"The farm loan-waiver schemes being discussed and rolled out across an increasing number of Indian states could have a significant impact on state government finances, and might undermine efforts to bring down general government debt," Fitch said in a statement.
Larger state deficits would delay an expected gradual reduction in general government debt, which includes central and state government debt.
"There is a risk that farm loan waivers - which we have not previously factored into our assumptions - will lead to further fiscal slippage at the state level or will reduce the funds available for public investment.
The central government has the authority to block states from borrowing to finance persistently large deficits, but it could be reluctant ahead of approaching elections in some states, with the 2019 Lok Sabha election drawing nearer," Fitch said.
The Centre has gradually consolidated its fiscal position in recent years, and has indicated that loan waivers will have to be funded from state coffers.
"However, the combined finances of the states - which are included in general government debt and deficits - have been under pressure.
Public pay hikes, election spending and higher interest costs stemming from the UDAY scheme - under which state governments have taken on debt from power distribution companies - are all likely to add to expenditure," Fitch said.
However, the impact on India's debt dynamics and capital spending will depend on the total size of loans waived, how the scheme is financed, and whether there are possible offsets from cuts to other forms of spending, including capital projects.
While affirming India's rating at 'BBB-' with stable outlook in May, Fitch forecast general government debt to fall to 64.9 per cent of GDP by fiscal 2020-21, from 67.9 per cent in fiscal 2016-17, and highlighted that potential changes to India's fiscal position are a rating sensitivity.
Public finances are a key weakness in India's sovereign credit profile, with general government debt well above the 'BBB' median of 40.9 per cent and the fiscal deficit of 6.6 per cent of GDP in 2016-17 much higher than the 'BBB' median of 2.7 per cent.
Fitch said banks could also be affected by the waiver schemes.
It will only benefit banks to the extent that they offload farm loans with weak repayment prospects to state governments.
Agricultural loans account for 14 per cent of total bank lending, and are equivalent to around 6.5 per cent of GDP.
"Uniform farm loan waivers could lead to moral hazard and weaken the general repayment culture among financially healthy farmers, but they will still have an incentive to repay loans in order to retain access to future funding," Fitch said.
The last widespread farm loan-waiver scheme was rolled out in 2008 by the central government under the UPA regime, and covered 43 million farmers. It reportedly cost around 1.3 per cent of GDP.
"The combined cost to the states could also become large this time," Fitch said, adding a roll-out of farm loan waiver scheme across much of India is not unthinkable.
Business Standard has always strived hard to provide up-to-date information and commentary on developments that are of interest to you and have wider political and economic implications for the country and the world. Your encouragement and constant feedback on how to improve our offering have only made our resolve and commitment to these ideals stronger. Even during these difficult times arising out of Covid-19, we continue to remain committed to keeping you informed and updated with credible news, authoritative views and incisive commentary on topical issues of relevance.
We, however, have a request.
As we battle the economic impact of the pandemic, we need your support even more, so that we can continue to offer you more quality content. Our subscription model has seen an encouraging response from many of you, who have subscribed to our online content. More subscription to our online content can only help us achieve the goals of offering you even better and more relevant content. We believe in free, fair and credible journalism. Your support through more subscriptions can help us practise the journalism to which we are committed.
Support quality journalism and subscribe to Business Standard.