Budget 2026 keeps fiscal discipline intact; bond market faces supply stress

The Centre continues to toe the delicate balance between fiscal consolidation and finding space to remain growth supportive.  Both the asks from the Union Budget are equally important as the markets are unforgiving if fiscal prudence isn’t maintained. Meanwhile, markets will be equally unforgiving if there isn’t focus on strengthening growth impulses.  

The budget faces challenges on both resource allocation as well as resource mobilisation. On the allocation front, nearly 50 per cent of the total on budget expenditure is already committed in the form of interest payments, pay, pensions and subsidies. Hence only 50 per cent of the remaining expenditure is actually at the disposal of the Centre. On the resource mobilisation front, it has taken 10-years for gross tax collection as a percentage of GDP to rise by 0.8per cent to 11.4 per cent in the financial year 2026.  

 

Hence, against this backdrop, today’s budget managed to meet both requirements despite challenging operational issues. The focus on fiscal consolidation was retained with fiscal deficit target set at 4.3% of GDP in the financial year (FY27) versus 4.4 per cent in the financial year (FY26). The fiscal consolidation anchor has shifted to debt-to-GDP from deficit-to-GDP from financial year 2027 (FY27) onwards. This gives the Centre the flexibility to moderate the pace of fiscal consolidation, creating space to support growth. At the same time, the target must be set such that debt-to-GDP reduces overtime to 50 per cent by financial year 2031 (FY31). 

In the financial year 2027 (FY27), the government-securities supply target was higher than expected at ₹17.2 trillion which is higher than last year by 18 per cent. 

For the bond market, funding of the deficit is important.  To complicate matters further state government bond issuances are also seeing a substantial rise. Unlike the Centre which has been on a path of fiscal consolidation, state governments are seeing worsening fiscal performance. Fiscal deficit in the financial year 2026 (FY26) is estimated at 3.3 per cent of Gross State Domestic Product (GSDP) versus 3.2 per cent in the financial year 2025 (FY25). In the financial year 2027 (FY27), the fiscal deficit is estimated at 3.2 per cent of Gross State Domestic Product (GSDP), implying a gross state government supply of ₹13 trillion.   ALSO READ | Budget 2026 changes SGB tax rules, ends blanket capital gains exemption 

The next financial year will see total gross supply of government securities (centre plus states) of ₹30.2 trillion, which is significantly higher than last year. The supply surge comes in a year when the rate cut cycle is essentially behind us and the RBI OMO purchases remains the sole anchor for the debt market. 

Globally also, fiscal pressures persist with sharp rise in developed market (DM) general government debt post Covid-19 shock.  Countries which run large current account surplus such as European Union and Japan and are net investors globally are seeing a sharp rise in domestic bond yields. The fiscal pressures in the US will ensure that US Treasury yields remain elevated, which sets the floor for emerging markets (EM) yields. 

The largest investors in the government bond market are banks, long-only investors (insurance, pensions and providend funds) and RBI. The investment demand of banks is constrained by deposit growth lagging credit growth. This is reflected in credit-to-deposit ratio rising to a historical high of 82 per cent. The gap between credit and deposits has been met via borrowings and reduction in SLR holdings. Banks investment in government securities has reduced to 27.7 per cent of Net Demand Time Liabilites (NDTL) as of December 2025 versus 29.0 per cent as of December 2024.  

The combination of surge in supply and weakness in investment demand has forced the RBI to bridge the gap. The dependence on RBI to bridge supply-demand gap will only rise in the financial year FY27 where the supply will be even higher.  

The tough position that the bond market finds itself reflects a much more fundamental issue, of rising government bond supply chasing limited domestic savings pool. Measure will be needed to widen the investor base for the bond market and attract much needed foreign savings.  Disclaimer: This article is by Gaura Sengupta, chief economist, IDFC First Bank. Views expressed are her own.