Government Borrowing Costs Climb Despite RBI Rate Reductions
In a surprising economic trend, both the central and state governments in India are facing higher borrowing costs, even as the Reserve Bank of India (RBI) has implemented significant cuts to its benchmark repo rate. This divergence highlights underlying structural and liquidity challenges that are impacting fiscal management across the country.
Recent Auction Data Reveals Rising Yields
Recent auction sales of state government securities illustrate this upward pressure on borrowing costs. On February 3, Andhra Pradesh and Assam borrowed Rs 1,100 crore and Rs 1,000 crore respectively through 15-year securities at an average yield of 7.66%. This marks a notable increase from just a year ago, on February 4, 2025, when similar auctions saw yields of only 7.15-7.16% for the same tenor, raising Rs 2,000 crore and Rs 900 crore respectively.
The trend is consistent across states. For instance, the Gujarat government mobilized Rs 2,000 crore via a 10-year security sale on January 27 at an average yield of 7.45%, compared to Rs 7.02% in a year-ago auction on January 28, 2025, which raised Rs 1,000 crore. These examples show that state governments are now paying 0.4-0.5 percentage points more for 10-15 year borrowings than they did last year.
Central Government Also Affected
This issue is not confined to state governments alone. Over the past year, yields on 10-year Government of India securities have risen from 6.66% to 6.73%, despite the RBI cutting its key lending rate by 1.25 percentage points during this period. Since February 6, 2025, the RBI has reduced its benchmark policy repo rate from 6.5% to 5.25%, but this easing has not translated into lower borrowing costs for governments, indicating a breakdown in monetary policy transmission.
Structural Factors: High Debt Levels
The primary reason for this situation is structural, stemming from the sheer scale of borrowings by both the Centre and state governments. An analysis of outstanding liabilities as a percentage of India's gross domestic product (GDP) reveals concerning trends. The Centre's debt-GDP ratio fell from 51.7% in 2011-12 to 48.1% in 2018-19, but economic slowdowns and pandemic-related fiscal expansions caused it to spike to 60.7% in 2020-21. It has since modestly declined to 55.2% in 2025-26, with a budgeted 54.7% for the fiscal year ending March 31, 2027.
For states, the consolidated debt ratio increased from 22.8% in 2011-12 to a peak of 31% in 2020-21, gradually declining to 29.2% in 2025-26. These levels are far from the Fiscal Responsibility and Budget Management Act targets of 40% for the Centre and 20% for states combined by 2024-25, set in a 2018 amendment.
The rising debt has led to ballooning interest payments. In 2025-26, interest payments amounted to Rs 12.74 lakh crore, or 38.1% of total revenue receipts for the Centre, and a budgeted Rs 6.25 lakh crore, or 12.2% for states. This consumes a large share of budgets, crowding out other expenditures and driving up rates in the money market as government borrowings limit private sector access to credit.
Liquidity Tightening Exacerbates the Issue
The second major factor is liquidity tightening. Historically, excessive government borrowings did not cause significant crowding out due to economic slack and abundant liquidity from foreign capital inflows, which averaged over $75 billion annually between 2017-18 and 2023-24. The RBI's purchase of surplus dollars injected rupee liquidity into the banking system, keeping rates low.
However, this dynamic has shifted from 2024-25. Net foreign capital inflows dropped to about $18 billion that fiscal year and $8.6 billion during April-September 2025. Foreign portfolio investors pulled out $18.9 billion from Indian equity markets in 2025 and another $3.1 billion in the current calendar year. To prevent rupee depreciation, the RBI has been selling dollars, draining rupee liquidity from the system.
This liquidity tightening coincides with a recovery in private sector credit demand, leading to a hardening of interest rates. Markets have reacted negatively to the government's large borrowing program, with the Centre budgeting gross market borrowings of Rs 19.70 lakh crore for 2026-27, up from Rs 16.19 lakh crore and Rs 15.47 lakh crore in the preceding two fiscals. Net borrowings are pegged at Rs 11.73 lakh crore, reflecting an increase from previous years.
Global Context and Future Outlook
Globally, the absence of cheap money exacerbates the situation. With 10-year government bond yields at nearly 4.25% in the US and 2.25% in Japan, there is no abundant global capital flowing into India as before. This has resulted in limited transmission of RBI's repo rate cuts; while the policy rate fell by 1.25 percentage points, commercial banks have only lowered rates by an average of 1.05 percentage points on fresh loans and 0.95 percentage points on term deposits.
Looking ahead, liquidity tightening could become a more severe problem if investment sentiment revives, particularly with potential developments like a bilateral trade agreement between India and the United States. Such agreements might stimulate the return of foreign portfolio investors, whose inflows could ease current liquidity concerns and support lower borrowing costs.
In summary, the rising borrowing costs for governments despite RBI rate cuts underscore the complex interplay of high debt levels and liquidity constraints. Addressing these issues will require careful fiscal management and potential policy adjustments to ensure sustainable economic growth.
