) provide securities with negligiblecredit risk; and

• Government debt is often a criticalcomponent of strategies aimed at reducingportfolio risk.

By making state government securitiesrelatively straightforward, tailoring theirmaturities to meeting market demand, andannouncing borrowing plans in advance, stategovernments can make their securities moreattractive to investors. This Part seeks to reviewthe nature of a (state) government debt marketincluding selling procedures and distributionchannels.

Indian financial markets consisting of the equityand debt markets underwent a hugetransformation in the 1990s and continue toevolve. While the equity market in India has

Annexure 1:

Financial Market Structurereached a state maturity and depth that can becompared to any developed country, the debtmarket is not fully developed. The debt markethas mainly two segments: the government (bothcentral and state governments) securities whichare SLR securities and the corporate securitieswhich may be called the NonSLR bonds (SeeFigure 1A.1). The central government securitiesmarket has grown substantially since the early1990s but the corporate securities market is yetto take off. The study of the development of thecentral government securities market providesan important step in the analyzing the wayforward for the states which are planning toapproach the market for their future borrowingneeds.

Market borrowing is not anything new for Indianstates as it already constitutes an importantcomponent of borrowing. However, the natureand quantum of such borrowing is going toundergo substantial change. At present,market borrowing for the states is conductedby the Reserve Bank of India and is donesimultaneously for all states and its subscription(price and quantity) does not really reflect thefinancial strength (creditworthiness) of eachstate. The future borrowing by states from themarket, in contrast, will have to be organized bythe states themselves based on their ownfinancial strength or creditworthiness. In thisconnection, it is most useful to understand howthe central government market borrowing hasevolved over the years.

Indian Debt MarketThe government dominates the Indian debtmarket with about three quarters of resources

49 See Annexure 3: BIS Definition of Liquidity.

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the total during 2003-04 and 2004-05. The debtmarket is fundamentally a wholesale market inIndia. As far as regulation is concerned, while theReserve Bank of India (RBI) regulates thegovernment securities market, the corporatedebt instruments traded on the stock exchangesare regulated by the Securities Exchange Boardof India (SEBI).

Table 1A.1: Debt Market: Selected Indicators (INR Crores)

Issuer/ Securities Amount Raised from Primary Market Turnover in Secondary Market

2003-04 2004-05 2003-04 2004-05

1. Government 1,98,157 1,45,602 26,79,208 29,55,263

2. Corporate/Nongovernment 52,752 59,279 42,262 38,419

3. Total 2,50,909 2,04,881 27,21,470 29,93,682

4. Government to Total (1/3) % 79.0 71.1 98.4 98.7

Source: NSE (2005).

Source: Madhav (2006).

Figure 1A.1: Indian Debt Market

PublicSector

Banks/Financial Institutions

T-billsDated GovtSecurities(G-SECS)

StateDevelopment

Loans

NonSLR Bonds

Government Securities

PrivateSector

Derivatives

InterestRate Futures

(Exchange Traded)

Interest RateSwaps (OTC)

Forward RateAgreements (OTC)

mobilized in this market by the central and stategovernments. Thus out of a total of INR 2,04,881crores raised through primary debt issues during2004-05 about 71 percent was mobilized by thegovernment alone (Table 1A.1). Thepredominance of government securities isnearly complete in the secondary market withtheir trading volumes almost 98-99 percent of

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Market Participants and InstrumentsTable 1A.2 broadly summarizes the presentstructure of Indian debt market. It provides themix of issuers, investors, instruments and theirmaturities in the debt market.

Primary DealersThe selection of the appropriate marketing anddistribution channel for state government debtinstruments should ensure cost-effectiveness;maximize participation from a broad range ofinvestors; maximize competition; minimizeplacement risk; and foster transparency. Formany countries with developed capital markets,government bond auctions are the primary salestechnique. Countries may also choose to sellgovernment debt in the form of syndication(s),underwriting, or private placements.

The selection of the appropriate marketing anddistribution channel for state government debtinstruments should ensure cost-effectiveness;maximize participation from a broad range ofinvestors; maximize competition; minimizeplacement risk; and foster transparency. For manycountries with developed capital markets,government bond auctions are the primary salestechnique. Countries may also choose to sellgovernment debt in the form of syndication(s),underwriting, or private placements.

Issuer Instruments Maturity Investors

Central Government Dated Securities 2-30 Years RBI, Insurance Companies, Provident Funds,Mutual Funds, PDs

Central Government T-bills 91/364 Days RBI, Banks, Insurance Companies, ProvidentFunds, Mutual Funds, Individuals, PDs

State Government Dated Securities 5 -13 Years Banks, Insurance Companies, Provident Funds

PSUs Bonds, Structured 5-10 Years Banks, Insurance Companies, Provident Funds,Obligations Mutual Funds, Individuals, Corporates

Corporates Debentures 1-12 Years Banks, Mutual Funds, Corporates, Individuals

Corporates, PDs Commercial Papers 15 Days to 1 Year Banks, Mutual Funds, Financial Institutions (FIs),Corporates, Individuals, Foreign InstitutionalInvestors (FIIs)

Scheduled Commercial Certificates of 15 Days to 1 Year Banks, Companies, Individuals, FIIs, Corporations,Banks, Select FIs Deposits for Banks and Trusts, Funds, Associations, FIs, Non-Resident

1 Year to 10 Years Indians (NRIs)for FIs

Scheduled Commercial Bank Bonds 1-10 Years Corporations, Individuals, Companies,Banks Trusts, Funds, Associations, FIs, NRIs

Urban Local Bodies Municipal Bonds 0-7 Years Banks, Corporations, Individuals, Companies,Trusts, Funds, Associations, FIs, NRIs

Table 1A.2: Structure of Indian Debt Market

Source: NSE (2005).

The use of primary dealers is considered to be amore competitive arrangement for the issuanceof government securities than the use ofsyndication or underwriting. Primary dealerstend to shrink commissions when marketsbecome more competitive to maintain market


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share, while the fees in syndication remain fixedfor the agreed upon period. The Government ofIndia has established a “Primary Dealer System”to promote liquidity for government T-bills andbonds in the market. Under this system, a groupof financial agents is chosen with the statedobjectives of fostering growth in the primaryand secondary market for these securities. Thesedealers have obligations to the government andenjoy some privileges which enhance their ownincentive to develop the market.

Primary Dealers (PDs) have become thebackbone of the government securities marketin developing countries in general and India inparticular. The system of Primary Dealers (PDs)was introduced in India in 1996 for underwritingprimary issuances of government securities andfor market making in the secondary market.There were 17 PDs in operation at the end ofMarch 2005. Some of them are promoted bypublic sector banks and financial institutions,and some by foreign banks and foreign securityhouses. PDs are obliged to provide annualbidding commitment, underwriting primaryissuance and offering two-way quotes. In return,they are provided with liquidity support by theRBI and access to call money market asborrowers and lenders. In addition, PDs can raiseresources through Commercial Papers (CPs) andcan take recourse to borrowing fromcommercial banks. The amount of absorption byPDs in the primary market of governmentsecurities and in the secondary market in Indiahas been rising over the years. As part of theFiscal Responsibility and Budget Management(FRBM) Act 2003, the RBI cannot participate inprimary issuances of government securitieseffective April 2006 and this entails furtherenhancement in the role of the PDs in primaryauctions.

Investor BaseA key challenge confronting many countries ishow to broaden the investor base so as toreduce the heavy reliance on a captive market. Abroader investor base improves market liquiditynot only because of the (increasing) size effectbut also because having a large number ofinvestors with diverse risk profiles enablessmooth dissipation of market shocks. In addition,a large investor base generates incentives forfinancial innovation.

The growth in local institutional investors suchas pension funds, insurance companies, andmutual funds is crucial in driving the demand forgovernment securities. A diversified investorbase with varied demand requirements,maturity profiles, and risk preference isimportant to ensure high liquidity and stabledemand in the market. In mature markets, theinvestor base is generally well-diversified withbanks, mutual funds, hedge funds, pension funds,and insurance companies providing a broaddemand base for bonds. In many emergingmarket countries, many of these financialinstitutions are underdeveloped and the growthof such an investor base has been slow. Theinvestor base in Indian debt market is indicatedbelow:

• Banks constitute the major investor base inthe Indian debt market particularly thegovernment securities market. They are alsothe main participants in the call money andterm money market as well as the repomarket. Banks also issue Certificate ofDeposits (CDs) and bonds. Moreover, theyarrange issues of Commercial Papers (CPs) ofcorporate entities;

• Mutual Funds have become largeparticipants in the debt market mobilizing

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substantial amounts from investors. Mutualfunds also have specialized debt funds knownas gilt funds and liquid funds which invest andtrade on their portfolios on a regular basis;

• Insurance Companies;

• Foreign Institutional Investors (FIIs) are alsoallowed to invest in government andcorporate securities up to certain limits;

• Provident and Pension Funds are alsoimportant investors in the debt markets. Theprudential regulations mandate theirinvestments predominantly in governmentand public sector bonds. They normally holdtheir investments till maturity and hence notvery active in the secondary market;

• Charitable institutions, trusts, and societies arealso large investors in the debt market; and

• Retail investors have been permitted sinceJanuary 2002 to submit noncompetitive bidsat primary auctions through any bank or PD.They can submit bids for a minimum ofINR 10,000 and a maximum of INR 1 crore.The total noncompetitive bids up to amaximum of 5 percent of the notifiedamount are accepted at the weightedaverage cut off price/yield.

Issuers of SecuritiesThe major issuers in the debt market are thecentral and state governments, public sector units,and the private corporates. There are other issuerslike local governments and mutual funds whichtap the market infrequently. International financialinstitutions like Asian Development Bank havealso entered the domestic market recently.

Primary Issuance ProcessGovernment securities are issued mainlythrough two methods in India:

1. Tap issue.

2. Auctions sale.

In tap issue, the Reserve Bank of India, on behalfof GoI or state governments announces sale ofsecurities at a fixed price or coupon rate. There isno indication of the aggregate amount ofissuance in the notification for a tap issue. Salemay be extended to more than one day orclosed any time on any day.

Auctions have become the primary channel forissuing government securities in manyinternational debt markets because they haveproved to be more cost affective andtransparent than other methods. In the case ofthe auction, it can be either on a price or on ayield basis. In a price-based auction, it will be forthe reissue of existing securities with apredetermined coupon. The bidders shouldquote price per INR 100 of the face value of thesecurity. Bids at cutoff price or higher areaccepted and bids below the cutoff pricerejected. In a yield-based auction, bids are invitedfor deciding the coupon rate of new securities.The coupon of the security is determined in theauction and the security carries the samecoupon till maturity. Based on the bids received,the RBI decides the cutoff yield; bids above the

The growth in local institutional investors such aspension funds, insurance companies, and mutualfunds is crucial in driving the demand forgovernment securities. A diversified investor basewith varied demand requirements, maturity profiles,and risk preference is important to ensure highliquidity and stable demand in the market.In mature markets, the investor base is generallywell-diversified with banks, mutual funds, hedgefunds, pension funds, and insurance companiesproviding a broad demand base for bonds.


94

cutoff yield are rejected and bids at cutoff yieldor below accepted.

There are two alternative methods of allotmentin auctions: “uniform price” or “multiple price”allotment. In the former, successful bidders areallotted securities at the cutoff yield or price. Forthe “multiple price” allotment, successfulbidders are given securities at the bidding priceor yield: at cutoff yield or below in case of ayield-based auction and at cutoff price or abovein case of a price-based auction.

In multiple price auctions, the issuer orders bidsby price in descending order and accepts thehigher bids until the issue is exhausted. Eachwinning bidder pays the price that it bid.Auctions are sometimes combined withissuance through a set of primary dealers whoalso act as underwriters. These primary dealers

In uniform price auctions, the issuer orders bidsin descending order (similarly to multiple priceauctions), and accepts only those bids that allowfull absorption of the amount up for the issue. Inuniform price auctions, all successful bidderspay the price of the lowest successful bid. Inboth multiple price and uniform price auctions,the lowest accepted price is the cutoff price.

Multiple price auctions have advantages for theissuer, including they maximize revenue for agiven demand curve.50 This is subject to what iscalled the “winners curse.” By contrast, in auniform price auction, the successful bidder(s)pay only the lowest (marginal) price regardlessof what they were initially prepared to pay.51

Individuals and specified institutionscategorized as retail investors by RBI canparticipate in the auctions on “noncompetitive”basis. Allocation to noncompetitive bidders aredone at the discretion of RBI and at the weightedaverage price arrived at on the basis of thecompetitive bids accepted at the auction or anyother price announced in the specificnotification. The amount of securities allocatedto retail investors is restricted to a maximumpercentage of the aggregate amount ofthe issue.

Types of Securities Issued by GovernmentThe types of securities issued by thegovernment are:

• Fixed coupon securities which carry a specificcoupon rate remaining fixed during the term

The states have the option of raising any part oftheir allocation for market borrowing throughauctions. However, most of the states currentlyraise resources through tap issuances. The share ofthe auction route fell from 13-15 percent during2000-02 successively to about 2 percent in 2004-05.

are also used to enhance the price discoveryprocess through the requirement of continuoustwo-way quoting (market making). Thecombination of primary dealers and multipleprice auction systems have been linked to theopportunity for primary dealers to acquire alarge fraction of new issues by aggressive bids,which then allows them some market power.

50 The issuer obtains the maximum price that each participant is willing to pay.51 The World Bank (2001) “Developing Government Bond Markets: A Handbook” page 155.

95


Syndication is useful when the demand forgovernment securities is uncertain. Syndicatingdebt securities can minimize government bondplacement risk and be valuable when thegovernment is trying to launch a new debtinstrument. However, syndications needsupporting arrangements to introduce theminto the market. Syndication can also havedisadvantages in terms of transparency. Forexample, the primary disadvantage associatedwith syndication is that it involves a negotiationregarding price and fees between thegovernment and the various institutions willingto participate. In contrast, auctions do notinvolve negotiation and as a result, are moretransparent.

An alternative government securities issuancemethod that state governments can use underconditions of uncertain demand is underwriting.In an underwriting arrangement, thegovernment establishes a minimum price atwhich the underwriter, for a commission,subscribes to the entire issue.53 Since acommission is charged, state governmentofficials have to determine whether theunderwriting is worth the price. At relativelyearly stages of state government debt marketdevelopment, syndication and underwriting canbe suitable ways to ensure the successfulissuance of government securities. However,these forms of issuance are normally phased outas the market develops and the demand forbonds becomes more stable.54

State Government Market BorrowingsThe states have the option of raising any part oftheir allocation for market borrowing through

of the security which may be issued at adiscount, at par or at premium to the facevalue but redeemed at par;

• Floating Rate Bonds which carry a couponrate consisting of a variable base, usually theweighted average yield of 364 day T-bills, anda spread which is decided at the auction;

• Zero Coupon Bonds which are issued adiscount and redeemed at par and the RBIdetermines the cutoff price at which tendersare accepted at the auction;

• Securities with Embedded Options which aresecurities with a “call” or “put” optionspecified and repaid any time at the optionbefore the specified redemption date; and

• Treasury Bills which are short-terminstruments issued by the centralgovernment currently either 91-days or364-days maturity and sold through anauction process announced by RBI at adiscount to its face value.

Syndications and Underwriting ofGovernment SecuritiesIn many countries, government debt marketparticipants may consist of only a fewinstitutions. The paltry number of institutionsparticipating in the market may be too limitedfor a government to run an auction.52 Under suchcircumstances, the government may try toachieve an effective bond sale by appointing agroup of institutions which for a negotiated feewill subscribe to its bond issue, and then sell thebonds to other retail or institutional investors.This type of sales mechanism is known assyndication.

52 A small number of institutions participating in an auction may prompt collusion. Or, the institutions may not participate at all, leading toan undersubscription of the bond.53 The World Bank (2001) “Developing Government Bond Markets: A Handbook” page 163.54 Ibid. Page 163.


96

auctions. However, most of the states currentlyraise resources through tap issuances. The shareof the auction route fell from 13-15 percentduring 2000-02 successively to about 2 percentin 2004-05 (Table 1A.3).

Investor response in 2004-05 to tap issuanceswas lukewarm closing short of target except intwo cases despite liquidity in the system.Also, the spread widened during the 2004-05auctions. In 2005-06, the states wereencouraged to access markets through theauction route following the implementation ofthe Twelfth Finance Commission. As a result, thesituation dramatically changed as 48.5 percentof borrowings were through auctions against2.3 percent in 2004-05.

However, the market borrowings during2005-06 were much lower than the previousyear due to the end of “debt swap scheme” in2004-05 and the buildup of surplus cashbalances with the states. Twenty-four statesopted for the auction route in 2005-06 againstjust three states in 2004-05. The spreads of cutoffyields for auctions were lower at 20-50 basispoints vis-à-vis tap issues which were at 50 basispoints. In 2006-07 so far up to 17 November,20 state governments raised INR 11026 croresexclusively through the auction route.The spreads ranged 22-47 basis points for allexcept two of the 20 states.

Secondary Market Operations forGovernment SecuritiesSecondary market trades in governmentsecurities are usually negotiated betweenmarket participants such as banks, FIs, PDs andmutual funds either directly between counterparties or negotiated through brokers.Negotiated Dealing System (NDS) of RBIprovides an electronic platform for negotiatingtrades in government securities. Trades are alsoexecuted on the electronic platform of theWholesale Debt Market (WDM) segment of theNational Stock Exchange (NSE).

