The Hindu: Published on 20th Jan 2026:
Why in News?
The issue has gained attention because a sharp rise in borrowing by Indian State governments is beginning to interfere with the Reserve Bank of India’s (RBI) ability to manage interest rates effectively. Even after reducing policy rates, the RBI is finding it difficult to ensure lower borrowing costs across the economy. The reason lies in the growing volume of State government debt, which is placing upward pressure on bond yields and weakening monetary transmission.
This concern has been highlighted by analysts and officials familiar with the RBI’s internal assessment, who warn that State borrowings may soon rival or even exceed those of the Central Government, creating structural challenges for India’s debt and monetary management framework.
Background and Context:
India follows a dual borrowing structure in which both the Central Government and State Governments raise funds from the market. The Centre issues Government Securities (G-Secs), while States issue State Development Loans (SDLs). Both instruments are purchased largely by the same group of investors—banks, insurance companies, mutual funds, and pension funds.
Traditionally, Central Government borrowing has dominated the market. However, this balance is changing rapidly. In the current financial year, State governments are expected to borrow nearly ₹12.5 trillion, while the Centre’s gross borrowing stands at around ₹14.6 trillion. In net terms, the difference is even narrower.
This narrowing gap is significant because it increases competition for funds in the bond market, affecting yields across the system.
Why Rising State Borrowings Are a Concern:
1. Pressure on Bond Yields
State government bonds generally offer a slightly higher return—about 80 to 100 basis points more than Central Government bonds—to attract investors. As States issue more debt, the supply of bonds in the market rises sharply.
When supply increases, investors demand higher yields to absorb the additional bonds. This pushes up interest rates not just for State debt but also for Central Government securities. As a result, even after the RBI cuts policy rates, bond yields remain elevated.
This defeats the purpose of monetary easing.
2. Weakening of Monetary Transmission:
One of the RBI’s primary goals in cutting interest rates is to stimulate economic activity by making borrowing cheaper for businesses and consumers. However, high bond yields prevent banks and financial institutions from lowering lending rates effectively.
Despite a cumulative 100 basis points cut in policy rates:
Corporate borrowing costs have risen,
Long-term government bond yields have increased,
Benefits of rate cuts have not fully reached the real economy.
This weak transmission undermines the effectiveness of monetary policy.
3. Distortion of the Yield Curve:
The yield curve reflects interest rates across different maturities. Heavy issuance of long-term State bonds has led to steepening of the yield curve, especially at the long end.
A distorted yield curve:
Signals inefficiency in financial markets
Raises long-term borrowing costs
Discourages private investment
Complicates debt management for the government
RBI officials fear that if State borrowings continue to rise unchecked, the yield curve could remain structurally elevated even during periods of monetary easing.
4. Sub-Sovereign Borrowing Risk:
Although State debt is technically different from Central Government debt, markets treat it as nearly risk-free because:
RBI maintains a Consolidated Sinking Fund
There is an implicit sovereign backing
No Indian State has ever defaulted
This makes State bonds almost as attractive as central bonds, leading investors to shift funds toward higher-yielding SDLs. As a result, Central Government securities face reduced demand unless yields are raised.
Over time, this trend may allow State borrowings to overtake Central Government borrowings—an unusual and potentially risky fiscal situation.
Impact on Economy and Financial Markets:
1. Higher Cost of Capital
Rising bond yields directly increase:
Government borrowing costs
Corporate bond yields
Infrastructure financing costs
Housing and long-term loans
This slows down investment and economic growth.
2. Crowding Out of Private Investment
When governments borrow heavily, they absorb a large share of available savings. This reduces the availability of funds for private companies, making it harder and more expensive for them to raise capital.
3. Pressure on RBI’s Balance Sheet
To counter rising yields, the RBI is expected to purchase nearly ₹5.7 trillion worth of government bonds this year. While this helps manage yields, excessive intervention can:
Distort market signals
Increase RBI’s balance sheet risk
Reduce policy flexibility in the future
Why States Are Borrowing More:
Several factors are driving higher State borrowings:
Increased welfare spending, including rural employment schemes.
Higher infrastructure expenditure by States.
Shift of financial burden from Centre to States in certain schemes.
Limited revenue growth, forcing reliance on market borrowings.
Absence of alternative low-cost funding mechanisms for States.
Possible Solutions and Policy Options:
1. Greater Central Support
The Centre could increase long-term interest-free or low-interest loans to States, reducing their need to borrow from markets.
2. Access to Small Savings Fund
Allowing States to borrow from small savings schemes, currently available only to the Centre, could ease market pressure.
3. Better Debt Management:
States can:
Spread borrowings over different maturities
Avoid bunching of issuances
Improve fiscal discipline
4. Coordinated Fiscal-Monetary Strategy:
Closer coordination between the Centre, States, and RBI is essential to:
Prevent excess liquidity stress
Maintain orderly bond markets
Ensure effective transmission of policy rates
Conclusion:
The rising borrowing by Indian States has emerged as a significant macroeconomic challenge. While States require funds for development and welfare, unchecked borrowing is distorting bond markets, weakening monetary transmission, and undermining the RBI’s efforts to stimulate growth through rate cuts.
If left unaddressed, this trend could lead to persistently high interest rates, crowding out of private investment, and reduced policy effectiveness. A coordinated approach involving fiscal discipline, alternative financing mechanisms, and stronger Centre–State cooperation is essential to preserve macroeconomic stability and ensure that monetary policy works as intended.
