Debt burden of the provinces

ON grounds of equity, greater efficiency and administrative convenience in the federal system, taxes are levied and collected by the central government with expenditure responsibilities assigned to the provincial and local governments. The resultant vertical imbalance requires transfers of resources from the centre to the provinces through the NFC Award. Historically, however, Islamabad has tended to appropriate the bulk of this central pool of resources for itself, because of the insatiable appetite of our real masters and the unitary nature of this supposed federal state structure. As a result, the provinces have been denied adequate resources to fulfil their constitutional mandates.

A depressed tax-to-GDP ratio in the country, a low level of transfers from the central divisible pool of resources to the provinces, the upward revisions in salary and pension payments in accordance with the recommendations of the Pay and Pensions Committees and high levels of interest on loans provided by the federal government are structural factors that have contributed to the deterioration in the fiscal situation of the provinces.

As structured at present, the government planning with regard to public financing operations ignores the role of incentives and the financial capacity of provincial governments. There is a failure to realize that fiscal discipline and responsibility cannot be planned from above and that rules and conditions need to be designed to facilitate implementation of fiscal responsibility of provincial governments. Moreover, the incentive structures are distorted. While the policies relating to transfers from the central divisible pool have tended to create the wrong incentives, those relating to pay revisions do not factor in appropriate incentive structures.

To illustrate, while the revenue raising capacity of the provinces is limited because of the taxation structure and the taxation powers enshrined in the Constitution, the federal government also restrains the provinces from exercising powers that they enjoy. Although both the multilaterals and the federal government lecture provincial governments ad nauseam on the need to enhance their revenues through the exploitation and widening of their revenue base, the federal government has simply refused to extend the GST on services to cover professionals like lawyers, accountants, engineers, tax practitioners, etc., although GST on services, a buoyant source of revenue, is a provincial subject under the Constitution.

It is reluctant to extend the net to a politically vocal community since it would have to face the political flak of taxing them while the revenue benefits would flow to the provinces, as Islamabad would only be entitled to a two per cent collection charge from such a source. That is why moves are afoot to include GST on services as an instrument by levying an excise duty in GST mode.

The federal government also controls, pre-empts and exploits the revenue base of the provinces. For instance, it has levied a withholding tax on motor vehicles, which is a potentially important revenue source for the provinces.

The provinces have limited leeway even in determining expenditure priorities. They are forced to adopt and implement national priorities set by Islamabad based on commitments made to donors. There is perfunctory, if any, participation of the provinces in determining these priorities, undermining fiscal federalism and decentralized decision-making. Take the recent example of the Poverty Reduction Strategy Paper (PRSP) designed in consultation with the multilateral donors. The provincial governments were hardly involved, even in determining the outcomes and indicators that are being used in judging the country’s performance.

Furthermore, whereas the federal government does not have a well conceived policy to control or regulate the size of its workforce, it has a policy to periodically revise salaries and pensions. The resulting increases are introduced in an ad-hoc manner every few years, which imposes a massive burden on the provinces (which carry the bulk of the civilian workforce engaged in the public sector) without matching devolution of funds from Islamabad and without regard to the size of the employee base of a province, its capacity to pay, its per capita income and the general level of wages outside the government.

The federal government cannot seriously argue that the provincial and local governments should deny their employees pay hikes if they cannot afford. It would be politically impossible for provincial and district governments not to enhance the salaries and parks of their employees.

Moving on to the subject of borrowings referred to above as a key factor affecting financial health of the provinces, whenever the latter have sought funds these have been provided by the federal government at interest rates significantly higher than what it pays on its own borrowings.

The centre’s financial strength comes not only from taxation powers superior to those enjoyed by the provinces, but also from its ability to raise capital to finance development expenditures. As things stand, there is a serious imbalance between central and provincial finances because of the authority exercised by the federal government over the mobilization and distribution of borrowings. Under the Constitution the federal government is empowered to determine both the level and the terms at which the provinces can borrow from any source.

This provision has been aggressively employed by Islamabad to restrict provinces from raising funds from different sources, including the financial market, by lending to them at interest rates substantially higher than what the federal government is paying for its own borrowings, itself, thereby raising their cost of borrowings. Until recently it would even profit from the loans given by multilateral donors like the World Bank and the ADB to the provinces by levying its own hefty service charge on the concessional interest rates at which the donors were lending to the provinces, instead of on lending to them at the same rate.