INR Crores

By Tap By Auction Total

2000-01 11,630 1,670 13,300

2001-02 15,942 2,765 18,707

2002-03 27,880 2,973 30,853

2003-04 47,626 2,895 50,521

2004-05 38,217 885 39,102

2005-06 11,186 10,543 21,729

2006-07 (up to17 November) 0 11,026 11,026

Percentage Share

2000-01 87.4 12.6 100.0

2001-02 85.2 14.8 100.0

2002-03 90.4 9.6 100.0

2003-04 94.3 5.7 100.0

2004-05 97.7 2.3 100.0

2005-06 51.5 48.5 100.0

2006-07 (up to17 November) 0 100.0 100.0

Table 1A.3: State Market Borrowing, 2000-01to 2006-07

Source: RBI Annual Reports and Study of State Budgets.

For tap issuances, the coupon rate remains thesame for all states who are pooled together inthe tap issue. In the auction system, the spreadbetween the cutoff yield and the yield on GoIsecurities of similar maturity varied between 48basis points to 93 basis points during 2003-04and 2004-05. In 2003-04, about 94 percent oftotal market borrowings and in 2004-05 almost98 percent were raised through tap issues. In2004-05 only three states (Kerala, Tamil Naduand West Bengal) went in for some amount ofmarket borrowings through auctions.

97


SGL AccountsSubsidiary General Ledger (SGL) account is afacility provided by the RBI to large banks andfinancial institutions to maintain records ofinvestment in government securities and T-billsin an electronic book entry form. These entitiescan settle their trades in securities held in SGLthrough DvP mechanism, which ensuressimultaneous movement of funds and securities.The Public Debt Office (PDO) within the RBIwhich oversees the settlement of transactionsthrough the SGL, transfers securities from oneparticipant to another and transfer of funds areaffected by crediting/debiting the currentaccount of the seller/buyer maintained with theRBI.

Investors who do not have an SGL facility areallowed to open a constituent SGL account withany entity authorized by RBI for the purpose andthese client accounts are called as “constituentSGL” (CSGL) accounts or SGL II accounts. Througha CSGL account an entity can participate in theprimary and secondary markets for governmentsecurities. All entities regulated by the RBI suchas FIs, PDs, cooperative banks, regional ruralbanks (RRBs), local area banks, and NBFCs shouldnecessarily hold their investments in either SGLor CSGL account.

Negotiated Dealing SystemNegotiated Dealing System (NDS) is anelectronic platform providing the facility fordealing in government securities and moneymarket instruments. NDS interfaces with theClearing Corporation of India Ltd. (CCIL) forsettlement of government securities trading forboth outright and repo transactions.

CCIL was established in April 2001 to supportclearing and settlement of trades in trades ingovernment securities (as well as in forex andmoney markets). CCIL acts as a centralcounterparty for clearing and settlement ofgovernment securities transactions done on theNDS and provides guaranteed settlement of tradesin government securities including repos throughimproved risk management practices.55 Only abank, FI, PD, mutual fund or a statutory corporationor a corporate that is a member of NDS and hasopened an SGL account and a current account withRBI can become a member of CCIL. Members paya onetime membership fee of INR 1 lakh. Inaddition, members have to pay fees and chargeslevied for different services offered by CCIL.

Order Matching SystemThe RBI has introduced recently (in August 2005)the NDS-Order Matching System which is anelectronic order matching system purely orderdriven with all orders from market participantsbeing matched based on strict price/timepriority. This is anonymous in the sense that theidentity of parties is not revealed at the time oforder entry. This also allows straight-throughprocessing (STP), that is, a seamless integrationof the various parts of the trading processstarting from displaying pretrade informationand ending with settlement and riskmanagement. In addition, the system allows thetrader to set his preference to enter his orderseither on the basis of price or time.

Wholesale Debt Market of NationalStock ExchangeNational Stock Exchange (NSE)’s Wholesale DebtMarket (WDM) offers a fully automated screen-

55 NDS risk management practices include daily mark-to-market margin and maintenance of the settlement guarantee fund.


98

based trading platform through the NationalStock Exchange for Automated Trading (NEAT)system. This permits only high value transactionsin debt securities meant primarily for banks, andinstitutional and corporate entities. Governmentsecurities, T-bills, PSU bonds, corporatedebentures, CPs, CDs, etc., are available fortrading in the segment of WDM of the NSE.The trades on the WDM segment could be eitheroutright trades or repo transactions withsettlement cycle of T+2 and repo periods(1 to 14 days).

Secondary Market TurnoverThe aggregate turnover in governmentsecurities (central and state government datedsecurities and T-bills) touched INR 29,55,263crores in 2004-05 of which INR 21,05,646 crores(71.3 percent) passed through RBI SGL accountand the rest through WDM segment of NSE. Thisincludes both outright and repo transactions.The turnover through nonrepo transactions wasINR 21,10,192 crores. Of this, central governmentsecurities accounted for 79.5 percent, T-bills for18.8 percent and state government securitiesonly 1.8 percent. The total nonrepo secondarymarket transactions and its share among centralgovernment dated securities, T-bills and stategovernment securities from 1995-96 to 2004-05are presented in Table 1A.4.

However, repo transactions have progressivelyovertaken the outright transactions ingovernment securities market. From about53 percent of total transactions in April-June2005, the share of repo transactions have movedup to 77 percent in April-June 2006 and furtherup to 84 percent in July 2006 (Table 1A.5).

In both outright transactions and repotransactions, the share of state government

securities in total government securitiesremains very low at just about 2 percent.

Improvement of Secondary MarketLiquidity in State GovernmentSecuritiesThe improvement of the secondary market forstate government securities is very crucial in thecontext of the proposed access to markets bystate government on their own. The issue of poorsecondary market liquidity in state governmentsecurities has been addressed by the WorkingGroup on Liquidity of State GovernmentSecurities (Chairman: Mr. V.K. Sharma) set up bythe Reserve Bank of India. The Group has madethe following short-run and medium-termmeasures to activate secondary market in stategovernment securities.

Short-run Measures

• Consolidation of securities by reissue ofexisting securities.

• Primary dealers should provide two-wayquotes for state government bonds.

• Retailing of state bonds to develop widerinvestor base.

• Market borrowing with a minimum size ofINR 1000 crores per tranche.

• Short-sale and reserved allotment at cutoffprice/yield to encourage retailing and marketmaking.

• Extension of noncompetitive bidding facilitythat already exists for central governmentsecurities to the state securities in theprimary auctions.

• Alignment of tax structure and incentives onsmall savings with state government bondsto encourage retail investment in thesesecurities.

99


SGL

No

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)W

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(IN

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t.Se

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ties

Secu

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curi

ties

Secu

riti

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curi

ties

Secu

riti

es

1995

-96

17,5

5311

,513

464

29,5

306,

813

2,25

517

69,

244

24,3

6613

,768

640

38,7

74

1999

-00

4,05

,285

47,5

753,

631

4,56

,491

2,78

,866

10,6

442,

082

2,91

,592

6,84

,151

58,2

195,

713

7,48

,083

2000

-01

5,09

,113

60,0

622,

971

5,72

,146

3,88

,097

23,1

441,

255

4,12

,496

8,97

,210

83,2

064,

226

9,84

,642

2001

-02

11,3

8,50

467

,332

6,13

112

,11,

967

9,00

,100

25,4

831,

412

9,26

,995

20,3

8,60

492

,815

7,54

321

,38,

962

2002

-03

13,0

6,15

376

,784

9,44

613

,92,

383

9,96

,582

31,3

992,

568

10,3

0,54

923

,02,

735

1,08

,183

12,0

1424

,22,

932

2003

-04

15,6

4,11

21,

20,0

5617

,196

17,0

1,36

412

,13,

839

55,5

974,

683

12,7

4,11

927

,77,

951

1,75

,663

21,8

7929

,75,

483

2004

-05

9,61

,151

2,71

,131

28,5

8412

,60,

866

7,15

,712

1,24

,660

8,95

48,

49,3

2616

,76,

863

3,95

,791

37,5

3821

,10,

192

SGL

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Mar

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(% t

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Secu

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curi

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1995

-96

59.4

438

.99

157

100.

0073

.70

2439

1.90

100.

0062

.84

3651

1.65

100.

00

1999

-00

88.7

810

.42

0.08

100.

0095

.64

3.65

0.71

100.

0091

.45

7.78

0.76

100.

00

2000

-01

88.9

810

.50

052

100.

0094

.09

5.61

03

100.

0091

.12

8.45

0.43

100.

00

2001

-02

93.9

45.

560

5110

0.00

97.1

02.

750.

1510

0.00

9531

434

0.35

100.

00

2002

-03

93.8

15.

510.

6810

0.00

96.7

03.

050.

2510

0.00

95.0

44.

460.

5010

0.00

2003

-04

91.9

37.

061.

0110

0.00

95.2

74

360.

3710

0.00

9336

5.90

0.74

100.

00

2004

-05

76.2

321

.50

227

100.

0084

.27

14.6

81.

0510

0.00

79.4

618

.76

1.78

100.

00

Sou

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NSE

(20

05)8

2

Tab

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A.4

: No

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Sec

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dar

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t Tr

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ns

in G

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rnm

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Sec

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ties


100

Apr-June Jul-Sep Oct-Dec Jan-Mar Apr-Jun Jul2005 2005 2005 2006 2006 2006

A. Outright Transaction

1. Central Government Securities 70.7 77.4 76.1 80.1 78.8 78.1

2. Treasury Bills 27.1 20.5 21.9 17.1 19.0 20 3

3. State Government Securities 2.2 2.1 2.1 2.8 2.2 1.6

Total (1+2+3) 100.0 100.0 100.0 100.0 100.0 100.0

B. Repo Transaction

1. Central Government Securities 76.1 82.0 80.3 83.0 78.3 69.4

2. Treasury Bills 20.3 16.5 18.3 12.2 19.2 28.4

3. State Government Securities 3.6 1.5 1 3 4.8 2.5 2 2

Total (1+2+3) 100.0 100.0 100.0 100.0 100.0 100.0

C. Grand Total (A+B) (INR Crores) 6,17,535 7,06,835 6,27,605 6,28,424 8,11,229 2,86,293

A as % of C 47.2 36.7 29.1 23.5 22.6 15.6

B as % of C 52.8 63.3 70.9 76.5 77.4 84.4

Table 1A.5: Secondary Market Transactions in Government Securities (in Percent)

Source: RBI Annual Report 2005-06.

Medium-term Measures

• The states to seek credit rating to bring ingreater transparency and attract wider baseof investors.

• Use of over-the-counter (OTC derivatives)with state government securities as theunderlying assets and permitting state bondsas eligible securities for delivery under thebond futures.

• Introduction of liquidity adjustment facility(LAF) repos using state government bonds.

• Use of State bonds as collateral for theprovision of intraday liquidity under the real-time gross settlement (RTGS) system.

• Setting up of a special purpose vehicle (SPV)to issue SPV securities backed by GoIguarantee for consolidation of outstandingstate government securities.

The Reserve Bank of India implemented two ofthe above measures in its Annual PolicyStatement 2006-07:

• Extension of facility of noncompetitivebidding to primary auctions of stategovernment bonds; and

• Purchase and resale of state governmentbonds under the LAF repo operations.

101


Strategic benchmarks, with respect to a stategovernment’s debt portfolio, represent thedesired structure or composition of a liabilityportfolio in terms of its characteristics such asinterest rate mix and overall maturity.State-level strategic benchmarks force thegovernment to evaluate its risk tolerance and toclarify its preference in light of potentiallyconflicting objectives regarding market,refinancing and liquidity risk, and expectedborrowing costs.56 However, strategicbenchmarks can be counterproductive if theyare not adequately specified or applied.

The state government should establishbenchmarks for managing its portfolio. Astrategic benchmark represents the portfoliostructure that the state government wouldprefer to have for its debt portfolio. Thebenchmark generally reflects the stategovernments’ preference as to the trade-offbetween expected risk and reward. Wheeler(2004) indicates that strategic benchmarks forgovernments generally are expressed asminimum or maximum levels of acceptable riskexposure, such as:57

• Acceptable interest rate risk for the overalldebt portfolio;58 and

• The debt maturity profile or the acceptablelevel of refinancing risk for the portfolio.59

Strategic benchmarks are based on optimizingasset and liability management. The aim of

Annexure 2:

Strategic Benchmarks on State Debtstrategic benchmarks is to lower the long termcost of state borrowing and minimize risks.Strategic benchmarks also should define:

• The currency configuration of debt;

• The share of domestic and foreign currencydebt;

• The share of fixed and floating interest debt;and

• The maturity profile.60

It is possible to develop state government debtbenchmarks that can reduce the government’sbalance sheet risk by taking into account thecharacteristics of the primary cash flows (e.g., taxrevenues) that are available to it for servicingthe government’s debt.

Debt-stress Policy VariablesUnder the current medium term fiscal reformprogram (MTFRP), a state debt to GSDP ratio ofthirty (30%) percent and a state debt to totalrevenue receipt ratio of three hundred (300%)percent is being used as a benchmark for statedebt. In the case of special category states, statedebt to total revenue receipts should notexceed two hundred (200%) percent. In addition,a state fiscal deficit of three (3%) percent ofGSDP has been prescribed as a medium-termgoal for structural adjustment guidelines.

On acceptance of the recommendations of theTFC and putting in place a Debt Consolidation

56 Please see Annexure7: Minnesota State Debt Policy on how a U.S. state government establishes its benchmark criteria.57 Wheeler (2004) Pg 112.58 This type of target is based on a multitude of factors including duration of the borrowing and a desired level of interest rate structure.59 In the State government’s debt policy manual a limit on the amount of debt maturing at any time is generally established. This limit ondebt maturity includes a quantifiable ceiling of debt (maturity) expressed as a percentage of the overall portfolio.60 Mr. Anil Bisen, Director, Planning Commission, New Delhi, ”Presentation for REFORM Debt Management Workshop,” Bangalore, Karnataka,September 26, 2006.


102

and Relief Facility, Ministry of Finance set abenchmark of debt sustainability of a State atinterest payment as percentage revenuereceipts at 20 percent (October 2005).

For measuring the excessive stock of debt, theMinistry of Finance, Government of India,measures indebtedness on the basis of severalcriteria, including:

• Debt to GSDP Ratio

– Benchmark: Greater than or equal to 30percent is poor or weak.

• Debt to Total Revenue Receipts

– Benchmark: Greater than or equal to 300percent for states indicate a poor debtcondition. Greater than or equal to 200percent for special category states is pooror weak.

For measuring the excessive stock of debt, theMinistry of Finance, Government of Indiameasures the excessive flow of debt on the basisof the following criteria:

• Fiscal Deficit to Total Revenue Receipts

– Benchmark: Fiscal Deficit as a percentageof total revenue, if greater than 25 percentindicates poor or weak position.

• Revenue Deficit as a percent of Fiscal Deficit

– Benchmark: If the revenue deficit as apercent of the fiscal deficit is greater thanor equal to 50 percent, it is an indication ofa poor or weak financial position.

• Rate of Growth of Debt to the Rate of Growthof Revenue

– Benchmark: If the rate of growth of debt tothe rate of growth of revenue is greaterthan or equal to 1.25, it is an indication of apoor or weak financial position.

Assessing the Fiscal Risk of StateGovernment GuaranteesIn 2003, the Ministry of Finance, Government ofIndia, the Reserve Bank of India, andrepresentatives of selected states met in a Panelto review State-level off-balance (contingent)liabilities problem. The Panel examined therising trend in outstanding guarantees of stategovernments and recognized the importance ofclassifying guarantees and the escalatinglikelihood of default associated with thoseoff-balance guarantees.

The Panel came to the conclusion that historicdefault data would not be an effective predictorof future default probabilities (for current state

Under the current medium term fiscal reformprogram (MTFRP) a state debt to GSDP ratio ofthirty (30%) percent and a state debt to totalrevenue receipt ratio of three hundred (300%)percent is being used as a benchmark for statedebt. In the case of special category states, statedebt to total revenue receipts should not exceedtwo hundred (200%) percent. In addition, a statefiscal deficit of three (3%) percent of GSDP has beenprescribed as a medium-term goal for structuraladjustment guidelines.

• Ratio of Interest Payments to Total RevenueReceipts

– Benchmark: If interest as a percent of totalrevenues is greater than or equal to18 percent, it is an indication of a weak orpoor financial position.

103


guarantees). As a result, the Panel suggested twomethodologies for assessing fiscal risk off-budget guarantees, including:

1. Full Value on the Budget: Under thismethodology, guarantees and the riskassociated with these guarantees areassessed at one-hundred (100%) percent. Inother words, off-balance sheet contingentliabilities would be equivalent to actual debtin state government reporting (and, riskprovision).

2. Partial Value on the Budget: The Panel alsorecommended for consideration theclassification of projects (or other activities)in terms of a risk weighting classificationscheme. Projects would be classified as high,medium, low, and very low risk and beassigned an appropriate risk weight. ThePanel suggested that State governmentscould use the assistance of Credit ratingagencies to assess the associated project risk(sans guarantee). The rating, sans guarantee,could then be used for the purpose ofclassifying the guarantees into high, medium,low and very low risk. States would then haveto use their best judgment to assign a riskprobability to each category (e.g., 5 percentfor very low risk, 25 percent for low risk, 50percent for medium risk, and 75 percent forhigh risk).61 Risk probabilities could then beapplied to the underlying contingentguarantees to estimate the state’sobligations. This could then be added to theannual debt service obligation to arrive at theannual fiscal burden of total state debt andcontingent liabilities.

