Who can you trust now ?

Conventional wisdom has been that a sovereign guarantee is the best form of security you can have when you lend money. You can be pretty much sure that your money is safe if you buy government debt. Doesn’t matter which government, if you leave aside rogue states like North Korea or Myanmar. Conventional wisdom that is.

That was before the financial crisis. As the crisis spread, Iceland was the first country to go virtually bankrupt. When that happened, it was viewed as an isolated instance of an insignificant country that didn’t matter.

Then came Dubai. Well technically, not Dubai the Emirate, but Dubai World, the company. But then in that part of the world, it’s the same thing. Didn’t people see it coming ? – virtually anybody who’s been to Dubai would know that it was a place gone financially crazy. Of course, everybody knew that. But then everybody expected that Abu Dhabi, the oil rich emirate would always stand by Dubai. That was the mistake. The really startling thing about the Dubai crisis, is that there’s stony silence from Abu Dhabi.

Lenders have woken up and are now no longer sure about government debt. The country under the spotlight is now Greece. This is serious, for Greece is in the Euro zone. For years Greece has had irresponsible governments. The commitment made to join the Euro was that. its deficit would be no more than 3% of GDP – instead Greece runs at above 12% of GDP. Lenders always assumed that since it was in the Euro area, “Europe” (read Germany) would bail them out if it came to a default. Now, after the Dubai experience, not so sure. Rating agencies have fallen over themselves to cut Greece’s credit rating. Interest rates have soared. Greece needs to borrow a large amount in the first half of 2010 just to keep the government going – pay salaries and all that. There’s now real uncertainty whether their debt issue would be taken up.

There’s a lesson here for India. Not just that India must rein in its deficit – that’s repeated ad nauseum and as long as there are a few responsible ministers and bureaucrats in the Central government, we are OK. The lesson is for the States.

Every State government in India is virtually bankrupt. It’s a crying shame that the richest state in India, Maharashtra, is the worst offender. Unlike the Centre, State governments are completely irresponsible and fall over each other to loot the Treasury. The quality of leadership in the States is abysmal, irrespective of which party is in power. Every single minister in every single state would flunk Economics 101.

State Governments survive by issuing debt. The RBI and the Central government exercise control by regulating this, but state governments are masters in resorting to brinksmanship. Nobody would buy state government debt, but for the fact that it is backed by the Central government. The guarantee of the Government of India still stands for something.

So here’s the thought. The Central Government must withdraw the sovereign guarantee for state government debts. Automatically state governments would be forced to become fiscally responsible. Actually the Centre doesn’t even need to do that. They just have to deny a rumour that they may withdraw the guarantee. That’s enough. The markets would do the rest !