India's Fiscal Stress Predated the West Asia Shock

The US-Iran crisis hit India's fiscal and external accounts hard: the government had to forgo fuel excise revenue, fertiliser costs and subsidies spiked, elevated oil prices threatened a widening of the trade deficit, and sustained instability in the Gulf not only disrupted India's exports to its top destination, but also put at risk the $20 billion–$25 billion in annual remittances that flow in from the region.

The rupee slid past 97 per US dollar, and sovereign yields touched 7.1% at the height of the conflict. Asset markets, in other words, reacted exactly as one would expect from a country with significant oil import dependence and Gulf exposure. It would be tempting, then, to conclude that India's fiscal and external stress is a recent, war-induced phenomenon, and that its resolution should bring relief.

But the bond and currency markets tell a different story.

The rupee had already lost 5.7% against the dollar before the war started, and was Asia's worst-performing currency in the year since US President Donald Trump's re-election. The 10-year Indian bond yield, reflecting the government's cost of borrowing, had been rising since June 2025, well before the first missile was fired, climbing from 6.25% to 6.65% by the time the conflict began.

What makes this particularly striking is that yields rose through a period when S&P upgraded India's sovereign rating from BBB- to BBB, inflation was averaging below 2%, and the RBI had cumulatively cut rates by 125 basis points. The spread over the 10-year US yield widened from 1.7% to 2.4% over the same period, which rules out a global bond sell-off as the explanation.

The puzzle deepens when you look at the headline fiscal numbers. The government met its 4.4% deficit target for 2025-26, showed restraint in the 2026-27 Budget by capping expenditure growth at 11%, and received a rating upgrade to boot.

So what exactly are investors worried about?

Quite a lot, as it turns out. At 81% combined debt-to-GDP across the state and central governments, India carries one of the highest debt burdens in the emerging-market universe. The gross market borrowing programme for 2026-27 came in larger than expected, adding supply pressure to an already strained bond market.

Most telling is the quality of the fiscal position: 40% of government revenue goes towards servicing interest on debt, a ratio that puts India in the company of stressed sovereigns like Egypt and Nigeria, and well above China at 6%, Indonesia and Malaysia at 15–18%, and even the US at 20%. The 4.4% deficit target, meanwhile, was achieved in part through underspending on flagship schemes such as the Jal Jeevan Mission.

Fiscal health is driven as much by investor perception as by the data, and when the data is mixed, perception fills the gap. The S&P rating upgrade did not move the needle on India's borrowing costs, just as the US rating downgrade did not move Treasury yields. Markets looked past the label and priced the underlying mixed arithmetic. For India, that arithmetic still raises questions on several fronts.

State government finances are one. The perception that states are expanding deficits to fund electoral spending has not sat well with foreign investors, and the deterioration in state-level metrics has begun to visibly pressure central government bond yields.

RBI-Government Nexus
The RBI's ownership of government bonds stands at 12.8%, down from a COVID-era peak of 17% and broadly comparable to the Federal Reserve's 15% share of US Treasuries. But the RBI absorbed close to 50% of the government bond supply in 2025-26 through open market operations.

Whatever the liquidity rationale, the effect is to suppress yields artificially, and investors read it as quasi-monetisation, or the central bank financing the sovereign by another name. The dividend channel compounds this. The government's reliance on RBI transfers to meet its fiscal targets is legally sound, and the RBI maintains adequate buffers by international standards, but the optics are uncomfortable.

More structurally, the RBI generates much of its income by selling previously accumulated US dollar reserves at a profit when defending the rupee. A large dividend, in this sense, comes at the cost of depleting foreign exchange reserves, tying fiscal strength and currency stability together in a way that foreign investors find difficult to price cleanly.

India's fiscal and external account challenges are ultimately two sides of the same coin, as without sustained foreign capital inflows, the cost of capital stays elevated, the fiscal position becomes harder to defend, and the very capital India needs stays away. What is encouraging is that the RBI and the government appear to recognise this circularity and are responding with structural solutions rather than reflexive ones.

The tax exemption on bond income and capital gains for foreign investors brings India on par with Hong Kong and meaningfully advances the case for inclusion in prime global bond indices, a development that could unlock large, sticky inflows.

This stands in deliberate contrast to Indonesia's resort to rate hikes, a blunt instrument that addressed the symptom while leaving the underlying vulnerabilities intact. India's path forward is harder and slower, but it is the right one, and the resolution of the West Asian crisis at least removes one headwind from an already crowded agenda.