The Eleventh (11th) Finance Commissionconcluded that states should aim to limitinterest payments to 18 percent of revenuereceipts. A modified recommendation proposedby the State Finance Secretaries Panel was tointegrate the risk-adjusted contingent liabilitiesso that total state obligations did not exceed20 percent of their revenue receipts.62 The StateFinance Secretaries Panel also recommendedthat states publish data regarding guaranteesregularly (in a specified format attached to theState Budget documents).

Benchmarks and State Policy ObjectivesState government strategic benchmarks shouldreflect the government’s debt managementphilosophy and debt management goals and thestate’s policy objectives. Incorporating thestate’s policy objectives and economic planunder one umbrella enables policies to bemutually reinforcing and reduces the risk ofpolicy tensions. By way of example, a stategovernment with a fiscal deficit and a highpublic sector debt to GSDP ratio may be anxiousto reduce the volatility cost of its debt servicingand may prefer to have a high proportion oflong-term (duration) fixed term debt. Whereas,another state government with the samefinancial conditions may seek to lower debtservicing costs by financing at short maturitiesand taking the risk that the rolled over debt isnot more expensive. Some strategic sovereignbenchmarks are listed in Table 2A.1.

Implementing Strategic BenchmarksOnce the strategic benchmarks are in place, thestate government’s debt manager must

61 GoI State Finance Secretaries Panel (2003) Mimeograph "Assess Fiscal Risk of State Government Guarantees" Pg. II.62 Ibid.


104

endeavor to move the state’s risk characteristicsof the actual portfolio to those embodied in thestrategic benchmark portfolio. In doing so, thedebt manager must follow the guidelines andprocedures laid out in the state’s debt policymanual. Transactions to rebalance the portfolio

Table 2A.1: Strategic Benchmarks Country Examples63

Country % of Domestic to % of Fixed to Refinancing/Maturity GuidelinesForeign Currency Floating

Belgium 98.2:100 – 10-15% on debt maturing in next year; smooth redemptionprofile, weighted average maturity, 6.2+/- 0.1 years

Columbia 67:33 70:30 15% in 12 months, 30% in 36 months

France 100 10% in inflation Average maturity of 5.5 yearsindexed debt

Portugal 100 68:22 20% in 12 months, 35% in 24 months, 45% in 35 months

Sweden 73:27 – 25% in 12 months

63 Mr. Anil Bisen, Director, Planning Commission, New Delhi, “Presentation for REFORM Debt Management Workshop,” Bangalore, Karnataka,September 26, 2006.

generally result in some transactions costs. Indevising the strategic benchmarks, it isimportant to also provide a range for theelements in the benchmarks in order to avoidincurring excessive transaction costs for whatmay be relatively small differences in risk.

105


Annexure 3:

Bank for International Settlements (BIS)Definition of Liquidity64

Liquid markets are defined as ones whereparticipants can rapidly execute largetransactions without having a significant impacton price. This feature enhances marketparticipants’ confidence in the function ofthese markets both in normal and stressconditions. (BIS, 1999). The concept of liquiditycan be further elaborated in a number ofdimensions, including:

• Tightness or how far transaction pricesdiverge from mid-market prices. This can bemeasured by the bid-ask spread. The tighterthe spread, the higher the liquidity and lesscost for the buyer or seller;

• Depth denoting either the volume of tradespossible without affecting prevailing marketprices or the amount of orders on the orderbooks of market makers at a given time;

• Resiliency referring to the speed with whichprice fluctuations resulting from trades aredissipated, or the speed with whichimbalances in order flows are adjusted; and

• Immediacy referring to the time that passesbetween the placing of a market order andits execution.65

Market liquidity has many dimensions, anddepends inter alia, on the volume and design ofthe relevant asset. Government bond marketshave advantages in this regard as typicallygovernment security issues are largelycompared with other bond issues. There is someevidence that larger issue sizes tends to beaccompanied by narrower bid-ask spreads.Furthermore, as a general rule, governmentsecurities are more homogenous because thereis only one issuer (the government) and becauseother features, such as coupon payment datesand issuance frequency are usually identicalacross issues. This implies a high substitutabilityamong the various issues. The desire to increasemarket liquidity is the rationale for the trend bymanagers of public debt towards passiveissuance policy — that is the regular issuance ofbonds within a limited set of maturities and inrelatively large sizes.

64 This section draws largely from Bank for International Settlements (1999).65 See Upper (2001).


106

After the discussions on the current system ofsubsovereign market borrowing and to themechanics of trading of government securitiesin India, this Part would go into the discussion ofthe various types of bonds that generally exist inthe financial market for borrowing by thesubnational governments. However, we need tokeep in mind that all types of fixed incomesecurities which are often traded in welldeveloped capital markets may not be relevantin Indian scenario.

The State Bond MarketThe bond market consists of the primary market,which deals in the issue of new securities, andthe secondary market, where securities aretraded after they have been issued. Figure 4A.1presents the flow of funds through the primarymarket. The process generally begins when theissuer (i.e., the state government) sees a need formoney to pay for capital investments or to fill

Annexure 4:

Types of Securitiesgaps in cash flow. The issuer then takes a seriesof steps that lead to the primary market. At thispoint, the bond dealer (which may beindependent or part of a securities firm or abank) purchases the issuer’s bonds through aprocess called underwriting.

The bonds are (in many instances) resold toinstitutional and individual investors, who pay thedealer directly for the debt that they havepurchased. The dealer (or underwriter) generallyuses these funds to reimburse itself for its capitalthat was used to purchase the bond from theissuer. If a dealer is an underwriter, and there is nobuyer, or inadequate buyer participation, then theunderwriter assumes the risk of holding the bondsin inventory until they are eventually sold. Bothprincipal and interest are paid to the investors bythe issuer. Payment of principal and interest to theinvestor usually takes place on a fixed schedulethrough a bank acting as a payment agent.

Figure 4A.1: Flow of Funds in the Primary Market

Source: The Bond Market Association (2003).

IssuersState Governments and State AuthoritiesLocal Governments and Local Authorities

Bond Dealers

InvestorsIndividual Investors

Bond FundsProperty and Casualty Insurance Companies

BankOther

Paying Agent

Principal andInterest

Secondary Market

Bonds Funds

107


The secondary market consists of activity andtrading in securities after they have been sold asnew issues. This market also supports theprimary market by providing liquidity toinvestors who are more likely to buy a security ifthey know they can sell that security at a fairmarket price prior to its stated maturity.

Rationale for Use of BondsState governments generally finance capitalproject requirements using three options:paying for projects with cash, borrowing forprojects and repaying the resulting debt overtime, and leasing facilities. Both long-term debtfinancing and lease rental agreements requirestates or their independent authorities to enterthe bond market.

Using cash requires the appropriation of eitherlump sum amounts, usually for smaller projects,or a series of lump sum payments as largerfacilities are built over several years. In recentyears, some (state) jurisdictions have earmarkedcontinuing revenue flows such as lotteryproceeds for current funding of capitalconstruction. An advantage of using cash is thatit may cost less, since there are no interest ordebt issuance costs. A disadvantage is thatadverse fiscal conditions or competing spendingpriorities can result in insufficient revenues tofund projects. If state revenues run low, newcapital projects may be delayed or dropped.Alternatively, using cash could require a taxincrease to fund government financingrequirements.66

If current revenues cannot support state capitalspending needs, states may choose bonding to

66 Increasing state taxes is usually politically difficult.67 Higher taxes may be avoided in the near term. However, some state governments increase some state-level taxes in order to servicethe bonded debt repayment.

finance projects. Long-term borrowing forcapital construction has several advantages:

• Costs can be spread over the useful life ofprojects with future users of projects sharingthose costs;

• Citizens can derive near-term benefits fromcapital expenditures;

• Higher taxes to provide necessary capitalfacilities may be avoided;67 and

• Costs may be reduced in period of highinflation when the interest paid on debt isless than the increased construction costsfrom waiting to finance projects with cash.

There can be disadvantages to the use of long-term financing, including:

• Debt repayment commits the state to manyyears of fixed costs (debt plus interestrepayments);

• Bonding can fund lower-priority projects thatmay not be approved using cash (budget)financing; and

• Excessive bonding can affect state creditratings which could increase interest costs onfuture bond issues.

The widespread use of bonding by stategovernments suggests that the advantagesoutweigh the disadvantages.

States can Lease FacilitiesFinally, States can lease facilities. The mostcommon leasing arrangement, the lease purchaseagreement, has elements of traditional long-term


108

debt financing. Under lease-purchase agreements,states usually contract with state buildingauthorities to construct facilities. Those authoritiessell bonds to finance the construction and thenlease the facilities back to the states, which payrent for the facility operations, maintenance, anddebt service costs. Often, states acquire title to thefacilities once the bonds have been retired by thebuilding authorities.

Lease purchase agreements permit states to

finance capital construction projects withoutaffecting their debt limits, since independentauthorities have title to the property and alldebt service payments are accounted for asroutine operating expenditures, such as rentalpayments. Lease purchase agreements, likelong-term debt financing, spread the costs of thefacilities over their useful life. A disadvantage ofthe approach is that lease-purchase financinggenerally carries higher interest rates thangeneral obligation bonds issued by the state.

109


Credit enhancement is a term denoting thecredit of a stronger, more highly rated entity, thatcan be used to strengthen or enhance the creditor a lower rated entity. The nature and type ofcredit enhancements has grown substantiallyover the past two decades for many reasons,including:

• Investor concerns about the credit qualityunderlying issuers;

• Increasingly complex security features;

• Use in the short-term market; and

• Cost efficiency in the pricing of insurance.

A bond is said to be unenhanced if it carries onlyits own rating and not that of a private or publicinsurance. Various forms of enhancing state bond(debt) issues are briefly discussed in the sectionsbelow.

Annexure 5:

Credit EnhancementsBond InsuranceBond insurance is a legal commitment by aninsurance company to make payments ofprincipal and interest on debt in the event thatthe issuer is unable to make those payments ontime. Generally, such payments will be made asoriginally scheduled and the principal will notbe accelerated.68 Bond insurance generallycovers the full maturity range of the bonds. Therole of bond insurance in the market is:

• To reduce interest costs to issuers;

• To provide a high level of comfort (security)to investors; and

• To furnish improved secondary marketliquidity and price support.

There has been tremendous growth, forexample, in the use of bond insurance in the U.S.Figure 5A.1 illustrates this trend. Bond insurance

68 Principal will not be paid earlier than its scheduled maturity date.

Source: Thomson Financial Securities and Association of Financial Guaranty Insurers (Various Years).

Figure 5A.1: Bond Insurance as a Percentage of the Long-term New Issues Marketin the U.S. (1980-04)

500

450

400

350

300

250

200

150

100

50

0

1980 1985 1990 1995 2000

2 0

0.9

60.0%

50.0%

40.0%

30.0%

20.0%

10.0%

0.0%

Billi

on

s o

f Do

llars

Perc

ent

of L

on

g-t

erm

Issu

ance

Insu

red

Long-term Issuancewith Bond Insurance

Total Long-termIssuance Amount

Percent of Long-termIssuance Insured


110

has grown from 2.5 percent of the USD 46.3billion new-issue long market in 1980, to morethan 46 percent of the USD 464 billion new-issue long market in 2004. In the earliest years ofmunicipal (state) bond insurance, most of thenewly insured issues were general obligationbonds, whereas now most insured issues arerevenue bonds. In 2000, four major bondinsurers in the United States accounted for 97percent of the new-issue insured market. Bondstraded in the secondary market, unit investmenttrusts and private portfolios can also be insured.The two major insurers of bonds in the UnitedStates are the Municipal Bond InvestorsAssurance Corporation (MBIA Corporation) andthe Ambac Financial Group (AMBAC).

Although bond insurance provides significantadditional security to the investor, the issuers arethe first source for payment of principal andinterest on the bonds. For that reason, not allinsured bonds carry identical prices and yields.69

Partial Risk GuaranteesPartial guarantees assure payment of debtservice to lenders up to a specified level, thusaddressing long-term credit risk concerns.Partial guarantees can help lenders bettermanage their balance sheets and fundingoperations and therefore aim at facilitating theparticipation of local investors. Partialguarantees can also be specifically targeted toinstitutional investors [e.g. pension funds,insurance funds] who can provide extendedmaturities, but may not be willing to do so inspecific projects without a risk reducingguarantee. Two examples of policy risks

enhancement mechanisms include IBRD PartialRisk Guarantee (PRG) Facility and MIGA PoliticalRisk Insurance (PRI).

IBRD Partial Risk Guarantee (PRG) FacilityThis facility covers transactions withsubsovereign (state, local) governments with arelatively high risk profile. Governments canestablish a partial risk guarantee mechanism inthe event of a state government breach ofcontract risk. The IBRD Partial Risk GuaranteeFacility is described in Figure 5A.2. In theexample provided below, the infrastructurecorporation issues a bond, or contracts a loanwith a private lender, to finance the investment.The private investor is generally concernedabout the sustainability of the project, theability to sustain cost-recovery tariffs, and theability of state (local) governments to maintaintheir agreements.

Under the facility, the IBRD would provide apartial risk guarantee against the breach of tariffpolicy agreement by the state authority. Forexample, if the contract is breached because thegovernment administration called for a generalreduction in tariffs, the investor may not be ableto repay the bond or loan. In this event, theguarantee would be called, and the IBRD wouldmake payment under the guarantee and thenexercise a counter-guarantee with the centralgovernment. A partial risk guaranteemechanism has several advantages, including:

• It provides better financing terms throughspread reduction and maturity extension; and

• Incremental public debt is leveraged.

69 Other technical and tax-related considerations play a role in differentiating bond price and yield.

111


Figure 5A.2: The Partial Risk Guarantee Facility

CentralGovernment

The World Bank

Local/StateGovernment

Local InfrastructureUtility/Private Operator

or Investor

CommercialBank

Backstop of IBRD PartialRisk Guarantee

IBRD Partial Risk GuaranteeOperational and

Tariff Agreements

Bond/Loan

Fiscal Transfer Intercept

MIGA Political Risk Insurance (PRI)FacilityThis facility is used to cover transactions withintermediate policy risk, including coverageagainst local/state government breach ofcontract risk. The objective of the MIGA facilitywould be to cover investors in a range of risksincluding: war, civil disturbance, expropriation,and transfer restrictions include inconvertibility,and breach of contract at the subsovereignlevel.70

The MIGA risk facility would generally apply inthe case of equity investments, contracts andmany non-shareholder loans. Such coverage isalso available for management contracts andother cross-border investments.71 In addition,MIGA coverage may also be provided if theproject is supported by a subsidy scheme. In thiscase, the investor(s) may want to cover their riskagainst any breach by the government inproviding the subsidy funding.

70 Noel and Brezski (2004).71 Ibid, p 24.

Letter of CreditBank letters and bank lines of credit are otherforms of credit enhancement. Bank letters of creditare typically written for a much shorter term thanbond insurance. A letter of credit will pay theinvestor principal and accrued interest if an eventof default has occurred. A letter of credit isgenerally stronger than a line of credit and hasmany more conditions that must be satisfiedbefore it will pay the investor principal and interest.

Debt Service Reserve FundA debt service reserve fund is a fund in whichmoneys are placed which may be used to paydebt service if pledged revenues are insufficientto satisfy the debt service requirements. (SeeFigure 5A.3: Establishing a Reserve Account). Thedebt service reserve fund may be entirelyfunded with bond proceeds, or may only bepartly funded at the time of issuance andallowed to reach its full funding requirementover time. In other words, some project


112

revenues over time are used to fund this debtservice reserve fund.

If the debt service reserve fund is used in whole,or part, to pay debt service, the issuer is usuallyrequired to replenish the funds from the firstavailable funds or revenues. A typical reserverequirement might be the maximum aggregateannual debt service requirement for any yearremaining until the bond reaches maturity. The

size and investment of the reserve may besubject to regulations.

Establishing a Reserve Account may satisfy debtholders and reduce the cost of debt. The sourceof funds for such a reserve account may be theproject’s revenue or an independent third party.In either case, this increases the overall cost ofthe project as the funds in the reserve accountcould have been better invested.

