Fiscal Rule

of fiscal rules and used a similar strategy to compare the change in the likelihood of contingent liability shocks for states that had recently adopted a fiscal rule to those who had not. Detailed coefficient estimates are reported in table 4C.4.

Our estimates suggest that the likelihood of a contingent liability shock diminishes significantly in the year before and the current year in which a fiscal rule is adopted (figure 4.18). Although this estimate is statistically significant, results also suggest that it is only temporary, because our estimates do not detect a significant effect of the fiscal rule adoption on the occurrence of contingent liability shocks in subsequent years.

Markets

Our evidence on fiscal rules is consistent with the perception that fiscal rules by themselves are unlikely to be a major driver of fiscal consolidation.28 This perception is shared by the markets. To validate this market perception, we estimated a panel regression of interest rates paid by states in a given year—calculated as annual interest payments divided by the debt stock—on an indicator of whether a state breached the fiscal deficit rule of 3 percent of GDP. In the estimation, we control for state and year fixed effects. The results suggest that interest rates paid do not respond to the breaching of the fiscal deficit rule by Indian states (figure 4.19). Future research could firm this preliminary finding by using actual current rates on Indian states’ debt—either newly issued, debt with floating rates, or debt refinancing.

Fiscal Capacity and the Intergovernmental Framework

The occurrence and impact of contingent liability shocks can also depend on the states’ capacity to buffer shocks. For example, some states have lower potential for generating their own revenue, or they depend more on transfers to fund their spending than other states.

To examine this hypothesis, we distinguish between special and general category states in India. India’s National Development Council has designated 11 states as special category states, owing to their hilly and difficult terrain, low population density or sizeable share of tribal population, strategic location along borders with neighboring countries, economic and infrastructural backwardness, and/or nonviable nature of state finances (PRS India 2013). This classification has two practical implications. First, given their unique circumstances, special category status can be considered a proxy for low fiscal capacity, thus making special category states more prone to contingent liability shocks and reducing the likelihood that they are able to mitigate the impact on the real economy.

Second, special category states have historically received favorable terms in the allocation of central funding. Until India’s Planning Commission was abolished, its funding allocation favored special category states by reserving 30 percent of total funds for them and distributing funds at a ratio of grants to loans of 90 percent to 10 percent, compared to 30 percent to 70 percent for general category states. This favorable treatment ended with the replacement of the Planning Commission by the National Institution for Transforming India (NITI Aayog) in 2015.

FiGURE 4.18 Occurrence of Contingent Liability Shocks around the Enactment of Fiscal Rule

E ect on contingent liability realization 0.2

0.1

0

−0.1

−0.2

−0.3

−2 −1 0 1 2 3 Time relative to fiscal rule enactment (years)

Source: Blum and Yoong 2020.