In the past, loans were given to the provinces simply on the basis of a formula that reflected population ratios without regard to their basic capacity to service the debt and the existing level of debt. In the case of Balochistan, the total debt (even without accounting for the massive liabilities for employees provident fund payments, accrued gratuity entitlement and the pension liability built up over the years) is 2.5 times total revenues (including transfers under the NFC Award) while annual interest payments absorbs 16 per cent of the total annual revenues. The corresponding figures for the NWFP are two and a half times and 28 per cent respectively. They were induced to borrow beyond their capacity, weakening fiscal discipline and creating an incentive for financial imprudence.

However, having contributed to the financial plight of the provinces, in a dramatic move, without addressing the issue of the burden of the large stock of inherited debt, the federal government decided, just four to five years ago, to cease lending to provincial governments, expecting them to fund their own expenditures and development programmes (excepting foreign aided projects supported by the federal government) from the transfers made to them from the central divisible pool of taxes under the NFC Award.

Until this abrupt decision the debt burden of the smaller provinces had already risen to unsustainable levels, much of which also owed to the polices of the federal government to keep for itself the bulk of the resources from the central divisible to fund its own profligacy and to put pressure on provinces to spend money on federal government programmes or to take foreign loans on behalf of Islamabad because it needed scarce foreign exchange to discharge its external liabilities. The debt servicing costs of these borrowing has severely impaired the capacity of provincial governments to deliver even basic services for which the Constitution makes them responsible.

As a result, there is a large overhang of debt previously contracted by provincial governments — although admittedly partly because of their past profligacy — which continues to require large interest payments (at an average interest rate of more than 15 per cent per annum) that have almost crippled their fiscal health and constrained them from providing decent quality social services that affect the daily lives of their populations. The provincial governments are, therefore, cash-strapped to fulfil their constitutional mandates.

For a year or two the federal government allowed the provinces to swap their old debt owed to Islamabad (contracted at high interest rates) by low-cost new debt from the World Bank and the Asian Development Bank at concessional interest rates. However, the federal government has now backed off from extending this concession and the debt-swap scheme has been discontinued, leaving provinces with a continuing high-cost massive-sized debt that has to be serviced.

Blanket prohibitions on provinces to retire high-cost debt (simply because Islamabad benefits from the high interest earnings from the funds that it had advanced in the past to the provinces at money lender rates) and supplement resources through borrowings and not allowing them any space to access financial markets not only makes no sense but also tantamounts to penalizing provinces for past fiscal indiscipline which was essentially an outcome of weak incentive structures, poor federal government policies and pressures brought to bear on provinces to borrow from external donors simply because Islamabad needed foreign exchange.

This discussion is intended to argue that the provinces, particularly the smaller ones, are precariously placed financially and that the objectives of fiscal discipline and consolidation cannot be met and sustained unless some of the root causes of the fiscal distress of the provinces are addressed.

There is, therefore, need to quickly attend to the issue of this odious debt burden by some write-offs and rescheduling, so that some fiscal space can also become available to the provinces for enhancing and improving the delivery of public services, and by granting provinces permission to supplement resources by borrowing from financial markets. Since powers of borrowing and controls over banking and capital markets at present rest squarely with the centre, and provincial and local governments are not permitted to participate directly in the market for capital funds, so that provincial governments are totally dependent on the federal government.

The present arrangement is an unfair one. The centre can be extravagant in its spending and borrow from the market, but places restraints on the provinces while asking them to fend for themselves. This dependence has to be reduced. Even the Finance Commission in next door India has now proposed that the states should be able to access funds directly from financial markets.

A move to market-based discipline on borrowings would be the best way forward. The market would lend to a province based on fiscal prudence and provincial financial management practices, resulting in the lowering of the interest rate on provincial borrowings under the present interest rate regime, especially those managing their financial resources better. The provinces should, therefore, be permitted to access commercial financial markets to raise funds for financing capital spending and for accelerated repayment of old, high cost, loans advanced by the federal government which it is neither allowing provinces to retire before maturity nor reschedule, although it has been able to craft similar deals for itself from donors after the events of September 11.

The writer is a former finance minister of Punjab.

The familiar script

THERE are many reasons why the joint statement by Prime Minister Manmohan Singh and President General Pervez Musharraf is so insipid and so disappointing. One, the spat over the prime minister’s remark to President Bush on Atal Behari Vajpayee’s opposition to the Indo-American nuclear deal may have deterred both New Delhi and Islamabad from announcing their agreement on the Siachen glacier and Sir Creek.

Both the accords are practically ready, although not yet signed and sealed. It has been probably considered politic not to disclose the terms of the agreements lest the BJP and other political parties pick on them and spoil a long, patient job done to reach them.

Another reason could be that the two countries want to announce the accords on the two irritants in a dramatic way on the soil of their country. They do not want the impact to be lost if made public amidst various other noises abroad. People back home need to know the pluses and minuses of the agreements. They are the ones who have to be involved to make the accords a success. Yet another reason could be that all expectations were centred around the discussion on Kashmir.

