RBI cautions states on fiscal discipline as borrowing costs surge

At a meeting with state finance secretaries last month, RBI governor Sanjay Malhotra urged states to keep borrowing in check and adhere to fiscal deficit targets under the Fiscal Responsibility and Budget Management (FRBM) framework, four people aware of the matter said.

The central bank's concerns were not reflected in a brief post-meeting statement, but have since gained urgency amid rising yields and expanding welfare commitments. The caution comes as market worries have deepened over the financial burden of populist schemes, the people cited above said on the condition of anonymity.

“Governor emphasised on the importance of fiscal discipline for promoting economic growth and prosperity," the RBI statement on the 35th Conference of State Finance Secretaries had said on 18 September.

RBI is particularly worried about states that are simultaneously facing extended monsoon-related losses and pre-election spending pressures, according to two of the four people cited earlier.

“Increased spending without commensurate revenue growth will push states to borrow more, and markets immediately price that in through higher yields," a third person aware of the development said, citing instances of fiscal strain in states such as Himachal Pradesh, Punjab, Uttarakhand, and Bihar.

Last month, the Bihar government, led by chief minister Nitish Kumar, approved a new scheme called Mukhyamantri Mahila Rojgar Yojna, which promises ₹10,000 in seed funding and up to ₹200,000 in later stages to women for self-employment from every family in the state. Bihar legislative assembly elections are scheduled to be held in two phases on 6 and 11 November, with counting of votes set for 14 November.

On 7 October, Maharashtra chief minister Devendra Fadnavis announced a ₹31,628 crore relief package for farmers affected by heavy rains and floods across the state.

“Overall, the fiscal health of all the states is reasonably good, but there are some states which put out optimistic fiscal deficit targets, which include grants from the centre, but when things don't pan out as planned, their fiscal deficit goes higher," said Paras Jasrai, associate director and economist, India Ratings & Research.

“To top that, many states have also announced some welfare schemes after their budget allocations ahead of elections. This is worrisome, considering that overall state of finances is not very good, especially for Bihar," Jasrai said.

Borrowings and costs

Market participants are also concerned that welfare outlays, if not matched by revenue generation, could widen state deficits and drive borrowing costs higher.

This is visible in states’ borrowing numbers. Bihar has raised ₹31,500 crore so far in the current financial year through market borrowings, nearly double the ₹16,000 crore borrowed in the same period a year ago, according to a research report by Bank of Baroda.

Other states, including Madhya Pradesh, Telangana, Gujarat, and Uttar Pradesh, have substantially increased their borrowing programmes this year, while Andhra Pradesh, Jammu and Kashmir, Punjab, and Karnataka have reduced their reliance on market borrowings.

Up until 14 October, states had borrowed ₹5.23 trillion—62.1% of their planned borrowing till the December quarter—higher than ₹4.37 trillion in the same period a year ago, the Bank of Baroda research report said.

A rise in market borrowings and an uncertain global environment widened the spreads between 10-year benchmark government bonds and state development securities (SDLs) to 106-112 basis points in early September, significantly higher than historical spreads of 30-40 bps.

While market borrowing by states announced on 3 October for Q3 at ₹2.82 trillion, compared with expectations of ₹3.2 trillion, narrowed the spread between SDLs and 10-year government bonds to 79-85 bps as of September-end, experts believe yields are only likely to rise from here. Currently, spreads are around 65-70 bps.

“The continued supply, combined with muted secondary market depth, has resulted in a visible risk premium. The borrowing calendar for Q3 FY2026 suggests that continued issuance will keep an upward bias on SGS (state government securities) yields, even if overall market liquidity remains comfortable," said Venkatakrishnan Srinivasan, market veteran and founder of Rockfort Fincap.

After the RBI kept the policy repo rate unchanged at 5.5% on 1 October, the bond market now expects a 25 bps rate cut in December as inflation shows signs of moderating. This could bring down yields on government bonds by 15-20 bps, Srinivasan said, adding that it may not fully transmit to state government securities.

“Spreads could only narrow if there is a clear easing cycle from RBI, moderation in state borrowing volumes, and a broader investor base, particularly higher participation from insurers, provident funds, and FPIs. In their absence, the SGS–G-Sec spread is likely to hold in the 50-75 bps range, with periodic spikes whenever weekly auctions bunch up," he said.

The yield on the benchmark 10-year government bond was at 6.5306% earlier today. It had closed at 6.5040% on Monday, according to a Reuters report. The 10-year yield has stayed above 6.50% all month, except on 15 October, ahead of the release of the central bank's policy meeting minutes.

Will states be able to adhere?

Economists remain divided. Some expect a wider-than-anticipated fiscal deficit for states due to a slowdown in nominal GDP growth and likely revenue loss from income tax and GST cuts, while others believe it will be managed, given that overall fiscal debt financing is capped within the debt-to-GSDP (Gross State Domestic Product) ratio and is regularly monitored by RBI.

The FY26 budget estimate of states has pegged the combined fiscal deficit at ₹11.4 trillion, or 3.2% of GDP, within the indicative limit of 3.5% of GSDP allowed by the central government, India Ratings & Research had said in a 6 May report.

In FY25, states had borrowed ₹10.73 trillion, 7% higher than FY24, a report by Reuters said. For FY26, the full-year budgeted estimate is ₹12.31 trillion through market borrowings, the rating agency said.

“We see a risk that states’ fiscal deficit will be wider by 0.2% of GDP; pressure on central government is likely to be half this figure," Standard Chartered Global Research said in a 22 September report.

Revenue loss is expected from lower direct taxes and GST collection. States receive 55-57% of total tax collected, which is the aggregate of all taxes collected by the centre, excluding cess. While the centre has some cushion to manage such losses through higher RBI dividend and excise duty proceeds on fuel products, no such offset is available to the states.

While RBI’s concerns remain valid, some economists argue that states generally remain within statutory deficit limits prescribed under the FRBM Act.

“States rarely breach the allocated fiscal deficit ceiling. Post covid-19, they have been able to maintain the fiscal deficit at 3% or even lower than that," said Madan Sabnavis, chief economist at Bank of Baroda.

If a state announces new welfare schemes, it often compensates by cutting down on other spending, Sabnavis said, adding that markets assume fiscal discipline will be compromised, leading to a rise in yields.