RevenueOperations and

Maintenance Costs

Wages, Fuel, Electricity, Other RawMaterials

EBITDADebt Repayment

(Debt Service)Taxes

Profit

ReserveAccount

Figure 5A.3: Establishing a Reserve Account

113


Annexure 6:

Government Debt Instruments andSales Methods

Co

un

try

Stan

dar

d In

stru

men

ts a

nd

Mat

uri

ties

Oth

er In

stru

men

ts, D

eriv

ativ

esSe

llin

g T

ech

niq

ues

Pri

mar

y D

eale

rs

Can

ada

Cas

h m

anag

emen

t b

ills;

tre

asu

ry b

ills;

STRI

PS; i

nd

exed

-lin

ked

bo

nd

s;A

uct

ion

sYe

sg

ove

rnm

ent b

on

ds:

2, 3

, 5, 1

0, 3

0 yr

sn

on

mar

keta

ble

Can

ada

savi

ng

sb

on

ds;

in

tere

st s

wap

pro

gra

m

Fran

ceTr

easu

ry b

ills;

trea

sury

no

tes;

fu

ng

ible

Flo

atin

g r

ate

OAT

s ag

ain

st l

on

g-

or

Au

ctio

ns,

syn

dic

ate

for

Yes

go

vern

men

t b

on

ds

(OAT

s) –

10

year

ssh

ort

-ter

m b

ench

mar

k ra

tes;

fore

ign

bo

rro

win

gin

flat

ion

-in

dex

ed; T

reas

ury

is

auth

ori

zed

to

en

gag

e in

inte

rest

rat

e sw

aps

Ger

man

yTr

easu

ry d

isco

un

t n

ote

s 1-

2 ye

ars;

STRI

PSB

ank

syn

dic

ate

and

No

, fed

eral

bo

nd

med

ium

-ter

m f

eder

al n

ote

s:m

ult

iple

pri

ce a

uct

ion

con

sort

ium

4 ye

ars,

5 y

ears

sp

ecia

l fe

der

al n

ote

sfo

r lo

ng

-ter

m b

on

ds,

pri

vate

pla

cem

ents

Jap

anTr

easu

ry b

ills;

med

ium

-ter

m i

nte

rest

No

ne

Au

ctio

ns:

Syn

dic

ate

No

, un

der

wri

tin

gb

eari

ng

go

vern

men

t b

on

ds:

2-y

ears

;Sy

stem

fo

r 10

yea

rsy

nd

icat

em

ediu

m-t

erm

dis

cou

nt

go

vern

men

tb

on

ds

no

tes:

5 y

rs; L

on

g-t

erm

inte

rest

bea

rin

g g

ove

rnm

ent

bo

nd

s: 1

0 yr

s;Su

per

lo

ng

-ter

m i

nte

rest

bea

rin

gb

on

ds:

20

year

s

Swed

enTr

easu

ry b

ills;

Tre

asu

ry b

on

ds

Ind

ex-l

inke

d b

on

ds;

Au

ctio

ns

Yes

less

th

an 1

5 ye

ars

no

nm

arke

tab

le:

nat

ion

al s

avin

gs

syst

em; N

atio

nal

Deb

t A

cco

un

t:Sw

aps

for

fore

ign

cu

rren

cy d

ebt

Un

ited

Fixe

d r

ate

gilt

-ed

ged

sec

uri

ties

;ST

RIP

S, i

nfla

tio

n-i

nd

exed

Au

ctio

ns;

un

iform

pri

ceYe

sK

ing

do

mtr

easu

ry b

ills

inst

rum

ents

auct

ion

s fo

r lo

ng

-ter

man

d m

ult

iple

pri

ceau

ctio

ns

for

sho

rt-t

erm

inst

rum

ents

; au

tom

ated

auct

ion

s fo

r sh

ort

-,m

ediu

m-

and

lo

ng

-ter

min

stru

men

ts

Un

ited

Trea

sury

bill

s; Tr

easu

ry n

ote

s:ST

RIPS

(N

ote

s an

d B

on

ds)

;M

ost

ly A

uct

ion

Yes

Stat

es2,

3, 5

, 7, 1

0 ye

ars,

an

din

flat

ion

-in

dex

ed b

on

ds

(Mu

ltip

le P

rice

d)

Trea

sury

bo

nd

s


114

The state sells general obligation bonds into themarket place. The proceeds from the sale of thebonds are used to pay the cost of building thecapital projects that are approved by theLegislature.

The state’s Debt Management Policy has threegoals. They are:

1. Maintain/Regain Aaa/AAA bond ratings;

2. Minimize state borrowing costs; and

3. Provide a reasonable financing capacitywithin a prudent debt limit.

The Debt Management Policy has fiveguidelines. They are:

1. The general fund appropriation for debtservice shall not exceed 3.0 percent ofnondedicated revenues (Figure 7A.1);

2. General obligation debt shall not exceed2.5 percent of state personal incomerevenues (Figure 7A.2);

3. State agency debt shall not exceed3.5 percent of state personal incomerevenues (Figure 7A.3);

4. The total amount of state general obligationdebt, moral obligation debt, state bondguarantees, equipment capital leases, andreal estate leases are not to exceed5.0 percent of state personal incomerevenues (Figure 7A.4); and

5. Forty percent of general obligation debt shallbe due within five years and 70 percentwithin 10 years revenues (Figure 7A.5).

Debt Capacity Forecasts are released inFebruary and November of each year. The DebtCapacity Forecasts are used by the Governor and

Annexure 7:

Minnesota State Debt Management PolicyFigure 7A.1: General Fund Appropriation forDebt Service not to Exceed 3.0% ofNondedicated Revenues

3.00%

2.50%

2.00%

1.50%

1.00%

0.50%

0.00%

2.61%2.47%

2.64%2.43% 2.32%

2.06%

2.43%

2.69%2.49%

1994-95 1996-97 1998-99 2000-01 2002-03 2004-05 2006-07 2008-09 2010-11

Biennium

Figure 7A.2: General Obligation Debt not toExceed 2.5% of State Personal Income

1.85

1.80

1.75

1.70

1.65

1.60

1.55

1.50

1.45

1.73%1.76% 1.75%

1.59%

1.73%

1.80%1.82%

1.77%

1.58%

1994-95 1996-97 1998-99 2000-01 2002-03 2004-05 2006-07 2008-09 2010-11

Biennium

February 2006 Forecast

February 2006 Forecast

Figure 7A.3: State Agency Debt not toExceed 3.5% of State Personal Income

3.50%

3.00%

2.50%

2.00%

1.50%

1.00%

0.50%

0.00%

3.07%

1994-95 1996-97 1998-99 2000-01 2002-03 2004-05

Biennium

2.94% 2.98%

2.59%

3.01% 2.97%

115


Figure 7A.4: Total Amount of State GeneralObligation Debt, Moral Obligation Debt,State Bond Guarantees, Equipment CapitalLeases, and Real Estate Leases not to Exceed5.0% of State Personal Income

Figure 7A.5: General Obligation DebtEstimated Outstanding June 30, 2006

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

4.37% 4.23% 4.14%

3.64%3.84%

3.60%3.20% 3.03% 3.15%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Fiscal Year

3.03% 2.96%3.18%

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.02006 2010 2014 2018 2022 2026

Fiscal Year

Deb

t (U

SD i

n B

illio

ns)

40.0% within five years

70.7% within 10 years

General Obligation bonds carry the full faith andcredit of the state. This means that the state haspledged to levy a statewide property tax to paythe debt service costs. Instead of levying thestatewide property tax, the Legislatureappropriates from the general fund and otherfunds an amount of money sufficient to pay thedebt service on the bonds.

Article XI, Section 5, of the MinnesotaConstitution states the requirement forincurring public debt (general obligationbonds). Subdivision (a) states “to acquire and tobetter public lands and buildings and otherpublic improvements of a capital nature, and toprovide money to be appropriated or loaned toany agency or political subdivision of the statefor such purposes.”

This means that the constitution requires fourtests to be met:

• The project for which the bonds are to beissued must be publicly owned;

• The project must be a capital expenditure;

• The project must be a public purpose; and

• The purpose for which bonds are to be issuedmust be clearly set forth in the law.

What are the constitutional provisions for whichbonds may be issued?

• Repel invasion or suppress insurrection;

• Borrow temporarily;

• Refund outstanding bonds of the state or anyof its agencies;

• Establish and maintain highways;

• Promote forestation and prevent and abateforest fires;

the Legislature in the capital budget process.Forecasts of the cost of debt service are alsomade at the same time.

The state receives credit rating on its generalobligation bonds from three credit ratingagencies. The state’s current ratings are:

• Moody’s Investors Service Aa1;

• Standard & Poor’s Corporation AAA; and

• Fitch Ratings AAA.


116

Year Actual Year Forecast

2003 297,640,000 2007 404,975,000

2004 266,947,000 2008 416,899,000

2005 324,568,000 2009 472,981,000

2006 353,728,000 2010 433,293,000

2011 476,983,000

2012 456,318,000

2013 478,429,000

• Construct, improve and operate airports andother air navigation facilities;

• Develop the state’s agricultural resources byextending credit on real estate; and

• Improve and rehabilitate railroad right-of-way and other facilities whether public orprivate.

Debt Capacity Forecast — February 2006Minnesota Statute 16A.105 requires theCommissioner of Finance in February andNovember of each year to prepare a debtcapacity forecast to be delivered to thegovernor and the legislature.

Statement of IndebtednessThe state of Minnesota on February 1, 2006 hadUSD 3,565,445,000 of general obligation bondsoutstanding. The state has no general obligationnotes outstanding. The Laws of Minnesota 1991,Chapter 350, authorized the state to issuerevenue bonds secured by the state’s full faithand credit to finance the construction andequipping of an engine repair facility in Hibbingand an aircraft maintenance facility in Duluth.The state issued USD 47,670,000 of theserevenue bonds in May 1995 of whichUSD 36,850,000 remains outstanding. The state’sfull faith and credit secures all of the bonds.

Debt Service CostsThe debt service costs for the state’s generalobligation bonds are shown below. The amountsshown are the general fund costs by fiscal yearand include the amount of debt service paidfrom the sports and health club tax. In thisforecast, the assumption for future capitalbudgets is USD 560 million in even numberedlegislative sessions and USD 135 million in oddnumbered years.

Debt Authorized and UnissuedThe state has authorized and unissued generalobligation bonds totaling USD 1,040,385,600.

Future Debt CapacityFuture general obligation debt capacity isforecast through the 2012-13 biennium. To makethis forecast, many variables must be forecasted.Following are some of the numerous variablesthat are part of making this forecast.

The state’s debt management policy has aguideline that limits the appropriation for debtservice from the general fund to 3 percent ofgeneral fund revenues. The Department ofFinance revenue forecast is used for revenues inthe next two biennia and is increased in futureyears based upon projected economic growthfactors. The 3 percent limit under the guidelineis then used to estimate the maximum amountof general fund revenues available for debtservice.

Other variables that are considered as part of theforecast are interest rates on bonds sold, interestrates for investment earnings on balances in thedebt service fund and the bond proceeds fund,various receipts coming into the debt servicefund, cash flow on future capital projects, thedollar amount of bonds to be sold, and thetiming of the sale of bonds.

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The forecast of future debt capacity alsoassumes that major capital budgets will beapproved in the even numbered legislativesessions and small emergency capital budgetswill be approved in the odd numbered years.The assumption is that the large capital budgetsare passed by the legislature in level amounts.

Based upon all these assumptions, themaximum debt capacity for capital budgets ineven numbered years is USD 990,000,000 eacheven numbered year through 2012 and is USD135,000,000 in each odd numbered yearthrough 2013.


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The following road map is a series of logicalsteps that a state needs to consider in orderto establish a DIMC and implement theCS-DRMS Software.

Timing ConsiderationsA state should consider factors that affect thetiming of the DIMC implementation. At its core,the DIMC should enhance fiscal management. Akey component of fiscal management is thedevelopment of the annual budget. The FinanceDepartment should consider the advantages ofphasing in the budget-related components ofthe cell so that the staff could work into theirnew duties as the budget process unfolds.

Successful implementation could mean thatDIMC members would observe and learn asmuch as possible by having close organizationalaccess to the Finance Department’s processesand procedures in budget development. Itwould be impossible to have the new DIMC stafffully trained in time to participate in a full andmeaningful way in the first year’s budgetdecision-making, but it would be advantageousfor them to view the process from the vantagepoint of their new position in the DIMC.

As members become familiar with the processthey would play a more significant role in thebudget process during the next year. Moreover,being able to observe the budget presentationsto the Legislature could be useful to DIMCanalysts with prior finance departmentexperience and especially helpful for the DIMCstaff that come from other government andnongovernment organizations.

An aggressive approach to beginning an DIMC

Annexure 8:

DIMC and CS-DRMS ImplementationRoad Map

may be difficult. For instance, the leadership ofthe DIMC will be subjected to the intense timepressures that accompany any budget processand might find very little time to oversee thenew organization. In addition, some of the verypeople who might be drawn from their currentduties in other Government departments maybe in positions that are critical to theirdepartment’s budget development. Theirdeparture in the short-term could leave thedepartments in a difficult position.

The Finance Department must consider thetime pressures of the budget calendar.Accordingly, the state must be cognizant of thetiming of DIMC creation in context of theseimportant events.

DIMC Organizational DevelopmentStepsIn connection with the desire to initiate theDIMC as expediently as possible, the REFORMteam recommends these initial steps. The majorcategories and sub categories can be viewedas indicators of progress in implementing theroad map.

Step 1. Preimplementation Planning

• Obtain the concurrence of the key decisionmakers in the Department of Finance. Buy-inis critical.

• Determine conditions for the operation ofthe DIMC. Examples of these conditions couldinclude requiring a term of three to five yearsfor each posting, protecting the postingsfrom job transfers and job rotations.

• Decide the elements to be included in the

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DIMC such as the extent of including debtmanagement in the cell.

Step 2. Roll-out DIMC

• Issuance of a Government Order as soon aspossible will establish the DIMC formally. Theorder should define any special conditionsthat accompany its creation.

• Appoint the DIMC Director.

• Finalize job descriptions and positionqualifications.

Step 3. Staffing Activities

• Develop strategies for filling positions.Examples of these strategies could be torecruit or assign people from within theFinance Department or from within stategovernment, from public financial agencies.

• Decide strategy for filling positions such asreassignment, deputation, recruitment, andrecruitment from outside state government.

• Develop a timetable for staffing the DIMC.

• Establish the vehicle for contracting staff, foruse on a case-by-case basis, primarily forappointments from entities outside theGovernment structure.

• Find suitable candidates and create a list ofcandidates.

• Develop short lists and make finalappointments.

Step 4. Initiate Networks

• Identify state-based academic, institutes,professional associations that can assist inDIMC research activities.

• Officially invite organizations identifiedabove to nominate a member to serve as a

DIMC resource person.

• Determine compensation package forresource persons.

Step 5. Initial Training

• Develop training plan for each employee.

• After collaboration with training facilities forappropriate coursework, scheduleemployees for training according to theirneeds and training plan.

Step 6. Make Assignments for DIMC Members

• Assignments to DIMC.

• Officially appointment of resource persons.

Step 7. Formal Government Order Issued

• Defines scope of the DIMC.

• Defines relationship to state government.

• Officially appoints the DIMC Director.

• Appoints membership positions.

• Describes reporting protocol.

• Defines study protocol.

• Allocates budget line, offices, furnishings, andequipment.

Step 8. DIMC Operationalized

• Operationalize FPAC/DIMC with formal “kick-off” ceremony.

• Ensure regular — at least once a fiscal year —reporting to the state legislature and cabinet.

Step 9. Hold Regular Meetings

• Establish meeting protocol regarding aquorum and venue.

• Ensure circulation of meeting agenda in


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advance of meetings.

• Schedule regular meetings of DIMCmembers and resource persons.

• Ensure participation of Finance Secretary orhis designate in meetings.

• Prepare and circulate detailed minutes withclear follow-up action.

Step 10. Prepare Regular Reports

• Establish report format and periodicity —e.g., biannual reports.

• Determine report recipients.

• Post on Web site under the Right toInformation (RTI) legislation.

Step 11. Publish Completed Studies

• Establish a publication format and periodicity— e.g., annual reports.

• Determine circulation list, which shouldinclude — at a minimum — the ChiefMinister, his cabinet, principal departmentalsecretaries, and all state legislators.


CS-DRMS Implementation StepsIn connection with the desire to initiate theFPAC as expediently as possible, the REFORMteam recommends these initial steps. The majorcategories and subcategories can be viewed asindicators of progress in implementing theroad map.

Step 1. Preimplementation Planning

• Obtain the concurrence of the key decisionmakers in the Department of Finance. Buy-in

is critical.

• Determine conditions for the operation ofthe FPAC. Examples of these conditions couldinclude requiring a term of three to five yearsfor each posting, protecting the postingsfrom job transfers and job rotations.

• Decide the elements to be included in theFPAC such as the extent of including debtmanagement in the cell.

Step 2. Collect Debt Data

• Issuance of a Government Order as soon aspossible will establish the FPAC formally. Theorder should define any special conditionsthat accompany its creation.

• Appoint the FPAC Director.

• Finalize job descriptions and positionqualifications.

Step 3. Assemble Dataset

• Develop strategies for filling positions.Examples of these strategies could be torecruit or assign people from within theFinance Department or from within stategovernment, from public financial agencies.

• Decide strategy for filling positions such asreassignment, deputation, recruitment, andrecruitment from outside state government.

• Develop a timetable for staffing the FPAC.

• Establish the vehicle for contracting staff, foruse on a case-by-case basis, primarily forappointments from entities outside theGovernment structure.

• Find suitable candidates and create a list ofcandidates.

• Develop short lists and make final

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appointments.

Step 4. Create MS Excel Database

• Identify state-based academic, institutes,professional associations that can assist inFPAC research activities.

• Officially invite organizations identifiedabove to nominate a member to serve as aFPAC resource person.

• Determine compensation package forresource persons.

Step 5. Initial CS-DRMS Training

• Develop training plan for each employee.

• After collaboration with training facilities forappropriate coursework, scheduleemployees for training according to theirneeds and training plan.

Step 6. Make Assignments for DRMS TeamMembers

• Department assignments for ExpenditureBudget Analysts.

• Assignments to DIMC.

• Assignments to Tax Analysis Wing.

• Assignments to Revenue Forecasting Wing.

• Officially appointment resource persons.

Step 7. Migration of MS-Excel Database toCS-DRMS Database

• Defines scope of the FPAC.

• Defines relationship to state government.

• Officially appoints the FPAC Director.

• Appoints membership positions.

• Describes reporting protocol.

• Defines study protocol.

• Allocates budget line, offices, furnishings, andequipment.

