The correct answer is Option 2 In News • Recent assessments of state finances in India point to increasing debt burdens, excessive revenue spending, and limited room for capital investments. States are also facing growing interest liabilities, putting pressure on development expenditure. Explanation & Key Takeaways: • Unsustainable borrowing by states increases demand for funds in the market, potentially raising interest rates and reducing funds available for private sector investment. Hence, this statement is correct. • With high borrowings, a large share of the state budget goes into servicing debt and salaries, leaving little for capital infrastructure like roads, schools, and hospitals. Hence, this statement is correct. • Borrowing by states is permitted under the Constitution and coordinated via the Centre. While excessive borrowing may affect macro-fiscal balance, it doesn’t inherently violate cooperative federalism. Hence, this statement is incorrect. • As the debt stock rises, states face higher interest outflows, which further worsens fiscal stress. Hence, this statement is correct. Related Concepts: • Interest Payments as % of Revenue Receipts: States like Punjab and Kerala spend over 20% of their revenue just on interest repayments — far above the recommended level. • Crowding Out Effect: A well-established macroeconomic concern where heavy government borrowing limits credit availability to the private sector. • FRBM Act Targets: State-level FRBM Acts recommend maintaining debt-to-GSDP below 20% and fiscal deficits within 3%. Many states have breached this. • Capex Squeeze: States with high committed expenditure (salaries, pensions, interest) often struggle to invest in infrastructure and long-term growth areas. • Economic Survey Observation: Fiscal expansion is justified during downturns, but persistent revenue spending and debt-funded freebies risk long-term sustainability.