State Governments in India cannot access external sources of finance directly. The 12th Finance Commission recommended the transfer of external assistance to State Governments in India by the Union Government on a ‘Back-to-Back’ basis. This recommendation was accepted by the Government of India for general category states and the arrangement came into effect from April 1, 2005. For special category states ( Northeastern states, Uttarakhand, Himachal and J&K), external borrowings are in the form of 90 per cent grant and 10 per cent loan from the Union Government.
Passing loans on ‘Back-to-Back’ basis to State Governments implies that States would face identical terms and conditions (including concessional interest rates, grace period and maturity profile, commitment charges and amortization schedules) on account of their access to finance from bilateral and multilateral sources, as is faced by the Union Government.
This arrangement entails exposure of States to uncertain movements in international rates of interest (as multilateral agencies viz. IBRD benchmark their interest rates to a reference rate viz. the LIBOR) and currency exchange rates. As per the ‘Back-to-Back’ loan transfer arrangement, states would have to face currency risk since principal repayments and interest payments on such loans to external agencies are designated in foreign currencies. In case of adverse exchange rate movement(s) larger rupee provisions may be required to meet debt service obligations that may negatively impact the fiscal health of the state concerned.
Thus, direct exposure to interest risk and currency risk carry implications for debt service burden and therefore for the fiscal status of sub national Governments in India. Capacity building in finance departments of State Governments is required to ensure that debt is prudently managed.