The Budget, govt borrowing and the RBI: Managing mounting FY27 pressures

The Centre's higher gross borrowing won't be a challenge in FY27, but the increasing size of state development loans is a concern

Finance Minister Nirmala Sitharaman will present the Union Budget on February 1 – the ninth consecutive Budget by any finance minister. It will be on a Sunday, and at a new address – Kartavya Bhavan at the Central Vista complex, New Delhi.

 

Beyond the trivia, this Budget will usher in a new era – the anchor for fiscal consolidation will shift from deficit-to-GDP (gross domestic product) to debt-to-GDP ratio. There is a medium-term glide path for debt-to-GDP ratio, from 56.1 per cent in the financial year (FY) 2026 to 50 per cent plus/minus 1 per cent by FY31.

 

Indeed, there is a shortfall in tax revenues, but most analysts expect the government to meet the 4.4 per cent fiscal deficit target for the current fiscal year, riding on liberal dividend payments by public sector undertakings as well as the central bank.

 

The fiscal deficit target will definitely be lower in FY27 – it could be 4.2-4.3 per cent of GDP. If the target is 4.3 per cent, then the central government’s debt-to-GDP ratio will drop to 55 per cent, from the current level of 56.1 per cent. If the government decides to cut expenditure on social and income-support schemes, the target could be 4.2 per cent. This will bring down the debt-to-GDP ratio to below 54 per cent.

 

The banking sector will keenly watch the size of the government’s annual borrowing programme. If this year’s borrowing programme is any indication, then the Reserve Bank of India (RBI) will have to lend a helping hand.

 

The central government’s gross borrowing could be Rs 16.5 trillion, at least, in FY27. Net of redemptions, the net borrowing will be much lower. But the state governments’ borrowing – the state development loan, or SDL – queers the pitch. It could be around Rs 13 trillion.

 

In the current year, the central government’s gross borrowing is pegged at Rs 14.72 trillion, and net of redemptions, the net borrowings, at Rs 11.54 trillion. Of this, Rs 12.79 trillion has so far been raised. The gross SDL in the current year is Rs 11.83 trillion. Of this, Rs 8.23 trillion has been raised.

 

This is the supply side story. Will there be demand for such a large borrowing programme? That’s the challenge before the RBI. In the current year, it has managed this by buying bonds from the market, popularly known as open market operations, or OMO. In FY26, a record Rs 6.45 trillion (till February 12) is being raised through this route, more than double of what the RBI had bought in FY25. The highest OMO before this was in FY21 – a little over Rs 3.13 trillion.

 

Such OMOs are a liquidity injection tool. When banks and other entities aren’t really excited to buy government bonds, the central bank steps in. It can also manage the yield of bonds through OMOs. In FY21, this was used for yield management as well, besides liquidity injection. Remember former RBI governor Shaktikanta Das’s famous quote: “Yield curve is a public good”?

 

Until the global financial crisis of 2008, the central government’s gross borrowing never crossed Rs 2 trillion. And SDLs were much lower – in thousands (for instance, Rs 20,825 crore in FY07).

 

In FY09, the central government’s gross borrowing crossed Rs 2 trillion for the first time. The following year, it jumped to over Rs 4 trillion. The next big jump came in the Covid-hit FY21. From a little over Rs 7 trillion in the previous fiscal year, it rose to Rs 13.7 trillion that year. It crossed Rs 15 trillion in FY24, and is now set to cross Rs 16 trillion in FY27.

 

Though the size of borrowing has increased over the years, as a percentage to GDP, it has remained largely in range. The years of Covid and the global financial crisis were the outliers.

 

Since FY08, the central government’s gross borrowing has gone up at least 10 times. The RBI has managed it well, and will do so in FY27 as well, since there won’t be any significant change in net borrowing, even though the gross borrowing will be large. 

 

But SDL is becoming a burden. Before the global financial crisis, state loans were just 15-20 per cent of central borrowing every year. In FY27, these could be 75-80 per cent; and over the next few years, SDL may even exceed the centre’s annual borrowing.

 

The oversupply of SDL has widened the spread between the yield of 10-year central government and state government papers to 85 basis points. Typically, it is about 40-50 basis points. One basis point is a hundredth of a percentage point.

 

Till about a decade ago, state governments had a porti on of the national small savings fund (NSSF) to bridge their fiscal deficit. The 14th Finance Commission recommended excluding state governments from NSSF because the money raised through this channel is costlier than market borrowings.

 

The government accepted this recommendation in February 2015, and the Cabinet gave its approval to excluding all state governments and Union territories from NSSF, except Arunachal Pradesh, Delhi, Kerala, and Madhya Pradesh, starting April 2016. The state governments will clear the outstanding amount in the NSSF scheme by FY39.

 

To deal with their fiscal deficit, states have shifted from the relatively high-cost NSSF to the market. Their borrowings have been on an upswing since an increasing number of states are busy declaring welfare schemes for agriculture, women, and unemployed in the form of direct cash transfers or subsidies. 

 

The RBI publication of state finances ("A Study of Budgets of 2025-26"), released last week, points out that the elevated debt levels of many states "necessitate a clear, transparent and time-bound glide path for debt consolidation by states".  

 

For buyers, the sub-sovereign papers bear no credit risk, thanks to the “automatic debt mechanism” in the Fiscal Responsibility and Budget Management framework. Shorn of technicalities and other details such as ways and means advance, or WMA, for short-term liquidity, the RBI is responsible for ensuring timely payment of both coupon (interest) and redemptions of SDLs.

 

Essentially, by shifting from NSSF to market, states have cut down the cost of resources. And, since there will always be takers for their papers, with the central bank as a sort of guarantor, why would they pare their borrowings?

 

Meanwhile, there have been certain structural changes in the market that have impacted the demand for government papers. The statutory liquidity ratio, which makes it mandatory for banks to buy government bonds, has been decreasing. Now, it is 18 per cent of their net demand and timely liabilities, a loose proxy for deposits. At its peak, in the early 1990s, it was 38 per cent.

 

Indexation benefits for mutual funds and the tax advantages of insurance products used for bond investments have been removed. In addition, provident funds and insurance firms have been allowed to put in more money in equities. So, the captive resources for bonds have reduced.

 

The classification norms of bond portfolios of banks have also been changed. Banks are allowed to shift bond investments from the held-to-maturity bucket to any other bucket once a year, but for this, besides the board’s approval, the RBI’s approval is also required.

 

All these have diminished the risk appetite of local bond buyers. Add to this the weakening rupee. A depreciating currency is unlikely to excite foreign investors to buy Indian bonds. An inclusion into the Bloomberg Global Aggregate Index could have ensured foreign money flow, but that hasn’t happened.

 

The 10-year bond yield is not reflecting the impact of the 125-bps rate cut by the RBI in the current cycle, but that’s the nature of the beast called the market. It always factors in any change in the policy rate in advance – be it a rate cut or a hike.

 

To sum up, the Centre’s higher gross borrowing won’t be a challenge in FY27, but the increasing size of the state development loans is a concern. Expect the RBI to continue buying bonds from the market through the OMO route. The yield on 10-year bonds can only rise, and the yield curve can stiffen further – dropping at the shorter end and rising at the longer. 

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The writer is an author and senior advisor to Jana Small Finance Bank Ltd. His latest book: Roller Coaster: An Affair with Banking. To read his previous columns, log on to www.bankerstrust.in. X: @TamalBandyo