Step 8. CS-DRMS Monitoring and QualityControl Visit

• Operationalize FPAC/DIMC with formal “kick-off” ceremony.

• Ensure regular — at least once a fiscal year —reporting to the state legislature and cabinet.

Step 9. Regular Collection of Debt Data

• Establish meeting protocol regarding aquorum and venue.

• Ensure circulation of meeting agenda inadvance of meetings.

• Schedule regular meetings of FPAC membersand resource persons.

• Ensure participation of Finance Secretary orhis designate in meetings.

• Prepare and circulate detailed minutes withclear follow-up action.

Step 10. Prepare Regular Reports

• Establish report format and periodicity —e.g., biannual reports.

• Determine report recipients.

• Post on web site under the Right toInformation (RTI) legislation.

Step 11. Publish Completed Studies

• Establish a publication format and periodicity— e.g., annual reports.


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• Determine circulation list, which shouldinclude — at a minimum — the ChiefMinister, his cabinet, principal departmentalsecretaries, and all state legislators.


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Annexure 9:

Public Debt Management LinksVirtual Links

www.kar.nic.inNational Informatics Centre, Karnataka State Unit…Please note that this page also provides links tothe Web sites/web pages of Government Ministries/Departments/Organizations.

http://jharkhand.nic.in/NIC, Jharkhand State Unit, Ranchi.

www.cgg.org.inEstablished by the state Government to plan and guide governance reforms in Andhra Pradesh.

http://www.sustainable.ufl.edu/indicators.pdfThis report was prepared in accordance with the Global Reporting Initiative’s (GRI) June 2000Sustainability Reporting Guidelines. The mission of the GRI is to promote international harmonizationin the reporting of relevant and credible corporate economic, environmental, and socialperformance information to enhance responsible decision-making……

Professional Societies

www.cbpsindia.orgThe Centre for Budget and Policy Studies was formed in January 1998. It is an independent,nonpartisan, not for profits society based in Bangalore……..The mission of the Society is tocontribute through research to understanding and implementing a process of sustainable andequitable development in India, with a focus on the local level. In this process, the budget process isa very useful tool to work with………………

www.cbpp.orgThe Center on Budget and Policy Priorities is one of the nation’s premier policy organizationsworking at the federal and state levels on fiscal policy and public programs that affect low- andmoderate-income families and individuals.

www.icma.orgThe Center on Budget and Policy Priorities is an international association that assists localgovernment officials to improve public service delivery and governance. There are some interestingbudget-related documents and newsletter articles available on their Web site. Their monthlynewsletter is called the ICMA Public Management Magazine.

www.gfoa.orgThe Government Finance Officers Association (GFAO) is the premier public budget and financeofficers professional society in the United States. There are many informative public financemanagement-related documents and links available on their Web site.


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Ablo, Emmanuel and Ritva Reinikka 1998 “DoBudgets Really Matter? Evidence from PublicSpending on Education and Health in Uganda”Policy Research Working Paper 1926, AfricaRegion, Macroeconomics 2, Washington, D.C.:The World Bank.

Arnone, Marco and George Iden 2003 ‘PrimaryDealers in Government Securities: PolicyIssues and Selected Countries’ Experience’,IMF Working Paper, No. 45, March 2003.

Baker, Martin L. 2002 “An Alternative Model forFinancing Water Projects” UnpublishedMimeograph Inter-American DevelopmentBank Washington, D.C.

Bagchi, Soumen 2001 Financing CapitalInvestments in Urban Infrastructure-Constraints in Accessing Capital Market byUrban Local Bodies; Economic and PoliticalWeekly; January 27 – February 2, 2001.

Bagchi, Soumen and Anirban Kundu 2003Development of Municipal Bond Market inIndia- Issues Concerning Financing of UrbanInfrastructure; Economic and Political Weekly;February 22-28, 2003.

Bardhan, Pranab and Dilip Mookherjee,Expenditure decentralization and thedelivery of public services in developingcountries, IED Discussion Paper, BostonUniversity, 1998.

Battelino, R. 2004 “Recent Developments inAsian Bond Markets”; Address by R. Battelino,Assistant Governor (Financial Markets) atAustralian Banking and Finance Conference.

Annexure 10:

BibliographyBird, Richard. 2003 “Fiscal Flows, Fiscal Balance,

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______________. 2001. “IntergovernmentalFiscal Transfers: Some Lessons fromInternational Experience.” UnpublishedPaper.

Brixi, Hana and Ashoka Mody 2000 “Priorities forthe Management of Contingent Liabilities”Draft World Bank: Washington D.C.

Campos, J Edgardo and Sanjay Pradhan 1996“Budgetary Institutions and ExpenditureOutcomes: Binding Governments to FiscalPerformance” Policy Research Working PaperNo. 1646. Washington, D.C.: World Bank.

Cassard, Marcel and David Folkerts-Landau 1997Risk Management of Sovereign Assets andLiabilities IMF Working Paper WP/97/166.

Caselli, Francisco, Alberto Giovannini, andTimothy Lane 1998 “Fiscal Discipline and theCost of Public Service Debt Service: SomeEstimates for OECD Countries.” IMF WorkingPaper WP/98/55 IMF: Washington, D.C.

Daher, Samir El 1999 “Credit Ratings-AnIntroduction (and the Case of Sub- sovereignRatings” World Bank Infrastructure Notes:Urban No.FM- 8c.

Diana Tom 2005 “Credit Risk Analysis and CreditScoring- Now and in Future; Business Creditpublished by National Association of CreditManagement.

Feldstein, Martin 2004 ‘Budget Deficits andNational Debt’, L.K.Memorial Lecture at

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Lewis, Christopher and Ashoka Mody 1997 “TheManagement of Contingent Liabilities: A RiskManagement Framework for NationalGovernments” In Timothy Irwin, MichaelKlein, Guillermo Perry, and Mateen Thobani,eds., “Dealing with Public Risk in PrivateInfrastructure.” World Bank Latin Americanand Caribbean Studies. Washington D.C.: TheWorld Bank.

Mahoney, Christopher 2002 The Bond RatingProcess: A Progress Report; Moody’s InvestorsServices- Global Credit Research; February2002.

McDaniel, Raymond 2003 The Role and Functionof Rating Agencies: Evolving Perceptions andthe Implications for Regulatory Oversight;Report based on speech presented to theAssociation of French Treasurers (AFTE) byPresident- Moody’s Investors’ Services.

Mohan, Rakesh 2004a ‘A Decade of Reforms inGovernment Securities Market in India andRoad Ahead’, Reserve Bank of India Bulletin,November, pp. 1009-27, Mumbai.

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Fitch Ratings “The 12 Habits of Highly SuccessfulFinance Officers” November 21, 2002, Pages3-7.

Freire, Mila and John Peterson “SubnationalCapital Markets in Developing Countries:From Theory to Practice” World Bank and OUP,2004 Pages 111- 129 and 159-161

Hope, Janet 2003 “Municipal Finance in Ontario”presentation to expert panel: Long-TermWater and Wastewater InfrastructureInvestment and Financing Strategy, Ministryof Municipal Affairs and Housing.

Government of India 2000 The Constitution ofIndia, Ministry of Law, Justice and Companyaffairs, New Delhi.

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Indo-US Financial Institutions Reform andExpansion Project – Debt Market Component(FIRE (D)) ‘Project Notes: Pooled FinanceModel For Water and Sanitation Projects: TheTamil Nadu Water and Sanitation Pooled Fund(WSPF)” Note No. 31 May 2003.

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Mohan, Rakesh 2004b ‘Debt Markets in India:Issues and Prospects’, Reserve Bank ofIndiaBulletin, December, pp. 1091-1100,Mumbai.

Mohan, Rakesh 2006 ‘Recent Trends in the IndianDebt Market and Current Initiatives’,www.rbi.org.in

Noel, Michel and W. Jan Brzeski 2004 “MobilizingPrivate Finance for Local Infrastructure inEurope and Central Asia” Washington, DC: TheWorld Bank.

NSE 2005 ‘Indian Securities Market: A Review’, VolVIII, 2005, National Stock Exchange of India,www.nseindia.com

Peterson, George, 1997 “Building Local CreditSystems” Revised Urban ManagementProgram Discussion Paper, Urban Institute.

Peterson, George, 1998 “Measuring LocalGovernment Credit Risk and Improving LocalCreditworthiness”; Washington, D.C.: TheWorld Bank.

Madhav, Pradeep, 2006 “Market Borrowing byIndian States” , presentation to the NationalWorkshop on State Creditworthiness and BondIssuances, REFORM Project, USAID/India,August 31-September 2006, New Delhi.

Rajaraman I., S. Bhide and R.K Pattnaik 2005 AStudy of Debt Sustainability at State Level inIndia, Reserve Bank of India, Mumbai.

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Economic and Political Weekly, Mumbai, 15November 2003, pp. 4851-8.

Rangarajan, C. and D.K. Srivastava 2005 ‘FiscalDeficits and Government Debt: Implicationsfor Growth and Stabilisation’, Economic andPolitical Weekly, Mumbai, pp. 2919-33.

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Annexure 11

Toward ImprovingDebt and InvestmentManagement at theIndian State Level:Case Studies of Jharkhand,Karnataka and Uttarakhand


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The following Parts provide a comparativeaccount of how the REFORM Project state teamsin Jharkhand, Karnataka, and Uttarakhandimplemented their various debt and investmentmanagement reform activities. These accountsdiscuss the implementation methodology, workplan execution, operational challenges and howthese were dealt with and, finally, the results ofthis work. Finally, these state team accounts havebeen approved by each respective stategovernment counterpart for use in thiscompendium.

The Debt and Investment Managementinterventions of the REFORM Project weredesigned to assist state governments to have awell-defined debt management program todocument, track, and assess implications of debt,contingent liabilities and investments on states'financial health on medium- and long-term basis.The pre-existing gap between state liabilities andthe state governments' knowledge and proactivemanagement of its debt portfolio led to a numberof negative consequences in the expenditurepractices, namely:

• Total current state-held debt is one-third(33 percent) of gross State domestic product;

• All Indian State governments spend at leastone-fifth (20 percent) of total expenditures ondebt servicing;

• Interest payments alone constitute at leastone-fourth (25 percent) of revenue receipts;

• High state debt service payment obligationsvery simply imply:

– Less funding available for infrastructure(e.g., water, sanitation, roads);

– Less funding available for social sectors(e.g., Education, Health);

Part 1:

Overview

• All States sector spending equals:

– Education Sector—Five (5 percent) percentof total spending;

– Health Sector—less than one and a halfpercent (1.4 percent) of total spending;

– Water and Sanitation—less than onepercent (0.76 percent) of total spending;and

– Urban Development—less than one-halfpercent (0.47 percent) of total spending.

Developed countries with developed marketsand a wide investor base face relatively low andeasily manageable risks in debt management.Even high debt levels can be financed in thedomestic markets, and while high deficits willonly result in increasing spreads, this may beenough for macroeconomic policy to considerfiscal improvements. Since debt structures areusually good any yield increases are gradual,drastic fiscal cuts can be avoided. With smallcurrency borrowing, the temporary extrafinancing needs could be covered until economicproblems are resolved. There the public debtmanagers of many developed country economiesusually have many alternatives and marketproblems have relatively modest and gradualeffects on the budget. Of course, in case of excessfiscal policy, even in a developed country mayface severe consequences, but these appear onvery high and increase debt level.

Developing market state and national governmentsconfront more difficult situations in public debtmanagement. The reasons for that are widespread.India, for example, has a relatively small capitalmarket. Unsuccessful issuances will not only meanless money for the government, but throughdecreasing investor's confidence maturing short-term debt will not be renewed and a severe


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Figure 11A1.1: Vicious Debt and Investment Management Process

1. Politically-basedPrograms

Politicians propose programs towin political office. They proceed todeliver on promises withoutconsidering fiscal and debtimplications of these programs onstate budgets

4. State fiscal conditionweakens. State may have

great difficulty in servicingdebt unable to service

debt

State may have to readjust prioritiesto service debt. Reduction in socialservices, education, health may be asignificant issue

2. No analysis of availablebudget or fiscal and debt

servicing implications

Projects are selected and fundingmobilized without any analysis ofthe long-term fiscal and debtsustainability impact(s) of theprogram

5. Precarious Stategovernment fiscal and

debt servicing may causeinterest rates/yields to

rise

Investors lose confidence,short-term and long-term stateborrowing more expensive. Thisimplies long-term state economicgrowth will be adversely impacted

3. Governmentcommitments made

State commits to long-term debtcommitments, andintergenerational, equity ofprojects. However, impact on statefiscal condition and long-term fiscalsustainability may not have beentaken under consideration

6. Long-term base linegrowth may be reduced

Higher cost of debt reduces andmakes more expensive the creationof capital assets (electricity), socialassets (schools, hospitals). Thisimplies that states becomeuncompetitive with other states forcapital and economic growth

Figure 11A1.2: Virtuous Debt and InvestmentManagement Process

1. Effective DebtManagement

States properly record debt andstate cash flow. States regularlyreview debt sustainability levels

2. Access to up to datedata on debt, contingent

liabilities and investmentsenable states to bettermanage their debt and

manage their investmentportfolios

Effective portfolio (debt andinvestment) management,translates “directly” to lower cost ofcapital (lower interest rates) andlower state government borrowingrisk

3. Reduced state governmentmarket borrowing risk

implies lower cost of capitalfor the creation of capital

assets (roads, schools,hospitals)

More schools, hospitals, roads,sanitation systems, etc., can beprudently financed. This impliesthat the state government canmore readily compete for privatesector investment. Hence, stategovernments can potentiallyexpect higher than baselineprojection economic growth levels

financing problem can evolve. There are many risksthat state governments and their debt managersare facing, therefore, a prudent approach is needed.Asset liability management as proposed byREFORMS debt and investment management unit isa tool normally used for private companies orfinancial companies, like asset managers. The idea isthat market risks and/or financial risks can bemanaged or limited on an acceptable level if theassets and the liabilities are maintained with similarrisk characteristics. Any deviation in the value of theliabilities (e.g., debt) will be followed by a similarmovement in the value of assets therefore the netvalue of that state governments assets will belargely unaffected.

To this end, REFORM offered a complete set ofexpertise covering all phases of debt andinvestment management. Specifically:

• Development of practical manuals in debt,investment, and contingent liability management;

Note : Vicious process refers to a situation where a series of actions leads to increasingly negative results

Note : Virtuous process refers to a situation where a series of actionsleads to increasingly positive results


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• Preparation of the operational terms of

reference and protocols for the DIMC;

• Consolidation of all state debt, investment, andcontingent liability data into one Microsoft

(MS) Excel dataset;

• Preparation of a guide for improving statecreditworthiness and bond issuance;

• Development of reporting templates andprotocols for use by the DIMC;

• Training and implementation of theCommonwealth Secretariat—Debt Recordingand Management System (CS-DRMS) software;

and

• Supervising migration of the MS-Excel datasetto the CS-DRMS Oracle database and

subsequent report generation.

Table 11A1.1 shows the debt and investment

management achievements of the REFORMProject in its three (3) partner states—Jharkhand,Karnataka, and Uttarakhand—as well as

nationally:

Finally, the REFORM team has learned the

following key lessons that can be leveraged byother state governments interested inintroducing new expenditure management tools

and techniques:

• The passage of the Fiscal Responsibility and

Budget Management (FRBM) Act provides thelegal and operational context in which debtand investment management work will take

place;

• Obtaining the early and strong andcoordinated support from the Principal

Finance Secretary, the state Comptroller and

Auditor General, and—if present—the state

RBI office—will greatly facilitate launching thedebt management capacity-building anddataset compilation and consolidation

programs in each partner state;

• Consolidating all state debt, contingentliability and investment data is a critical step in

proactive debt portfolio management;

• Appointment of dedicated debt cell (DIMC)team members creates the critical mass and

requisite team cohesion and continuityneeded for the consistent and disciplinedmanagement of a state debt and investment

portfolio;

• Appointing a team of debt cell officersproficient in the use of MS Excel and other

software applications is essential to ensurecompilation, maintenance and migration ofthe initial data set to the Oracle-based

CS-DRMS database;

• Passage of Government Orders (GO) requiring

the use of the CS-DRMS software for debt andcontingent liability reporting as appendixes tothe annual budget submission to the state

legislature ensures maintenance of a valid andcurrent debt database and reporting of thesame;

• Official request for the involvement of theGovernment of India (GoI) Ministry of Finance(MoF) provides, enables and facilitates

implementation of the CS-DRMS software;

• A good operational relationship between thestate finance department and the State

Auditor General (SAG) to ensure access tocurrent and accurate debt, investment,expenditure, and contingent liability data for

populating the CS-DRMS database; and


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Government

Jharkhand

Karnataka

Achievement

GoJ has established an FPACand DIMC unit (as previouslyreported). The DIMC unit hasone active (albeit part-time)member

GoJ has introduced CS-DRMSinto their normal operationalenvironment

REFORM provided stategovernment officials withdebt data templates to beginthe task of collecting debt,contingent liability andinvestment data moresystematically

Created a Debt andInvestment Management Cell(DIMC) which would betasked with analyzing,evaluating, monitoring andmanaging the State’s debt,investments and guarantees(contingent liabilities)

Impact

• The DIMC member taskedwith standardizing debtreporting requirementsalong the linesrecommended by REFORM

• DIMC/FPAC is tasked withregular governmentanalytical reporting; and

• DIMC must now present areport on current GoJ debtsustainability levels,establishing stategovernment benchmarks,and developing a state debt"traffic" light warning signalof indicators

Previous debt and contingentliability datasets have nowbeen migrated to theOracle-based CS-DRMSdatabase

GoJ and the debt unit of thestate’s FPAC began toreorganize the data along thelines REFORM suggested

DIMC is reporting along linessuggested by REFORM buthave adjusted to theirparticular reportingrequirements

Leveraging

State budget line and staffappointments to DIMC

State budget line and staffappointments to DIMCCS-DRMS team; andCommonwealth Secretariatfunding and technical supportfor use and maintenance ofthe CS-DRMS databases


Table 11A1.1: REFORM Project Initiatives, Impact and Leveraging


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Achievement Impact Leveraging

Karnataka GoK has introduced CS-DRMSinto their normal operationalenvironment

Developed and delivered anoperation and proceduresmanual has also beendeveloped in three parts toassist practitioners with themonitoring and managementof state government debt,investments and governmentguarantees

Provided debt preparationtables to begin the process ofdocumenting debt in a morecomprehensive and systematicmanner

Provided GoK offices with anInvestment analysis andinternal procedures manual forevaluating state governmentinvestments

Training and reference materialfor the effective managementof state government debt,investment and guarantees togovernment officers to enablethe Government of Karnatakato carry these operations in asustainable manner


• GoK data assembly templatesto collate all (paperbound)state government explicitcontingent liabilities intoconsolidated guaranteetables

• The GoK is now using thesetables to gradually assembleits explicit guarantees in asystematic manner

GoK established a stateinvestment department whichis currently using many of thetemplates and reportingstreams proposed by REFORM

State budget line and staffappointments to DIMCCS-DRMS team; andCommonwealth Secretariatfunding and technical supportfor use and maintenance of theCS-DRMS databases

Table 11A1.1: REFORM Project Initiatives, Impact and Leveraging (Contd.)

