GST Council – Take a Dollar ‘Risk’, Save India’s Federal Democracy

“The clock is ticking ominously, and India’s federalism is hinged on a ventilator,” writes Raghav Bahl.

The federal structure of India’s democracy is threatened with violence and obliteration!

No, this is not the usual hyperbole peddled under our now-obliterated news ethics. It’s the scary truth, unless the Modi government and Opposition-ruled states can strike an equitable compromise on Monday, 12 October 2020. With less than 72 hours to go, the clock is ticking ominously, and India’s federalism is hinged on a ventilator.

C’mon, you would say, stop exaggerating, it can’t be Armageddon. But it is.

What would you say if a sovereign guarantee and a constitutional right – two core principles of a federal democracy – were together being violated? It’s bad enough for just one to be negated – but when both are torn together, then it’s pretty close to Armageddon.

Let me explain as simply as I can.

Prime Minister Modi’s Treaty of Faith With the States

At the stroke of the midnight hour, on 1 July 2017, Prime Minister Narendra Modi emulated Jawaharlal Nehru’s iconic Parliament moment to launch a “second Indian Independence”, ie, freedom for a nation divided into fragments by myriad, cascading taxes. His government enacted a Treaty of Faith with the states:

• The states gave up their most powerful political instrument, the right to tax residents; instead, the central government was given the privilege of collecting revenue on their behalf
• In return, the states won a cast-iron protection – the central government would guarantee them a 14 percent growth in year-on-year revenues for the first five years. To further fortify the states’ rights, a special compensation cess was promulgated whose revenue was sequestered away from the Union budget to ensure that the central government fulfilled its solemn obligation
• A truly federal GST Council was set up with near-equal rights for the central and state governments, to administer the new tax regime; this was the sanctum sanctorum of the Treaty of Faith, the guardian angel of the federal doctrine that underscored the new tax architecture

In theory and spirit, the structure was perfect, holding fine through the honeymoon years, the good and easy times (GST!). But sooner or later, every good intention must confront an ugly moment of adversity. Does it then still hold good? Or crumble? Or worse, become dishonest, deny, repudiate?

For the GST regime, COVID-19 became that cruel moment – the virus stalled the economy, emptied the central government’s coffers, but could do little to avert its Rs 2.35 lakh crore liability towards the states under the Treaty of Faith.

A Cop-Out for India’s Democracy

Instead of squaring up to its obligation, the central government shrank in fear:

• What would happen to interest rates and its debt servicing liabilities if it borrowed such a large amount in G-Secs? Already, it had breached the gross borrowing limit for the current year by nearly Rs 5 lakh crore
• Wouldn’t its fiscal deficit balloon out of control, forcing a sovereign downgrade?

To be fair to the Modi government, these fears are legitimate, but the prescription, of denying its constitutional obligation, is a cop-out for democracy.

Couldn’t it have come up with a bold, innovative, out-of-the-box solution which preserved its fiscal integrity and yet allowed the central government to remain faithful to the Constitution of India?

Yes, an option is hiding in plain sight, if only Prime Minister Modi’s economic advisors have the intellectual chutzpah to think beyond old and tired policies.

Just imagine if they resurrect the shelved plan of raising dollar bonds for this commitment...

I know I will be pilloried for re-re-re-raising the efficacy of floating a sovereign Indian dollar bond in overseas debt markets, but what the heck – if you are convinced of its merit, why slink into the shadows just because you will be criticised? So, check out this plan/structure:

• The GST Council sets up an SPV (special purpose vehicle) which gets a lien over future revenues from the compensation cess (so, it has a guaranteed revenue line to meet its debt obligations)
• The SPV borrows $30 billion at record low interest rates in overseas bond markets. It further takes a dollar/INR hedge to eliminate the foreign exchange risk. Its total cost of borrowing could be in the 5-6 percent range, which should be palatable even for die-hard critics of dollar bonds. If you want to lower the costs even further, the repayment could be jointly guaranteed by the central and state governments (which is just another reiteration of using the compensation cess as underlying collateral)

Pronto, all objectives are met! The central government’s fiscal deficit does not balloon, local interest rates are almost unaffected, and India’s constitutional sanctity is preserved. It’s a win-win-win solution, if only our policymakers had the gumption to think slightly out-of-the-box.

Unfortunately, I can already hear the naysayers, but let’s debunk each objection one-by-one:

Objection: Volatile dollar/rupee rates will create “unquantifiable” costs in the long term

Counter: Wrong. By paying a premium of 5-odd percent to hedge against future dollar rates, our costs will forever be controlled and quantifiable. While the hedged interest rate would be a few basis points higher than what the government could borrow at, in local markets, these shall get compensated by the several positives that accrue on venturing overseas, including the fact that private borrowers get more cash in domestic bond markets

Objection: Why go overseas when you can ask FPIs (foreign portfolio investors) to lend more in the domestic market, ie, sell them more rupee bonds

Counter: This one is specious. Because when you float a sovereign bond overseas, you access an entirely new category of lenders, over and above FPIs that are authorised to invest in India

Objection: Foreign investors could indiscriminately dump our bonds, creating a run on the rupee and “importing” contagion

Counter: False. Since the bonds will be denominated in dollars and traded on overseas exchanges, any “dumping” would not directly impact the rupee or domestic markets. In fact, the alternative being advocated above, of increased FPI exposure to rupee bonds, creates exactly the “dumping risk” that is being wrongly attributed to dollar bonds

Objection: India could stare at an international default in frightful, flight-ful times

Counter: This fear is not even worth a soiled one-dollar bill. India gets an annuity of nearly $70 billion from its hard-working sons and daughters living overseas, who willingly repatriate to their loved ones left behind. NRIs have also kept an unflinching $100 billion in term deposits in their motherland. Finally, India’s forex reserves are nearly 18 times $30 billion (and growing). If we can’t have the stomach for this much risk, let’s just quit (or take voluntary retirement).

So c’mon ye noble women and men of the GST Council – take a little dollar ‘risk’, be bold, and salute the Constitution of India.