How heavy state borrowing has blunted the RBI's rate cuts and bond buying

RBI's liquidity push is being neutralised by record state borrowing, keeping yields elevated and markets subdued - exposing deep fiscal strains beneath India's strong GDP numbers

The Reserve Bank of India (RBI) on December 23 announced a $32 billion programme of liquidity injection via purchases of government bonds and dollar-rupee swaps. In normal times such largesse would have lifted spirits on Dalal Street. Instead, equity indices fell that very day and continued to slide over the next two. Throughout the year 2025 the central bank has been cutting interest rates and pumping money into the financial system, hoping that cheaper credit and abundant liquidity would lift loan demand and spur growth. Yet the bond market has barely obliged. The yield on India’s 10-year government bond has fallen by only 13 basis points this year, while the yields on top-rated corporate bonds have risen by 11 basis points. State-government bonds have fared worse still. Their spread over central-government securities has widened to about 40 basis points, according to Bloomberg. The problem lies in states and their borrowing plans. 

The finance minister has said in multiple public forums that while India’s debt-to-gross domestic product ratio had improved after the pandemic, some states showed worrisome debt levels. While the RBI is easing the flow of money, states are financing themselves more and more through the debt market. State debt is up almost 20 per cent in one year from FY24 to FY25 at ₹12 trillion ($134 billion). In the next quarter (January-March), states are estimated to borrow ₹4.5 trillion. No wonder investors are demanding higher yields; India’s 10-year bond yield rose to a nine-month high of 6.68 per cent last Monday as states announced a larger than scheduled bond auction for the week. That led to state-owned utility firm Power Finance Corporation scrapping its bond sale on Tuesday. 

In effect, states have thrown a spanner in the RBI’s easy-money machine. They are soaking up much of the liquidity the central bank injects by flooding the market with their own bonds. On December 24 Vikas Jain, a senior trader at Bank of America, warned that record state borrowing would weigh on bonds and keep interest rates stubbornly high. “The state bond supply is definitely going to increase sharply and that’s why real-money investors are not ready to commit a significant amount at this point,” he told Bloomberg. Could the finance ministry rein in this spree? Probably not, for two stubborn reasons. 

High GDP 

State debt is rising, first, because revenues are disappointingly weak. States complain, with some justification, their share in goods and services tax is lower than the levies it replaced, and that transfers from the Centre have been tight. But that cannot be the whole story. India’s economy is supposedly booming: Gross domestic product (GDP) grew by 8.2 per cent in the latest quarter, and most forecasters expect growth of 7 per cent or more next year. Such vigour ought to translate into buoyant tax receipts. Yet, as noted in these pages earlier, headline GDP growth is not mirrored in corporate earnings — and now it appears not to be reflected in state coffers either. Either growth is overstated, or it is less fiscally potent than many assume. 

Low revenues, high spending 

The other half of the problem is spending. The RBI estimates that aggregate state debt now stands at 27-28 per cent of gross state domestic product (GSDP), well above the 20 per cent ceiling recommended by India’s fiscal-responsibility watchdog. Ten states have debt ratios exceeding 30 per cent. Under India’s federal system, states are responsible for most public services and for delivering many centrally sponsored schemes. But much of their outlay is locked in rigid overheads. According to PRS Legislative Research, interest payments, salaries, pensions, and subsidies consumed 62 per cent of state revenues in 2023-24. That year states ran a revenue deficit of 0.4 per cent of GSDP, meaning they were borrowing simply to meet day-to-day expenses. 

The freebie trap 

Worsening matters is the rise of competitive populism. In a bid to win elections, parties in states like Bihar, Punjab, Rajasthan, Madhya Pradesh, and Andhra Pradesh have rolled out lavish giveaways — cash transfers, farm-loan waiver, free power, and transport — pushing up deficits beyond the limits set by fiscal-responsibility laws. In 2025-26, 12 states that provide cash transfers to women will together spend ₹1.68 trillion, estimates PRS Legislative Research. Six of them already run revenue deficits. No party is innocent. On December 26 Punjab announced free medical treatment of up to ₹10 lakh per family from January. Punjab is also one of India’s most indebted states, with a debt-to-GSDP ratio of 46 per cent, compared to 19 per cent in Maharashtra, 18 per cent in Gujarat, and 16 per cent in Odisha. 

What should investors make of all this? The markets appear to have drawn their own sombre conclusions. Strong GDP figures and the RBI’s easy-money policy should have been an explosive fuel. Instead, all major indices have barely stirred. Indeed, the hidden fiscal risks are bigger. States’ official deficit figures exclude large contingent liabilities — from loss-making power-distribution companies to transport firms and infrastructure projects. Add these in and the true burden looks heavier still. India’s bond and equity markets will shrug off the overhang of rampant state borrowing only if something more compelling comes along to distract them. 

The writer is editor of www.moneylife.in and a  trustee of the Moneylife Foundation; @Moneylifers