Government


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Government Achievement Impact Leveraging

Uttarakhand

Government ofIndia

GoU has established a DIMCunit, which has one active(albeit part-time) member

GoU has introduced CS-DRMSinto their normal operationalenvironment

GoU assembled stategovernment debt informationin a single consolidatedspreadsheet

State government officialshave accepted the investmentmanual

Introduction of internationalbest practice debtmanagement software toimprove management of statedebt as well as to track andmanage contingent liabilitiesat the subnational level

Debt Toolkit (with guidelinesdeveloped for debt, issuance ofstate guarantees, investment,and creditworthiness) hasbeen finalized

Construction of reportingstructures for state investmentto track, report on and improveits management

The DIMC member has beentasked with standardizing debtreporting requirements alongthe lines recommended byREFORM. Further, the DIMC/FPAC is currently tasked withregular government analyticalreporting


State officials used thesuggested templates (more orless) as guidelines for datacollection

State government officials havealready begun the task ofcollecting state governmentinvestment data along the linessuggested by REFORM

The CS-DRMS softwareimplementation in all three (3)REFORM partner states hasprovided invaluable fieldexperience for suchsubnational implementationsin India and elsewhere in theworld

Guidelines are helping partnerstate governments toproactively manage their debt,contingent liability andinvestment portfolios

Reporting structures are beingused by REFORM partner stategovernments to improve theirmanagement, tracking andreporting on publicinvestments


State budget line and staffappointments to DIMCCS-DRMS team; andCommonwealth Secretariatfunding and technicalsupport for use andmaintenance of the CS-DRMSdatabases

As the first-ever CS-DRMSsubnational implementationin the world, this experienceshould be able to providevaluable lessons learned forother Indian and non-Indiansubnational governments.

These guidelines can be usedby other Indian stategovernments considering theissuance of state guarantees

These reporting structurescan be used by other Indianstate governments toimprove their management,tracking and reporting onpublic investments

Table 11A1.1: REFORM Project Initiatives, Impact and Leveraging (Contd.)


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• Periodic press coverage of state debt andinvestment management efforts of the stategovernment helped to engender public andpolitical interest in these reform efforts that,in turn, reinforces and compels the stategovernment to continue down thereform path.

The following Parts describe the actual debtand management work experiences of all threeREFORM project state teams. These workexperiences discuss tool and techniqueimplementation methodology, operationalchallenges and outcomes, and thelessons learned.


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Indian states had the distinction of being amongthe most highly leveraged subnationalgovernments in the world. In 2000-01, the WorldBank estimated that the combined debt-to-revenue ratio of India's states was as high as203 percent, compared to the World Bank'sestimates of 189 percent for the fiscal federationin Canada in that same period, 170 percent inBrazil, and 44 percent in the United States. Thisindebtedness was attributed to the stateshabitually spending more than their budgetaryresources. The inadequacy of budgetary resourcesmeant that states had to fund current spendingby incurring debt and accumulating interestliabilities. Persistent revenue deficits and an everincreasing interest bill caused subnational debt toburgeon leading to a fiscal crisis at the state levelin fiscal year 2000 (FY2000) (Figure 11A2.1).

The FY2000 crisis gave an enormous impetus toreforms advocated by the Twelfth FinanceCommission (“TFC”), a constitutionallyestablished independent fiscal agency convened

Part 2:

The Challenges of State Debt Management

Figure 11A2.1: State Debt-to-GSDP Ratio(Uttarakhand 2003-04; All Other States 2001-02)

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Source: Government of India (GoI), Ministry of Finance (MoF), Reserve Bank of India (RBI), State Governments (Various).

every five years. In brief, the TFC determines thedevolution of resources from the Centre to thestates. The TFC recommended that the Centrestop lending to states, forcing them to approachthe market for funds, that outstanding loans fromthe Centre to the states be consolidated andrescheduled at a lower interest rate, and that debtrelive by way of write-offs by linked to a reductionin revenue deficits. State government marketborrowing had largely been limited through theReserve Bank of India (RBI). However, the TFCsrecommendation to discontinue centralgovernment loans to state governments for planfunding required Indian states to mobilize largerresources from the market.

Trends and PracticesThe states relative freedom to borrow resulted inthe breach of constitutional borrowing limits anddeteriorating fiscal deficits over time. Thebreaching of constitutional limits could in part beattributed to institutional factors. Indian states arerequired to incur a certain amount of expenditure


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under their five-year plans. In brief, these areeconomic development agendas mapped out bythe Planning Commission and bilaterallynegotiated between the state government(s) andthe Planning Commission. The centralgovernment provides part of the resources forthese plans by way of loans and grants. Indianstate governments are required to provide theremainder either from their own tax and nontaxrevenues or through debt from other sources.Neither state governments nor the PlanningCommission were required to undertake anysystematic evaluation of state debt sustainabilitybefore the borrowing limits for state plans arenegotiated. Heretofore, this institutionalarrangement is one of the reasons why state debtlevels escalated (Figure 11A2.2). The totaloutstanding liabilities of Indian stategovernments increased from an average of21 percent of GDP for FY91-FY00 to 29.3 percentfor FY01-FY05. Debt growth averaged about16 percent in FY91-FY00 period. It hassince moderated.

State government debt composition was alreadybeginning to change. A snapshot of state

Figure 11A2.2: Indian State Debt Growth(1991-06)

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government borrowing over a 15-year period(1991-2006) indicates that state governmentsincreasingly approached the market to raiseresources. Additionally, a sharp decline in theproportion of loans from the centre occurred—primarily on account of the reclassification ofloans from small savings funds. Nevertheless, in2004-06 the relatively high cost small savingsfunds remained a primary source of aboutone-fifth of state debt.

Figure 11A2.3 provides a portrait of selectedstate level interest payments as a percent oftotal revenue receipts for 2002-03. Thebenchmark used by the Ministry of Finance(MoF), Government of India (GoI) is 18 percent(interest payment as a percent of total revenuereceipt). In other words, all states whoseinterest payment are greater than or equal to18 percent are considered to be financiallydistressed. In 2002-03, virtually all Indian stategovernments found themselves above thethreshold eighteen (18 percent) level. With therestructuring of its long-term high interest rateloans to the Centre, REFORM project states(Jharkhand, Karnataka, and Uttarakhand72)

72 The state of Uttaranchal changed their name to Uttarakhand in 2004-05.

Figure 11A2.3: Interest Payments as % ofRevenue Receipt (FY 2002-03)

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were able to reduce their near-term interestrate burden and fall below or hover marginallyabove the benchmark threshold.

The tougher budget constraints that Indian stategovernments faced prompted them to shift a lotof financing activities off-budget. The mostsignificant off-budget liabilities for stategovernments have been those arising fromsubsidies to the power sector. State governmentguarantees were increasingly used to supportborrowing via special-purpose vehicles. Theseguarantees should be considered as actual ratherthan contingent liabilities, as they will devolveinto the state budget should they be invoked.

Indian State Governments: Gaps toModern Debt Management PracticesA historical snapshot of Jharkhand, Karnataka andUttarakhand prior to USAID-REFORM interventionindicates varying levels of debt managementcapacity. In 2002-03, Uttarakhand and Jharkhand,being newly established states, had nascentability to manage debt. Karnataka was moresophisticated with its debt recording andmanagement analysis ability. A generalizedreview of state debt management abilityindicates that state debt (and contingent liabilitymanagement) did not correspond to thedemands placed on a modern system of statedebt and liquidity management. In brief:

• The determination of strategic goals in amidterm and long-term horizon was missing.Decision-making was supported with limitedfinancial analysis and forecasting;

• There was no integrated information system inplace. Recording of debt, contingent liabilities,and state government investments at thestate level was ambiguous, nontransparentand inexact;

• Debt service calculation was performed viamanual inputs without additional preparationand controls;

• There was a total absence of risk managementsystems and analysis: Risk management frommethodology of risk analysis, throughmonitoring and evaluation are completelynonexistent. A brief case-in-point, the longterm debt forecast is contingent onmacroeconomic projections on the fiscalstance made by the state’s Department ofFinance. There is some basic sensitivity analysisperformed in terms of alternative scenario. Yet,there was no systematic evaluation of risks tothe state budget and the potential riskcontribution of a certain debt structurestrategy within the present framework; and

• Uttarakhand, Jharkhand and Karnataka neededto strengthen its legal framework for debtmanagement; upgrade its staff capabilities todeal with debt management issues; and improvethe information available for debt managementtracking and reporting through new orexpanded automation capabilities.

A critical issue was how to improve stategovernment debt accountability and monitoringand to increase the access of state governmentsto financial markets, broadly defined as thebanking system and the securities market.Information and state government accountabilityare key factors in the effective operation of statedebt markets. Assessment of risk, crucial fordetermining the cost of capital, requires stategovernments to produce reliable, complete andtimely financial information. Without thediscipline of the hard budget constraint, financialmarkets and credit assessors have little reason todistinguish among the various state governmentcredits, and the rationale for market allocation ofresources is consequently lost.


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Did the State Governments have theCapacity to Succeed?Jharkhand and Uttarakhand should be viewedunder a different set of optics than Karnataka.Both Jharkhand and Uttarakhand were newlycreated states with reasonably well trained andforward thinking Finance Departments.However, as newly created states they werelacking in human resource capacity. Conversely,Karnataka a long-standing state that has beenreasonably well managed could devoteresources to improving its fiscal managementoperations.

Were Indian State GovernmentsForward Looking?The FY2000 subnational debt crisis gave anenormous impetus to reforms and theintroduction of numerous polices aimed at fiscalrationalization at the federal and state levels. Onthe debt front the TFC recommended that GoIshould stop providing loans to the states and thatthe states should take recourse to the financialmarkets for meeting their borrowingrequirements. The TFC recommended theconsolidation of existing debt extended by thecentre to the states up to FY2004 andoutstanding at FY2005, conditional on the statesadopting Fiscal Responsibility and BudgetManagement (“FRBM”) legislation.

Figure 11A2.4 provides an illustration of therestructured Uttarakhand restructured debt andestimated repayment of bullet bond maturitydates under a "no change" in fiscal responsibilityscenario. In effect, without the leverage of fiscalresponsibility fiscal deficits and mounting debtwould once again begin to overwhelm statefinances. However, the leverage of fiscalresponsibility legislation forced Indian states tobegin to tighten finances, introduce financial

Figure 11A2.4: Uttarakhand Interest andPrincipal Debt Repayment Forecast(FY 2002-18)

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management reforms, and proactively keep theirfiscal house in order. The newly created states,Jharkhand and Uttaranchal began thecumbersome process of archiving their financialliabilities (balance and off-balance) and began toundertake basic cash flow (debt service) analysisfor their primary outstanding obligations.

Historically, Indian states have been able to raisethe greater part of their funds from the market onequal terms (i.e., terms that do not reflect theirindependent creditworthiness). This is becausethe Reserve Bank of India (RBI), which acts as amerchant banker to the states, packages a mix ofbonds issued by different states under anumbrella tap tranche, whereby a targeted amountof combined borrowings for all states are raised ata predetermined coupon without specifying theindividual state. As a result, RBI encouragedinvestors to buy paper with varied credit risks atthe same rate. This in effect, caused bettermanaged states to cross-subsidize the worsemanaged states. When states were first allowed toapproach the market individually in 1999-2000,using the auction method, with a predetermined


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notified amount, but not a predeterminedcoupon rate, states with better financials couldavail themselves with more favorable borrowingterms. This act alone precipitated the need forstates to not only get their fiscal house in order,but has prompted state treasuries to proactivelymanage their debt.

As a reasonably well-off and long-standing state,Karnataka had different debt issues to confrontthan did Jharkhand and Uttarakhand. Even in2003-04, Karnataka had a reasonably robust"shadow credit" rating provided by the various

Indian credit rating agencies. Further, Karnatakaalso kept detailed records of their borrowingsfrom the Centre and had documentation withrespect to their off-balance liabilities. WhereKarnataka needed to improve was in its archiving(recording) and record-keeping of both itsbalance and off-budget liabilities (e.g., stategovernment guarantees), providing better cashand risk management profiles of its balance andoff-balance liabilities, and engaging in systematicevaluation of state debt. Karnataka was alreadybeginning to take steps to surgically improvesome of these shortcomings.


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The primary objective of a government’s debtmanagement strategy is to finance governmentborrowing needs efficiently and to ensure thatthe government’s debt servicing obligations aremet.73 Another objective is to ensure that thegovernment debt portfolio is managed accordingto the government’s costs and risk objectives(Wheeler 2004). However, a goal of minimizingdebt-servicing costs (irrespective of risk) shouldnot be considered as an explicit objective. Thisstrategy can result in riskier borrowing structuresthan might be warranted. In effect, adverse shocksto the macroeconomic environment can result inhigher than projected debt-servicing costs,reduction in government services, and potentiallyhigher tax levels.

In developing a state government debtmanagement strategy, government debtmanagers are confronted with a number ofstrategic choices as to the proposed (and, desired)financial characteristics of the debt. The debtmanagement strategy must include (but is notlimited to) the following: i) an understanding ofthe desired maturity structure and liquidity of thedebt; ii) the duration and/or interest ratesensitivity of the debt; and iii) determiningwhether the debt should be transformed throughswaps, buybacks, or through new issuance. Manyof these strategic debt management decisionsinvolve difficult financial (and, political) trade-offs.For example, if there is a high inflation (or default)risk premium built into longer-term debt rates;short-term debt may be expected to be cheaper(than long-term debt). However, excessiveshort-term debt increases risk by increasing thevolatility of debt servicing costs and may posefuture liquidity risk.

Part 3:

REFORM’s Response to these GapsBecause short-term debt requires more frequentrefinancing, there is always the risk that the stategovernment may be unable to access the marketsat an optimal interest rate spread. Sound debtmanagement strategies generally involveanalyzing fiscal policy and macroeconomicenvironment issues and linking this analysis tothe government’s debt management and othereconomic policies. In building the capacity tomanage state government debt, it is essential thatthe starting point begin with the establishmentof a set of governance practices embodying adetailed debt management manual whichoutlines the risk management practices andpolicies of the state government.

Interface between Debt Managementand Fiscal PolicyHow should fiscal policy advisers and state debtmanagers’ interface with each other? Fiscal (and,monetary policy) advisors share a commoninterest with debt management advisors inensuring that the growth of public debt remainson a sustainable path such that a sound fiscalpolicy remain in place and that excessive debtlevels can be reduced. Both the fiscal and debtmanagement policy advisors should be involvedin developing state-level objectives and a riskmanagement framework for state governmentdebt management.

Close coordination is required between the stategovernment’s fiscal policy advisors and its debtmangers in preparing budgets and other fiscalprojections. As inputs to these projections, statedebt managers generally run debt servicingforecasts which are then, in turn, linked to thestate’s fiscal policy projections. The

73 Wheeler, Graeme, (2004) “Sound Practice in Government Debt Management” Pp 13 World Bank: Washington D.C.


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responsibilities of the debt management advisorsalso include providing advice on the size and thecomposition of the state government’s borrowingprogram and how the proposed debt structurecan be amended in light of changes in the state’sfiscal program or near- and future-projected cash(liquidity) position. Considerable coordinationand exchanging of information is requiredbetween the debt manager and the state treasuryoperations in daily cash management. Reliableforecasts of government departmentalexpenditures and revenue flows, combined withfuture debt servicing obligations are needed inorder to determine the near- and long-termliquidity requirements of the state government.

