Is UDAY Bad For Indian States?

Mon, 11 Apr Pre-Open

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Did you know power distribution companies (DISCOMs) had a total debt of Rs 4.3 trillion? This was as on September 2015 when the government got serious about cleaning up the mess. The result was Ujwal DISCOM Assurance Yojana (UDAY) launched in November 2015.

This is essentially a bailout package for DISCOMs. We believe it is crucial for the power sector's revival. There are four parts to the UDAY scheme.

• Improvement of the DISCOMs operational efficiency.
• Reduction in the cost of power.
• Reduction in interest costs of the DISCOMs.
• Enforcing strict financial discipline on DISCOMs.

Under the scheme the state governments (that own them) will take over 75% of the debt burden (mentioned above) over two years. This debt won't be counted in the respective state government's fiscal deficit for these two years.

The states in turn will issue bonds to the respective banks and financial institutions (FIs) in lieu of the original loans granted to the DISCOMs. The states will guarantee repayment of these bonds. The interest paid by the state government will be 0.1% greater than the respective bank's base rate.

The bonds that are guaranteed by the state will help bring down the burden of bad loans and provisioning for banks. But the downsides are that the bonds offer low yields and are exempted from the Reserve Bank of India's SLR requirements. The SLR or the Statutory Liquidity Ratio is the percentage of total deposits that banks cannot lend and must be held in certain approved securities (usually government bonds).

States joining this scheme will receive additional support from the central government to ensure the financial viability of the DISCOMs. Presently 15 states have come on board. This covers 90% of the outstanding DISCOM debt.

Unfortunately, this scheme will place a huge financial burden on the state governments. As per an article in Livemint, not only will it increase the debt of the states, it will also increase the interest costs (as they have to guarantee the UDAY bonds). This will place additional pressure on their already strained finances.

A recent report by the RBI has warned that states could respond by cutting back on capital expenditure. This would be a big negative for India's economic growth. There is now a very real fear that states may reduce spending on essential services like education and health just to keep their deficits in check.

The fiscal deficit of states narrowed to 2.4% of the state's GDP in fiscal 2016, from 2.9% in fiscal 2015. However, their market borrowing jumped by 26% YoY. This has put additional pressure on the bond market.

We believe, long term interest rates may not fall in a hurry if this situation continues. State government's will need to find additional sources of revenue if they are to meet this challenge. This will be no easy task in our opinion.

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