Budget’s Bond Test Lies in Solving the States’ Borrowing Problem

When the Union Budget for 2026–27 is presented on February 1, financial markets will scan the fine print less for headline-grabbing giveaways and more for signals on how the government intends to manage an increasingly binding fiscal arithmetic. Equity investors will, as usual, hope for tax relief. Bond markets will focus on something more prosaic but more consequential: the scale and composition of sovereign borrowing.

Fiscal consolidation is no longer a rhetorical commitment but a binding constraint. The Centre has articulated a medium-term objective of lowering its debt-to-GDP ratio to around pre-pandemic levels by the end of the decade, from roughly 57% at present. Consolidated fiscal numbers have already come off sharply from the pandemic peak, with the combined deficit of the Centre and states now estimated at about 7.3% of GDP in 2025–26, down from over 13% in 2020–21.

For 2026–27, a central government fiscal deficit of around 4.2% of GDP looks plausible, assuming nominal growth near 10%. States are expected to run deficits close to 2.8% of GDP. That arithmetic implies a consolidated deficit near 7%, a pace of adjustment consistent with gradual debt reduction rather than fiscal shock therapy.

For bond markets, however, the issue is not just the deficit number but the supply it translates into. A 4.2% central deficit implies gross market borrowing of roughly ₹17 trillion, with net borrowing of about ₹11.5 trillion after redemptions. States, assuming that close to 90% of their financing needs are met through market borrowings, are likely to add another ₹13.5 trillion of gross issuance, or roughly ₹9.5 trillion on a net basis.

Taken together, the sovereign bond market is staring at a supply of around ₹30.5 trillion in 2026–27.

Bond Glut
Even with benign inflation and an easing bias on policy rates, such supply places a natural floor under yields. Without explicit support from the Reserve Bank of India, through open market purchases of at least ₹4 trillion, it is difficult to see government bond yields declining meaningfully from current levels. The 10-year benchmark is likely to remain range-bound around 6.55–6.75% through the end of the current financial year.

The more acute stress, however, is not in central government bonds but in state development loans and, by extension, corporate credit. Elevated state borrowing is already pushing up spreads, and sustained heavy issuance risks crowding out private borrowers or forcing them to pay up for borrowings at very high yields. Even bank lending rates are inching up in response to rising corporate bond yields, which further impair monetary transmission. In that sense, state bond supply has quietly become the binding constraint for the broader fixed-income market.

This is where Budget 2026–27 has the potential to surprise through balance-sheet engineering. One option is to expand the use of interest-free capital expenditure loans to states, reducing their reliance on market borrowing without compromising investment spending. These loans have already shown that they can tilt incentives towards productive expenditure while easing pressure on bond markets.

A more structural solution would go further. The Centre could borrow on behalf of states through a dedicated series of government securities, potentially carrying tax incentives for investors. Such instruments would consolidate borrowing at the sovereign level, improve market liquidity, and lower the all-in cost of funds for states. For investors, tax-advantaged sovereign paper would offer an alternative to small savings schemes, whose growing role in fiscal financing already reflects the distortions created by high administered rates.

This approach would not eliminate fiscal discipline, nor would it blur accountability if designed transparently. Instead, it would recognise a market reality: fragmented and heavy state issuance is now a key driver of elevated yields across the curve. Addressing that constraint directly may do more for financial conditions than marginal tweaks to headline deficit targets.

On the taxation front, expectations are more muted. Equity investors may hope for relief on long-term or short-term capital gains, particularly given that the reintroduction of long-term capital gains tax in 2018 remains a point of contention. Any preferential treatment extended to foreign long-term investors would inevitably sharpen the case for similar treatment of domestic savers. Yet with revenues already earmarked for consolidation, sweeping changes look unlikely.

Currency markets are also unlikely to find much comfort in the Budget alone. Persistent portfolio outflows and delayed bond index inclusion continue to weigh on the rupee, which may underperform peers even in a softer global dollar environment unless earnings momentum improves or valuations reset.

The more realistic outcome is that Budget 2026–27 leans towards structural reform, banking sector measures, customs rationalisation, and incremental improvements in the ease of doing business. These are not measures that excite markets on announcement day, but they shape growth and financial stability over time.

For bond investors, the real test will be whether the government acknowledges that state borrowing has become the fulcrum of the yield equation. If the Budget signals a credible strategy to absorb or restructure that burden, markets may be willing to look past the sheer size of issuance. If not, yields may remain elevated, not because policy is tight, but because supply is.