Rational for InterventionsThe India State Fiscal Management REFORMProject worked with the Government of India andeach of the three states—Jharkhand, Karnatakaand Uttarakhand—to reverse the negative fiscaltrends defined above. Reversing the fiscal (debt,investment, contingent liability) trends requiredseveral different kinds of assistance over the pastthree to five years including:

• Defining new organizational structures—Debtand Investment Management Unit;

• Suggesting amendments to existing laws orprocedures to add more discipline to financialmanagement and the development of policieswith financial effects;

• Developing analytical tools (databases andmodels);

• Training staff in analytical and debtmanagement techniques;

• Defining more effective governmentalinformation systems and communicationprocesses; and (Commonwealth SecretariatDebt Management Systems (CS-DRMS).

Thus, the project’s vision was to have in place ineach state the organizational structures, debtmanagement analytical tools, decision processes,communication channels, information sources,and trained staff that will enable the states tomaintain a prudent debt, contingent liability andinvestment management (balanced fiscalposture) on a sustainable basis. Achieving thisoutcome would enable the states to reverse thedebt spiral and, over time, be able to graduallyallot additional public resources to the moreproductive development and infrastructureneeds.

It was essential for REFORM in these three statesas well as all states that are in fiscal distress towork toward this vision. Failure to do so wouldhave caused the debt load to increase, resulting inmore and more public resources being allocatedto unproductive debt service costs, and fewerresources being allocated to productive use.Ultimately, this could place more pressure on theGovernment of India (GoI) to provide increasingamounts of financial aid to the states, particularlyin connection with the nation’s broader social andeconomic agenda. However, the Government ofIndia faces its own constraints in setting fiscal andmonetary policy. In this manner, spiralling statedebt could lead to diminished real economicgrowth. Fortunately, each of the three statesarticulated its concern with this situation, andeach state expressed keen motivation to addressthe problem.

What Process Steps were Undertakenin REFORM States?REFORM’s vision was geared to improving thestates’ fiscal situation on a sustainable basis. Allforms of debt, investment and contingent liabilityassistance were designed to this end. Forexample, training sessions included employees at


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mid- and lower-levels of the organization, theones who are likely to be in the operativepositions for a longer period of time than theirmanagers or leaders. Another way REFORMinstituted sustainable reforms was by providingtechnical assistance face-to-face with thepermanent staff after the training has beenprovided. This served as reinforcement to thetraining. And finally, in reforms that involve moretangible products (e.g., advice on newinformation systems, or helping implementamended laws or procedures), REFORM providedadvice, guidance and assistance with theselection and implementation of appropriatedebt management software. In this manner, thestates have taken ownership of the newstructures and the reforms will stand a betterchance of being infused into the way states dotheir business on an ongoing basis.

What Operational Constraints wereEncountered?Operational constraints that occurred at the statelevel during the life of the REFORM projectincluded:

• A substantial problem at the state level is thelack of state debt, investment, and contingentliability data warehousing (database) andanalysis. A significant level of debt informationis retained by the Accountant General (AG),but states (in general) do not have efficientdebt and contingent liability inventorying andarchiving systems. In many state governmentoffices, the debt management informationprocess consists largely of recordingtransactions either in handwritten ledgers ofin excel spreadsheets;

• State level debt recording are not marked tomarket, calculation of portfolio duration isdifficult, and only rudimentary scenario

analysis is possible. However the complexity ofthe decisions and transactions handled byState government debt managers hasincreased significantly;

• Budget staff resources are allocateddisproportionately to the areas of budgetcontrol and the release of funds, withinadequate resources allocated to budgetplanning, evaluation, and analytical studies ofpolicy options; and

• While all states were on a path of improvingcomputerization of treasury operations, this wasnot being done with adequate attention tochanging many related business processes.There were inadequate structures in place toreview or simplify the existing processes, or toquestion if there are alternative ways to betterutilize the computerized systems and, therehas not been adequate planning to integratethe required changes in budget formatand presentation associated with futurebudget reforms.

How were these Constraints Overcome?Some, albeit not all of these constraints, wereovercome in the following manner:

• REFORM developed a “Debt ManagementUnit—Overview and Proposed

REFORM’s vision was geared to improving the states’fiscal situation on a sustainable basis. All forms of debt,investment and contingent liability assistance weredesigned to this end. For example, training sessionsincluded employees at mid- and lower-levels of theorganization, the ones who are likely to be in theoperative positions for a longer period of time thantheir managers or leaders. Another way that REFORMinstituted sustainable reforms is by providing technicalassistance face-to-face with the permanent staff afterthe training has been provided.


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Organizational Structure” manual. Thismanual presents a basic guidebook forstates in describing effective debtmanagement, the importance of debtportfolio management and presenting areview of an effective debt managementoperation and reporting structure. All stateshave used elements of the manual to assistthem in their development of their FinancialResponsibility Act (FRA). As Karnatakaalready has a FRA, they have also asked forand received comments from REFORM onhow to improve their FRA and contingentliability processes;

• REFORM developed a data flow diagram toidentify state debt and investments. Thesedata flow diagrams follow the coding schemepracticed by the AG’s office. Both the data flowand data field diagrams were be submitted tostate government officials;

• A key question confronting many stategovernments is whether to adoptcomputerized systems and, if so, howsophisticated and comprehensive shouldthose systems be. Sound managementinformation systems are essential for asset andliability management. However, systemsdevelopment is an area in which substantialamounts of funds, management and staff timecan be deployed and expensive mistakes caneasily be made. A primary lesson learned, isthat state governments should review withcaution introducing new IT systems into theirgeneral financial management operations. Thefollowing core functionality is required in thesuccessful maintenance and operations ofdebt management systems: Capture of MarketData; Risk and Performance Analysis; and, Debt,Investment and Contingent Liability Recordingand Debt Analysis. It may not be possible tocapture all of these capabilities in one system.

If additional systems are involved it isimportant that they share a common databaseor data warehouse to satisfy concerns aboutdata integrity and security;

• The adoption of an off-the-shelf softwareprogram would greatly enhance each state’sability to monitor and analyze their currentdebt status. REFORM introduced Uttaranchal,Jharkhand and Karnataka to theCommonwealth Secretariat Debt Recordingand Management (CS-DRMS) analysissoftware; and

• Only by enforcing budgetary controls at thetime that financial assistance is committed canthe appropriate budgetary incentives berealigned to eliminate the potential for moralhazard. There are a number of policy options,benchmarks, and reporting procedures that astate can undertake to minimize the potentialfinancial hazards with respect to contingentliabilities. REFORM devised a ContingentLiability Policy Manual which serves as theguiding principal(s) for reviewing, appraising,and documenting contingent liabilities. Thepurpose of the guarantee and contingentliability manual is: (i) understand the basicunderpinnings of state governmentguarantees and contingent liabilities; and(ii) review State Government OfficialMemorandums, Governments Orders andCirculars with respect to governmentguarantees and prepare a draft set ofrecommendations to enhance the state’scontingent liability policy. The governmentguarantees and contingent policy manual isdivided into the following five (5) sections:Assessing the Fiscal Risk of State GovernmentGuarantees; Reform Measures in the State;Contingent Liability Manual; Application ofGuarantee Fees; and, Basic Requirements forEvaluating Investment Projects.


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Establishment of Debt ManagementUnitAs part of its primary role, REFORM assisted in theestablishment of Debt (and Investment)Management units to assist the three stategovernments. The organization of a debt(contingent liability, and investment)management cell may vary from country-to-country and from state-to-state but several keyareas of responsibility or functional duties weredeveloped in order for a state to achieve aseamless integration between the fiscal policyside and effective debt management. The debtunit was assisted in: i) developing an effectivedata base of all state balance and off-balanceobligations; ii) producing effective cash flowprojections; iii) establishing a cost and riskmanagement strategy or framework for the Stategovernment’s debt portfolio; and iv) monitoringcompliance with the state’s portfolio and riskmanagement policies. With respect to monitoringcompliance with the state’s debt portfolio, thismeans that the debt management unit’sresponsibility covered broad obligation’s on thegovernment’s balance sheet including (but notlimited to) guarantees and other contingentliabilities. Using the state government’spreferences with respect to expected cost andrisk, the debt management unit stated toestablish a set of portfolio management policies,discuss and obtain approval from theDepartment of Finance and performed a mixtureof research, analysis and due diligence withrespect to the state’s debt managementportfolio position.

Contingent Liability and InvestmentProcedures ManualsThe Governments of Jharkhand (GoJ),Uttarakhand (GoU) and Karnataka (GoK) haveestablished a Debt and Investment

Management Cells (DIMC). These cells aretasked with analyzing, evaluating, monitoringand managing the state’s debt, investmentsand guarantees (contingent liabilities). As partof this undertaking, the state governmentshave developed three manuals to assist in itspractitioners with the monitoring andmanagement of state government debt,investments and government guarantees.

• Volume I is “Debt Management UnitOrganizational Structure and ProceduresManual.”

• Volume II is “Government Guarantees andContingent Liabilities: Commentary andContingent Guarantee Policy Instructions.”

• Volume III is “Effective Monitoring ofInvestments: A General Review andInstructions Manual.”

In planning the structure and content of theabove mentioned trilogy of manuals, thecontributing authors and state governmentswere mindful of the existing international andIndian best practices and the literature on thesubject which addresses specific elements of themanagement of government debt, investmentand guarantees. The trilogy of manuals,nevertheless, should be viewed in the nature of awork-in-progress, and as an ongoing effort of theMoF and REFORM to provide Indian stategovernments with a comprehensive referencesource for the development of an effectivemanagement of state government debt,investment and guarantees.

States Going to Market andCreditworthiness GuideState government market borrowing has largelybeen limited through the Reserve Bank of India


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(RBI). However, the TFC’s recommendation todiscontinue central government loans to stategovernments for plan funding will require Indianstates to mobilize larger resources from themarket. State government borrowing is not anend in itself. Ideally, it should be used to obtainlong-term capital for expenditures that providebenefits that stretch into the future. Repayingstate government debt represents the fulfilling ofan intergenerational contract obligating thosewho benefit from the capital investment to paytheir share of the costs. Successfully incurring andrepaying debt is an affirmation that stategovernments are capable of planning for thefuture and fulfilling their obligations.

The gap between the ideal and the real in Indianstate government borrowing in the domesticcapital market is substantial. The challenge toraise funds from the market by stategovernments comes at a time of transition anduncertainty. There is increasing pressure to makestate governments (and governments at all levels)more accountable to citizens and more attunedto the demands of the marketplace. Thissensitivity to market behavior includes the driveto make more activities self-supporting. A criticalissue is how to increase the access of stategovernments to financial markets, broadlydefined as the banking system and thesecurities market.

Credit market access has been approached fromvarious angles in REFORM’s State’s Going to Marketand Creditworthiness Guide (“CreditworthinessGuide”) including: the changing nature of Indianstate government borrowing, state debtmanagement operations, mechanisms to enterthe nonSLR bond market, and the organizationand regulation of the financial market. Otherareas that are reviewed include the likely investorgroups, the need for information to analyze credit,

credit rating and finally, private insurance (orenhancement) of state government securities.This Creditworthiness Guide explores the marketfor state government debt in the Indian contextand is presented in six parts. The first five partsestablish a framework for understanding the debtmarket in the Indian context and the manner inwhich the current debt market functions, themarket structure, operation and regulations, thekinds of security instruments that are available,and the main participants in the market. In thesesections, the mechanisms for state’s going tomarket on their own, state creditworthiness, andmonitoring of oversight of state debt is broughtinto focus. The final section provides generalguidelines and recommendations.

While there is no one right way of developing andexpanding the Indian state government securitiesmarket, there are ways to facilitate the success ofa state government bond market. Elements thatare essential for expanding the demand for stategovernment securities include:

• The financial marketplace should be free towork with state governments to decide on thetypes of instruments and associated paymentstructures to employ;

• Wherever possible, it is best to introduce andpromote competition into the state securitiesmarket; and


Information and state government accountabilityare key factors in the effective operation of statedebt markets. Assessment of risk, crucial fordetermining the cost of capital, requires state


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governments to produce reliable, complete andtimely financial information. Without thediscipline of the hard budget constraint, financialmarkets and credit assessors have little reason todistinguish among the various state governmentcredits, and the rationale for market allocation ofresources is consequently lost.

Review of REFORM InterventionsA brief state-by-state review of REFORM effortsfollows:

KarnatakaAs REFORM began operations, Karnataka hadpre-existing time series with respect to GoI andother related debt time series. However, some oftheir potential liabilities were notcomprehensively documented. The Governmentof Karnataka (GoK) had assembled a collection ofits guarantees in a series of paperbound volumes.REFORM provided the GoK and other REFORMstates with debt preparation tables to begin theprocess of documenting debt and guarantees in amore comprehensive and systematic manner. TheGoK used these tables to gradually assemble itsexplicit guarantees in systematic manner.

REFORM provided GoK officials with anInvestment analysis and internal proceduresmanual for evaluating state governmentinvestments and guarantees. Further, REFORMmembers proposed substantial reportingrequirements for government investments witha large balance sheet, and more limitedreporting requirements for other stategovernment investments. GoK established astate investment department which is currentlyusing many of the templates and reportingstreams proposed by REFORM. The process ofcollecting and evaluating state governmentinvestments takes time.

Government of Karnataka is well on its way toachieving better debt and investmentmanagement. However, the issues discussed withthe state and in this brief paper indicate the needfor a parallel work agenda in “micro” issues relatedto the analysis of sustainable public finances.

• On the effect of fiscal policy and long rungrowth, there is a need for betterunderstanding of the impact of different typesof government expenditures and differenttypes of taxation on growth and welfare.

• A more in-depth sustainability analysis shouldbe grounded on the comparison between thesocial rate of return of public expenditures andthe social opportunity cost, including thepossible costs associated with futuredistorting taxation. Hence, the design andimplementation of the evaluation method is offirst order importance.

• Finally, application of the golden rule requiresestimates of the rate of depreciation ofpublic capital.

JharkhandGovernment of Jharkhand (GoJ) began the task ofcollecting its GoI debt and other outstandingdebt information ex ante to REFORMs

National governments can provide an environment topromote marketability of state government debt.Several questions arise when considering assistance forstate governments, especially those states that mayhave limited opportunities to gain access to credit. Howshould developmental resources be allocated? Further,what administrative and technical assistance should beused to deliver assistance? Technical assistance thatfamiliarizes state government jurisdictions with creditmarket and multilateral lending institution practicesand helps them become more creditworthy will bemost useful.


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intervention. However, the data collection taskwas incomplete and not comprehensive. REFORMprovided state government officials with debtdata templates to begin the task of collectingdebt, contingent liability and investment datamore systematically. GoJ established a FiscalPolicy Analysis Cell (FPAC) and Debt andInvestment Management Cell (DIMC).

The DIMC has been tasked with standardizingdebt reporting requirements along the linesrecommended by REFORM. Further, the DIMC/FPAC is currently tasked with regulargovernment analytical reporting. For example,DIMC must now present a report on currentGoJ debt sustainability levels, establishingstate government benchmarks, and developinga state debt “traffic” light warning signal ofindicators. GoJ and the Debt Managementunit organized the data along the linesREFORM suggested.

practices such as Jharkhand, are best served byinstitutionalizing and archiving debt andinvestment data in a standardized platform,and reviewing and revising (where necessary)debt, investment and contingent guaranteemanuals as required. Further, it may be necessaryto enroll and train a broader range of personsinto best practice debt and investmentmanagement practices.

UttarakhandWith the assistance from REFORM, stategovernment officials assembled stategovernment debt information in a singleconsolidated spreadsheet. State officials used thesuggested templates (more or less) as guidelinesfor data collection. However, state officials andREFORM agreed that excel spreadsheets areinappropriate format for state debt storage andevaluation. State officials delayed collection/warehousing of state debt data until theCommonwealth Secretariat debt management(CS-DRMS) software is in place. This would reducethe time spent on collecting and inputting datatwice. State officials have collected "explicit" stategovernment guarantees where appropriate.

REFORM Debt, Guarantee (Contingent Liability)and Investment manuals were combined into asingle comprehensive operations and proceduresmanual for use and distribution for a broadernumber of Indian states. State governmentofficials have accepted these manuals. Stategovernment officials have already begun the taskof collecting state government investment dataalong the lines suggested by REFORM.

Uttarakhand presented REFORM with uniquechallenges. The debt management unit could atbest be considered a "virtual" unit. In other words,a unit without a fixed address but consisting ofvarious members of the Finance Department. One

State government borrowing is not an end in itself.Ideally, it should be used to obtain long-term capital forexpenditures that provide benefits that stretch into thefuture. Repaying state government debt represents thefulfilling of an intergenerational contract obligatingthose who benefit from the capital investment to paytheir share of the costs. Successfully incurring andrepaying debt is an affirmation that state governmentsare capable of planning for the future and fulfillingtheir obligations.

The primary area of concern with respect toJharkhand was the lack of dedicated, physicalresources for undertaking effective debt (and,investment analysis). In order to alleviate thishuman resource constraint, it was consideredessential to enlist one key member of the FinanceDepartment as a sustainable dedicated resource.New states, with evolving financial management


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of the ways that the state government dealt withthis is to anchor the unit with one or two regularemployees that would be responsible for debtmanagement. However, in the future, it wouldbe advantageous for Uttarakhand to consolidateits debt management practices in a singlephysical location with dedicated and permanentstaff members.