Should the joint statement say what is still at the consultation stage through the back channel? The four and a half hours consultation — two hours between Manmohan Singh and Musharraf, and two and a half hours at dinner — should have touched unresolved issues. The joint statement makes a general observation that unresolved issues would be settled peacefully. There is nothing new in it.

I also suspect that Islamabad does not want to make any announcement until Kashmir figures in it. Its people may regard everything else anticlimax.

Strangely, Musharraf took a hard line in his speech at the UN. He brought back the Security Council resolution which, he conveyed many a time earlier, is not possible to implement. He again spoke about Kashmir and Palestine in the same breath for domestic consumption. Sometimes, Musharraf gives the impression of having two lines: one for the lobby in Pakistan and another for the world, including India, where he wants to go down as reasonable and pragmatic. The UN speech was for the first, while the joint statement for the second.

However, the joint statement should not be written off. There was Pakistan’s reiteration to weed out terrorism, the point that both New Delhi and Washington have emphasized on Musharraf. No doubt, infiltration has decreased but there is no evidence about the demolition of scores of training camps in Pakistan. Musharraf had promised Manmohan Singh that Islamabad would see to it that no terrorism would flow from their soil. But this is not a hundred per cent correct. However, one good development is that Musharraf has stopped comparing terrorists with “freedom fighters” or “jihadis”.

I wish the joint statement had talked about trade and more people-to-people contact between the two countries. Such steps will decrease distrust without which no settlement can survive. This reminds me of the remark Jawaharlal Nehru made to Zulfikar Ali Bhutto at London in November 1961. “Zulfi, I know that we must find a solution for Kashmir. But we have got caught in a situation which we cannot get out of without causing damage to the system and structures of our respective societies.”

By and large, this is as much true today as it was 44 years ago. None of the two sides is bold enough to defy society. Yet both of them have come a long way from the positions in which they have been frozen for decades. Whatever Musharraf’s statement, Pakistan has realized the futility of sticking to the UN resolution or a plebiscite. India, on the other hand, has conceded, without saying so, that Kashmir is a dispute because it is discussing with Pakistan and the Hurriyat leaders the future of the state which New Delhi considers an integral part of the country.

History of conflicts and confrontations between them is a long and bitter one. Still they have sustained the peace accord which they signed 33 years ago at Shimla. Manmohan Singh and Musharraf have gone further. They have firmed up the ceasefire on the Line of Control (LoC) and it has held good for more than a year.

Of course, there is fear that the process towards normalisation can be defeated if there are no specific talks on Kashmir and Musharraf says so openly. It all depends on what are his options after he has assessed the pressure from within, the army commanders and extreme public opinion. If he pitches in his demand too high, the irreversible process of peace can reverse. Former prime minister Nawaz Sharif was realistic. He told the then prime minister Inder Kumar Gujral that he had realized that India could not give Kashmir to Pakistan, nor could Pakistan take it from India forcibly. He said there was no alternative to talks, however long it took to find a solution. It looks as if Musharraf is veering around to that point.

Redeployment of forces at Siachen glacier is something which should have taken place long ago. Either the place should have been reverted to the status of no-man’s land or the LoC should have been extended to the Siachen area following the norms that the army commanders of the two countries had agreed upon after the Shimla conference. The key is trust. Can India expect from Pakistan not to occupy the Siachen glacier it vacates?

A midway solution bandied about is an independent valley. Both former prime ministers Benazir Bhutto and Nawaz Sharif are reportedly dead against it. Musharraf was also not in its favour but he has been brought round on the plea that independent valley will ultimately merge with Pakistan. The difficulty is with India. I have heard communal elements, repulsed at the last polls but not defeated, arguing that if the Muslims in the valley can opt out after being part of India for 60 years, then how “loyal” would the 150 million Muslims in the rest of India be? No government or, for that matter, no political party can agree to such a proposition. It can undo India. Hindu rashtra idea may then come to prevail.

Shabaz Sharif, then the chief minister of Pakistan’s Punjab, suggested to me once at Lahore to give Pakistan the Muslim- majority valley. I told him that I did not want to see another partition, the ravages of which I had experienced when I travelled from Sialkot, my hometown, to Amritsar. It was a horrifying thought.

Manmohan Singh’s remark that he wants to make borders irrelevant can provide the basis for settlement. An economic union embracing India, Pakistan, Jammu and Kashmir and Azad Kashmir can eliminate borders. The economic union can be expanded subsequently to include all countries in the region, from Afghanistan to Myanmar.

The writer is a leading columnist based in New Delhi.