On 23rd December, the Reserve Bank of India (RBI) announced a $32bn programme of liquidity injections 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 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 yields on top-rated corporate bonds have actually risen by 11. 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.
At a public event on 17th December, the Finance Minister said, while India’s Debt-to-GDP ratio has improved from 60.4% (post-Covid) to an expected 56.1% (although international estimates are higher), some States show worrisome debt levels. While RBI is easing the flow of money, States are financing themselves more and more through the debt market. State debt is up almost 20% in one year from FY24 to FY25 at ₹12 lakh crore ($134 billion). In the next quarter (Jan-Mar), states are estimated to borrow ₹4.5 lakh crore. No wonder investors are demanding higher yields; India’s 10-year bond yield rose to a nine-month high of 6.68% last Monday, as States announced a larger-than-scheduled bond auction for the week. That led to India's state-owned utilities firm Power Finance Corporation scraping its bond sale on Tuesday.
In effect, India’s states have thrown a spanner into 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. Of course, RBI is also forced to soak up liquidity while defending the rupee against dollar. But that is episodic. The problem of State borrowing is endemic. On December 24th 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.
1. High GDP, Low Revenues
State debt is rising first because revenues are disappointingly weak. States complain, with some justification, that their share of the 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: GDP grew by 8.2% in the latest quarter, and most forecasters expect growth of 7% 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.
2. Low Revenues, High Spending
The other half of the problem is spending. The RBI estimates that aggregate state debt now stands at 27–28% of gross state domestic product (GSDP), well above the 20% ceiling recommended by India’s fiscal-responsibility watchdog. Ten states have debt ratios exceeding 30%. 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 into rigid overheads. According to PRS Legislative Research, interest payments, salaries, pensions and subsidies consumed 62% of state revenues in 2023-24. That year states ran a revenue deficit of 0.4% 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 waivers, free power and transport—pushing deficits beyond the limits set by fiscal-responsibility laws. In 2025-26, 12 states that provide cash transfers to women will together spend ₹1.68trn, estimates PRS Legislative Research; six of them already run revenue deficits. No party is innocent. On December 26th Punjab announced free medical treatment of up to ₹1m per family from January 2026. Punjab is also one of India’s most indebted states, with a debt-to-GSDP ratio of 46% (GSDP Gross State Domestic Product), compared with 19% in Maharashtra, 18% in Gujarat and 16% in Odisha.
What should investors make of all this? Markets appear to have drawn their own sombre conclusions. Strong GDP figures and 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. As of now, this is a prime concern.
(This article first appeared in Business Standard newspaper)
Market is the ultimate barometer. And if the market is showing a steady/rising yield on government bonds despite rate cuts by RBI, then, it means that the market is expecting more such deficit-bridge bond issuances by the central and more particularly by the State governments.
With all these alarming inputs by the author, why can something more substantial be brought in? I think there are enough options available. Why delay???
It is extremely strange that RBI is completely unaware of the quantum of borrowings being planned by Central and State Governments.
Under Sanjay Malhotra, RBI rolled out two rate cuts - 50 bps in June and 25 bps in Dec - the immediate effect of these is a sharp jump in 10 year bond yields - exposing a clear divergence in market perception of the RBI governor speech -
RBI needs to immediately address this huge gap - and ensure that it's policy direction is swiftly reflected in interest rates across the economy - especially bond yields.
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Under Sanjay Malhotra, RBI rolled out two rate cuts - 50 bps in June and 25 bps in Dec - the immediate effect of these is a sharp jump in 10 year bond yields - exposing a clear divergence in market perception of the RBI governor speech -
RBI needs to immediately address this huge gap - and ensure that it's policy direction is swiftly reflected in interest rates across the economy - especially bond yields.