Markets caught in a fiscal tug of war

The Reserve Bank of India (RBI) on December 23 announced a $32 billion programme of liquidity injection via purchases of government bonds and dollarrupee swaps.

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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 the year 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 the yields on toprated corporate bonds have risen by 11 basis points.

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.

The finance minister has said in multiple public forums that while India's debt-to-gross domestic product ratio had improved after the pandemic, some states showed worrisome debt levels. While the RBI is easing the flow of money, states are financing themselves more and more through the debt market. State debt is up almost 20 per cent in one year from FY24 to FY25 at 12 trillion ($134 billion). In the next quarter (January-March), states are estimated to borrow ₹4.5 trillion. No wonder investors are demanding higher yields; India's 10-year bond yield rose to a nine-month high of 6.68 per cent last Monday as states announced a larger than scheduled bond auction for the week. That led to state-owned utility firm Power Finance Corporation scrapping its bond sale on Tuesday.