Lessons Learned?National governments can provide an environmentto promote marketability of state government debt.Several questions arise when considering assistancefor state governments, especially those states thatmay have limited opportunities to gain access tocredit. How should developmental resources beallocated? Further, what administrative andtechnical assistance should be used to deliverassistance? Technical assistance that familiarizesstate government jurisdictions with credit marketand multilateral lending institution practices andhelps them become more creditworthy will be mostuseful. Other lessons learned include:

• In addition to data verification, analysis andprojections, state governments should ensurethat state debt management objectives areclearly expressed and understood by thestate’s policy and debt management advisorsby developing a Debt and Risk ManagementPolicy Manual which clearly outlines thegovernment’s objectives and establishesportfolio benchmarks. An unambiguousassignment of responsibilities andaccountabilities is needed to ensure effectivedebt management implementation;

• In outlining its debt management objectives,state governments should specify their risktolerance or its degree of risk aversion.Decisions in the areas of interest rate risk, termstructure, and the volatility of debt-servicing

costs are important because states’ do havesome choices with respect to maturity, andinterest rate basis. Making policy decisions inthese areas is meaningless, if the desire orcapacity to implement them is lacking;

• It is better not to make distinctions amongstate borrowers as to their powers and theprocedures that they are to follow with respectto borrowing. Generic laws (rules) that containgenerally broad formulations and simpleparameters based on objective criteria arebetter. Parties to debt transactions should beempowered to design security provisions tomeet circumstantial and specific needs, as wellas general requirements. Short-term debtshould be limited to only providing for cashflow shortfalls in anticipation of realisticincome streams to be realized with thefiscal period;

• Indian state government borrowing should fitwithin the overall regulatory framework forbank and securities markets. Balancing thecompetitive norms of market efficiency anddevelopment while preserving the integrity ofthe payment system and protection ofinvestors as necessary;

• A secondary market for securities is importantto investor liquidity. But formal listing onexchanges should only be required where thepotential size of secondary activity justifies thetime and expense. A secondary market forstate debt can be developed among theover-the-counter markets which may proveto be more efficient for small state issuersof bonds (the bonds/debt that may betraded infrequently);

• A key concern in market regulation is that ofdisclosure. Subsovereign (state government)securities should be subject to disclosurestandards that require both information at the


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time of the initial offering and subsequentregular reporting to investors. The focusshould be on the process and generic needs.The substantive data needs in meeting suchstandards may best be left to self-regulatorybodies in the market and to participants inindividual transactions;

• Only by enforcing budgetary controls at thetime that financial assistance is committed canthe appropriate budgetary incentives berealigned to eliminate the potential for moralhazard. There are a number of policy options,benchmarks, and reporting procedures thatthe State can undertake to minimize thepotential financial hazards with respect tocontingent liabilities. States should devise aContingent Liability Policy Manuals which willserve as the guiding principal(s) for reviewing,appraising, and documenting contingentliabilities; and

• In many countries, freely operating creditmarkets effectively classify borrowers on theirown and reflect their credit assessments in theprices charged for borrowing. However, even inthese mature markets, regulatory classificationis sometimes practiced by central or stategovernments in order to provide certainprivileges to some borrowers or to imposerestrictions on others. To guard againstimprudent behavior, most nationalgovernmental credit systems useclassifications. These classifications are notmeant to prohibit debt for some classes ofborrowers, but to differentiate amongjurisdictions in terms of allowable maximumoutstanding debt. More typically, themaximum debt outstanding is taken inrelation to some revenue source. The strongestargument against rigid classification is thatupward mobility between categories offinancial strength and managerial maturity

should be encouraged. Classifying agovernment jurisdiction in a way thatencourages it to be dependent on externalassistance and avoid responsible borrowingon its own should be opposite to the effect thegovernment should have.

Indian state government market borrowing haslargely been limited through the Reserve Bank ofIndia (RBI). However, the Twelfth FinanceCommission’s recommendation to discontinueloans to state governments for plan funding willrequire Indian states to mobilize larger resourcesfrom the market. State government borrowing isnot an end in itself. Ideally, it should be used toobtain long-term capital for expenditures thatprovide benefits that stretch into the future.Repaying state government debt represents thefulfilling of an intergenerational contractobligating those who benefit from the capitalinvestment to pay their share of the costs.Successfully incurring and repaying debt is anaffirmation that state governments are capable ofplanning for the future and fulfilling theirobligations. The following section provides someconcluding observations and general guidelineswith respect to improving the Indian stategovernment securities market.

Expanding the Playing Field for State Securities

• In promoting the Indian state governmentsecurities market, the governing laws andregulations should make clear the legalstatus and remedies available to investorsin state government obligations. Thesecurity and enforcement process should beexplicit and easy to call on. However, indesigning the security and enforcementprocedures, the regulators must be somewhatflexible in establishing the boundaries ofprudential behavior.


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• In addition to developing security provisionsto meet general requirements, parties to statedebt transactions should be able to designsecurity provisions to meet specific needs andcircumstances. Other elements that areessential for expanding the demand for statesecurities include:– The financial marketplace should be free to

work with state governments to decide onthe types of instruments and associatedpayment structures to employ; and

– Wherever possible, it is best to introduceand promote competition into the statesecurities market.


Even in places where the securities market is notfully developed, and effective competition islimited, the bidding process and full disclosure oftransactions should encourage participation inthe debt market.

Financial Market Regulation and DisclosureA key concern in securities market regulation isproper financial disclosure. State governmentsecurities should be subject to disclosurestandards that require both information at thetime of the initial offering and regular reportingto investors subsequently. State governmentfinancial information needs to be promptlydisclosed after the close of the fiscal period inclear, consistent formats. For debt monitoringpurposes, reporting on a modified accrual basis isessential (as are cash flow statements). A centralrepository (e.g., State level Debt InvestmentManagement Cell (DIMC)) of financial informationon government borrowings is an essential tool in

promoting efficient disclosure. The repositoryshould have current data on debt outstandingand information on security pledges and liens.The following measures are recommended forimproving the financial disclosure (and, hence thecreditworthiness) of Indian state governments:

• The FRL should provide for a mandatory DebtManagement Plan to be prepared over aperiod of three to five years to ensureachievement of the various targets for prudentdebt management;

• There should be a detailed capital budgetproviding for all capital expenditure forecastsfor the state governments;

• The debt sustainability norm as put forth bythe Planning Commission should be strictlyadhered to. This should be established in theform of a Government Order (GO);

• State governments should ensure that theyhave details of all information pertaining totheir assets, particularly financial assetsand liabilities;

• The formats recommended by the ExpertGroup on Model Fiscal ResponsibilityLegislation at State Level could be adoptedfor the purpose with some state specificchanges; and

• There should be a system ensured through arule under a statute for maintaining completedetail of all loans guaranteed by thegovernment as well as all loans for which therepayment liability falls on the government.

Credit Analysis and RatingsCredit analysis is a product of the credit market’sneed to assess state government financial risk,whereas, credit ratings are the leading form ofinstitutionalized credit analysis. Credit analysis


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and ratings play an important role in expandingstate government securities instruments. Creditratings focus on credit risk (risk of paymentdefault) which then is used to help determineoverall risk and reward. A financial market onlybecomes viable when there is a variety ofcompeting investors, and investments withdifferent risk and reward characteristics. Creditratings have the benefit of ranking stategovernments on their perceived ability andwillingness to pay their debts and avoid financialstress. Credit ratings are relatively easy tounderstand, hence their popular appeal withinstitutional investors in the capital market. Thebroad-based appeal of credit ratings represents acatalyst for state governments, providing anincentive to upgrade one’s credit rating.

Other IssuesA regular and universal reporting system forstate governments founded on an accountingsystem (modified accrual) relevant to theinformation needs of investors and preparedby properly trained officials is a prerequisite formarket development. Most important is theability to report direct and contingent debtsoutstanding, current state debt servicerequirements and cash funds available to meetthese demands as well as baseline operatingexpenses. While the ability to support manyother measures of performance and conditionsis desirable, reliable baseline data on pendingstate debt obligations and reporting needs areindispensable to developing the state debtsecurities market.


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The effect of fiscal rules that limit debt finance ismeant to curtail inappropriate behavior of stategovernments that push costs to futuregenerations who have little option but to paythem. The effect of these rules is to reduce therole of debt finance to redistribute tax burdensacross generations and to smooth tax burdens.Clearly, trade-offs are encountered in determininga fiscal rule that provides incentives for publicinvestment while discouraging excessive debtfinance. Any rule must balance theseconsiderations. This section briefly reviews somepolicy and pragmatic issues that Indian stategovernments must review, in providing moreeffective debt management and capitalinvestment policies.

Debt and Fiscal Policy IssuesThe golden rule for public investments asadvocated by the Government of India (GoI)—budget balance for operational accounts, includingdepreciation and interest expense, and debt financefor public investment, potentially imposes severaldistortions in public decision making. Specifically,from a public policy perspective the followingpoints of criticism may need to be addressed:

1. Distortions in the Choice of Capital Projects:Under the golden rule, debt finance could beused for capital expenditures that can becommercially valued so that asset disposalscan sustain debt levels. Those investments thatcannot be valued would be subject to thebalance-budget constraint. While compared tothe cash balance rule that discriminatesagainst public investment spending, severaldistortions in public decision makingremain—potentially leading to too muchpublic investment spending.

a. The sustainable debt view for deficitfinance would limit capital budgeting toassets only sold in markets (building andperhaps roads and bridges that can betolled and/or privately run) or operated as apublic private partnership. When debtfinance is limited to commercial capitalassets, other types of public capitalexpenditures would be included in theoperational budget. If fiscal constraints,such as balanced budget apply to only theoperational budget, then public sectorinvestment decisions are distorted to theextent that only commercial activities areleft off the operational budget and can bedebt-financed.

b. If capital expenditures are taken off thebudget (e.g., school buildings) but otherinputs used in production are subject tofiscal limits (e.g. ,teacher salaries),production techniques could be distortedin favor of capital intensity (i.e., teaching bycomputer rather than by people).

c. Capital expenditures that have unknowndepreciation rates are typically expensed(such as employee training). If publictangible expenditures such as employeetraining is expensed and subject to fiscallimitation, then investments in other assetssuch as tangible capital like (for example)military equipment is more favored iffinancing is not subject to fiscal rules forthe operational budget.

d. Debt financed capital expenditures thatwould be subject to fiscal constraints maybe important for intergenerational equity

Part 4:

Remaining Gaps and Prioritizing these Gaps


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and tax smoothing objectives. However,clearly a trade-off exists from the need toensure the financing of public investmentswith the desire to limit bad governmentbehavior that might result in excessivespending and debt. The type of fiscal anddebt rule used becomes important inthis context.

2. Valuation Distortions: Even if public capitalcan be measured using the typical valuationtechniques that are often used in the privatesector, the valuation may be distorted. Forexample, the use of historical prices (such asequipment, land and buildings) would implythat depreciation of capital goods isunderestimated. With debt finance limited tothe estimated value of capital, historicalvaluations would put some additionalconstraint on investments, especially incountries with high rates of inflation. Finally,contingencies such as those related topublic-private partnerships would be valuedas debt and hard to estimate, leading toincorrect valuation of a state government’sasset and liability position.

Given these difficulties, it is not surprising thatsome other potential fiscal rules should beconsidered to provide an opportunity to limitpoor state government behavior and to providebetter incentive for public investmentdecision-making.

3. Debt Financing of Self-liquidating Assets:Based on sustainability and tax smoothingconsiderations, a case can be made for debtfinancing of capital projects that generatecommercial or self-liquidity assets, or whichwill generate revenues from user fees that willultimately recoup initial outlays. While capital

budgeting is appropriate for self-liquidatingassets, other types of capital expenditureshould be included in the operational budget.This does not mean that commercialinvestment projects should be financed fullybe debt. Some portion of capital expendituresshould remain tax-financed for financialreasons. With economic uncertainty, assetvalues change. Lenders are willing to providedebt financing for only a portion ofinvestment costs to ensure that their principaland interest will be repaid over time. Thissuggests that limitation may be imposed onthe capital assets that can be debt financed.

Ongoing IssuesThe nonavailability of an accrual basedaccounting system at the state level fails toenable states to provide a clear picture of thefinancial position of the state governments. Whilethe TFC through its recommendations has tried toreward the better performing states with debtwrite-offs. Debt write-off measures recommendedby the TFC have been related to bringing downthe revenue deficit to zero and fiscal deficit below3 percent over a stipulated period. It would bepossible for state governments to defercommitted expenditure and generate surplus onthe revenue account to avail these write-offs. Thishas become possible due to the existence of acash-based accounting system. Documenting andbringing changes in accounting policies (e.g.,accrual accounting) and disclosure norms by thevarious state governments to the public domainwould enable most state government bondinvestors to be more informed.

There is an ongoing lack of detailedinformation pertaining to guarantees issued bystate governments to facilitate borrowings bythe Special Purpose Vehicles that are not


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constrained by the provisions of Art. 293 (4).Often there are no budgetary provisions madefor the guarantees issued by stategovernments. It is very difficult to capture suchinformation in the absence of an accrual basedaccounting system. Having expressed theabove concerns, it becomes very important tounderstand how far a true ratio analysis wouldbe useful and relevant in the context of asubnational entity in India.

A strict sense corporate rating may not be veryuseful and relevant for a subsovereign entity.Under such circumstances, it is very important tounderstand the risks involved in subsovereignborrowings. It is equally important to know whatmakes a state government solvent and whethersolvency does ensures credibility. Solvency mayor may not necessarily imply creditworthy. A cashsurplus subsovereign entity may or may not be asustainable debt repayer. It would depend to alarge extent on the nature of existingresponsibilities of the entity and the nature offuture commitments.

Hands-on Issues: Debt ManagementIssuesFuture debt, guarantee, and investment workshould be concentrated on just a few areas:

1. Risk Management—Establishing risk (debt)management analysis and evaluation withrespect to debt and state governmentinvestments;

2. State Government Investment—Work hasbeen done on investment—most notably GoKhas taken the investment manual, establishedan investment (government equity) unit, butJharkhand and Uttaranchal still needadditional assistance in moving this forward

and mainstreaming the reporting and internalprocedures; and

3. Debt Investment Management Cell—Karnataka is pretty much on their way withDIMC. Jharkhand and Uttarakhand arelagging but doing the best that they canespecially when taking resource and otherconstraints under consideration.Mainstreaming of internal debt, guaranteeand investment management proceduresshould continue.

Similar Subnational Debt ReformInterventions in India:RecommendationsIf REFORM states can be taken as a representativesample of Indian state government debtmanagement practices, the following gaps frombest practice may occur:

Staffing and Training

• Inadequate number and specialization of staff.• Staff members may need training in debt

monitoring and debt managementprocedures.

A strict sense corporate rating may not be very usefuland relevant for a subsovereign entity. Under suchcircumstances, it is very important to understand therisks involved in subsovereign borrowings. It is equallyimportant to know what makes a state governmentsolvent and whether solvency does ensures credibility.Solvency may or may not necessarily implycreditworthy. A cash surplus subsovereign entity mayor may not be a sustainable debt repayer. It woulddepend to a large extent on the nature of existingresponsibilities of the entity and the nature offuture commitments.


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Data Coverage

• There may be inadequate information oncreditor, borrower, and sectoral allocation.

• Payment dates may only be available to themonth they fall due, not to the exact paymentdate.

• Inadequate information on marketborrowings.

• Inadequate records are kept on guaranteedloans.

• Nonguaranteed loans of enterprises that seekguarantees are not recorded at all.

Computerization

• There is no comprehensive system toaccommodate the various debt instruments orguarantees for which data should bemaintained.

As such, the following change strategies arerecommended:

Extend Data Coverage

• Data on all loans should be maintained in acomputer system (e.g., CS-DRMS), where theycan readily be aggregated. The data for eachloan should include:– Descriptive information, such as borrower,

lender, sector for which loan is designated,and so on, in order to provide informationfor analytical purposes.

– Terms information, such as amount,maturity and grace periods, interest rateor rates, frequency and dates ofpayments.

– The anticipated draw down schedule—this

would be modified as necessary to providean accurate projection of inflows from theloan.

– Information on future drawings shouldcome from the Planning Department,together with staff involved on thespecific project using the loan proceeds.

– Schedules of payments, which should beautomatically generated by thecomputer.

– The computerized data would bemaintained by the staff of a debt unit,who would be trained to beknowledgeable on debt managementtechniques. Coverage should beincreased to include all loans to the State,all loans guaranteed by the State, and allloans of enterprises to which the Stateextends guarantees.

– Reporting should be enforced under theterms of the proposed new debt actand subsidies and new guaranteesshould be withheld from enterprises thatfail to comply.

Modify Organizational Structure and Staffing

• Increasing the coverage of debt datamaintained would mean that staff couldconcentrate on specific types of debt.

• The anticipated initial staff allocation wouldbe: (i) one head of debt unit, who wouldsupervise the other staff of the unit andwould be capable of providing help withany of the functions and would be availableto cover other staff at times of extraworkload. Head of cell would alsocoordinate transfer of information toanalytical, budget and accounting units;


(ii) one staff member to maintain records onguaranteed debt and the debt ofcorporations. The staff member would alsomake periodic visits to enterprises to verifyamounts from time-to-time; and (iii) onestaff member to maintain records on otherloans: direct loans from the Government ofIndia and the Approved Institutions, such asthe NABARD.

Provide Training to Implement Improved DebtManagement

• Start training staff in basic aspects of debtmonitoring such as the forms of loans, data thatshould be maintained to provide analytical andstatistical information, the links between loandata and accounts. Subsequently, introducethe concepts of more complex debtinstruments and analytical aspects of debt.


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The Debt & Investment Management Practitioners' Guide

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