The Reserve Bank of India [Get Quote] on Friday said the state governments' tendency to park their large cash-surplus balances in market instruments like 14-day treasury bills reflects imprudent fund management strategy that earn less return. Instead, they should use this money to reduce fiscal deficit.

States have been keeping large surplus cash balances, which stood at Rs 74,857 crore (Rs 748.57 billion) as on December 17, 2008. Such high magnitude of cash balances raises questions about the cash management, the RBI said in its study of budgets for 2008-09.

The financial instruments like 14-day treasury bills issued by the Centre carry a lower interest rate than the weighted average interest rate of the market borrowings of the states.

Therefore, outstanding cash balances may have a negative effect on the revenue account. Hence, it would be prudent for the state governments to finance fiscal deficit by reducing surplus cash balances.

Initially, the excessive autonomous inflow of National Small Savings Fund (NSSF) collections contributed to the cash balances. Yet, it is significant that the phenomenon of high surplus cash balances has persisted despite a sharp decline in NSSF inflows in recent years, the RBI said.

The weekly average investment by the states in 14-day ITBs and ATBs during 2008-09 (up to November 30, 2008) amounted to Rs 79,221 crore (Rs 792.21 billion), higher than that of Rs 70,727 crore (Rs 707.27 billion) in the same period last year. The surplus cash balances of the states also impart volatility to the cash balances of the Centre.

Referring to the use of surplus balances, the RBI said large build-up of funds in recent years and the negative spread earned on such investments prompted some state governments to utilise them to retire outstanding debt.

The scheme for the buyback of outstanding State Development Loans (SDL) was made effective during 2006-07 through two rounds of reverse auctions. The scheme operations continued during 2007-08.

Orissa and Tamil Nadu also bought back the loans amounting to Rs 217 crore (Rs billion2.17 ) and Rs 1,178 crore (Rs 11.78 billion), respectively, borrowed from the NSSF. During 2008-09, the average use of normal Ways and Means Advances (WMA), special WMA and overdrafts by states has remained low. It reflects improvement in the overall cash position resulting in build-up of high level of surplus cash balances, the RBI added.

The consolidated fiscal position of the state governments has shown a marked improvement in recent years. This health of revenue account has seen a change for good. The ratio of gross fiscal deficit to gross domestic product (GDP) was 1.9 per cent in 2006-07 (accounts).

The gross fiscal deficit as a ratio to GDP was estimated higher at 2.3 per cent in 2007-08 due to higher capital outlay. But it is projected to decline to 2.1 per cent during 2008-09, the RBI added.