States pause spending as they await 16th Finance Commission's payouts

Most states have reduced their market borrowings, and raised less-than-projected amounts via state government securities, pushing up yields for short-term papers that the Centre typically uses

In a new trend in India's federal financing system, states are hitting a spending pause as they wait for the 16th Finance Commission award to amp up their expenditures in the remaining five months of the current financial year. While the award period technically begins from the next financial year, states are hoping the report outlining fiscal pressures on them will goad the Centre into bringing bring forward some sizeable relief. 

 

How does lower state borrowing weaken the Centre’s fiscal influence?

 

When states borrow heavily from the markets to meet the gap between their revenue and expenditures, the Centre gets an opportunity to influence those costs by offering higher accommodation via short term papers. But if states stay away from the markets, the Centre's leeway is diminished. Many policy goals, such as reforms in the power sector or municipal works, depend on the Centre’s ability to influence state finances; these become difficult in the Centre is not effectively able to control the flow of funds.

 

The Finance Commission report, which was presented to President Droupadi Murmu by the chairman of the Commission, Arvind Panagariya on November 17, is expected to shortly be made public by the finance ministry. Typically, the finance minister, while tabling the report in Parliament, which describes how the tax pie will be shared between the states and the centre every five years, affirms the award will be adhered to. It is expected that the effective division of tax between the Centre and the states will remain unchanged in the award of the 16th Finance Commission.

 

Why are states slowing expenditure?

 

States, it would appear, are speculating that it will be financially better for them to wait for the money to ramp up their expenditure instead of borrowing more to finance the spending, given that the funding stream from the earlier 15th Finance Commission has tapered off by now. Additionally, many are in financial stress due to the burden of cash doles - most of them promised ahead of elections - to large segments of their population.

 

This has created an interesting shortage of state government papers in the bond market. As ratings agency Icra noted, while seven state governments and one union territory (UT) raised Rs 12,800 crore through state government securities (SGS) on October 14, 2025, this was less than half of the amount indicated in their Q3FY2026 auction calendar for the week. This was not a one-off event. In the next auction, eight more state governments and one UT raised only Rs 15,600 crore through state government securities on November 11, again a substantial 40 per cent below the Rs 26,000 crore indicated in the Q3FY2026 auction calendar for that week.

 

Similar withdrawal symptoms can be seen across most states. Except Bihar, which had been spending heavily in the run-up to the recently-concluded Assembly elections, north Indian states' spending was on average 300 to 400 basis points behind actuals for FY25. Southern states were much more circumspect but here, too, the sluggishness was visible in their shopping carts: they were spending on capital expenditure as a large part of the money is financed by the Centre (see chart).

 

Of course, there are some factors which have helped the states. Icra itself notes that the lower-than-indicated issuance could possibly be on account of release of two tranches of tax devolution by the Centre in October 2025, “which may have eased borrowing requirements of some states”. A government release in October noted that in view of the impending festive season and to enable States to accelerate capital spending and finance their development/ welfare related expenditure, the Union Government released an additional tax devolution of Rs 1.01 trillion to state governments at the start of October, over and above the normal monthly devolution that was due to be released on October 10.

 

How is the bond market reacting to states’ limited presence?

 

The ramifications of such funding and expenditure patterns show up in the bond market, which has a strong appetite for short term papers. The cut-off yield for the 182-day paper - the typical instrument the Centre uses to finance short term financing requirements of states - has remained high. It was 7.11 percent in the latest auctions in November. As a Business Standard report noted: “Over the last two months, yields on Treasury bills have gone up by 7-11 basis points across tenures,” indicating higher supply of these papers, instead of long dated bonds by the states. In other words, the states are missing from the short-term bond market. The problem is that the interest cost for these short-term papers is borne by the Centre, unlike those of more than one year which are designated as dated securities.

 

Also, whatever little the states are willing to borrow is through longer term papers. Data shows the share of the longer tenor papers in total issuance by the states has increased to 72 per cent in November 2025, compared with an average of 64-67 per cent in the previous three months. The percentage of shorter tenors has dipped to 21 per cent from 25-30 percent. So far, the states have raised just Rs 80,000 crore through SGS in the current October to December quarter of FY26. This is 36 percent below the amount of Rs 1.3 trillion that was indicated for this period.

 

The financial arrangement between the Centre and the states have clearly come under strain. Given the circumstances, how the 16th Finance Commission resolves it will be of considerable significance for both sides.  

How States Have Been Spending