Why Public Debt Is Important for Monetary Policy Transmission

India’s latest easing cycle has highlighted a gap in monetary policy transmission. Between February and December 2025, the repo rate fell from 6.5% to 5.25%, while the yield on the 10-year government security dropped only marginally, from 6.7% to 6.6%. Unlike in the previous policy cycle, the yield did not move proportionately with the repo rate.

This can be attributed to rising crude oil prices, hardening US yields, and increased foreign portfolio investor outflows, particularly around November and December. Similarly, the rise in the yield from 6.7% to 7.07% in March 2026 can be explained by heightened geopolitical tensions in West Asia and the government’s excise duty cut on petrol and diesel. 

These events illustrate how transmission can weaken under external stress caused by global uncertainties.

This matters at a time when public debt is rising globally. In 2025, global public debt stood at 93.9% of GDP and is estimated to increase to 102.3% by 2031. While advanced economies are expected to see an increase from 108% to 114.8%, emerging economies are likely to experience a sharper rise, from 73.9% to 86.2%.

India, however, is expected to fare better as its public debt is estimated to decline from 84.1% of GDP to 77.7% over the same period. This shows that India’s debt levels are consolidating towards the Fiscal Responsibility and Budget Management Act’s long-term target of 60%.

These debt dynamics have significant implications for monetary policy transmission, as highlighted in the Bank for International Settlements’ Annual Report 2026. Higher public debt can put upward pressure on yields as governments issue more debt. It can also prompt investors to reassess fiscal sustainability and liquidity conditions, leading to sharp and frequent swings in yields. This can impair monetary transmission, threaten policy credibility and lead to inefficient macroeconomic management.

Debt Sustainability
While India’s debt is forecast to be on a downward trajectory, it is important to assess its sustainability.

Under Domar’s g > i condition, debt remains sustainable as long as the growth of GDP stays above the cost of debt. Here, g stands for nominal GDP growth and i for the interest rate. Since the pandemic, the yield on the 10-year government security has remained between 6% and 7%, while nominal GDP growth has consistently stayed above those levels. This suggests that economic growth is helping to keep the debt sustainable.

Furthermore, looking at the relationship between fiscal policy and debt sustainability, Eichengreen et al. (2026) viewed debt sustainability in terms of the government’s ability to absorb its debt-servicing burden. This can be measured through the primary balance generated by the fiscal authority.

Since 2021, the combined primary deficit of the central and state governments has fallen from 7.8% of GDP to 1.9%, broadly similar to its pre-pandemic average between 2014 and 2020. Together, these indicators suggest that India’s public debt remains sustainable.

Monetary Policy Transmission
India’s sustainable debt position had supported relatively robust monetary transmission during the previous policy cycle.

When the COVID-induced monetary easing ended around May 2022, the tightening cycle began, with the repo rate rising from 4.4% to 6.5% by February 2023. During this period, the yield on the 10-year government security rose from 6.8% to 7.4%, broadly in line with the policy repo rate.

Crucially, even before the next easing cycle began in February 2025, the yield had settled much lower, at 6.7%. This shows that even when the policy repo rate remained constant, rising absolute government borrowing requirements did not exert sustained pressure on yields, signalling a resilient transmission mechanism.

The latest easing cycle, however, has produced a different outcome. Although the repo rate fell by 125 basis points between February and December 2025, the 10-year yield declined by only around 10 basis points. The contrast between the two cycles suggests that debt sustainability can support transmission, but cannot insulate the bond market from global rates, commodity prices, capital flows and geopolitical risks.

Policy Measures
While little can be done to mitigate such structural risks in the short run, research shows that the composition of bondholders can affect the sensitivity of yields.

According to Pawar et al. (2026), the rising share of non-banking financial companies and the declining share of banks among government bondholders reduced bond-yield sensitivity by 39% in the post-pandemic period.

The increase in NBFCholdings has been attributed to policy initiatives by the RBI to diversify the investor base, as well as to a decline in institutional risk appetite following sharp market corrections during the pandemic.

Lower yield sensitivity can help keep debt-sustainability concerns muted. If the issuance of a given amount of public debt results in a smaller increase in yields, the g > i condition is more likely to remain favourable.

Another area that can improve borrowing efficiency is the design of debt issuance itself. The RBI’s pilot Benchmark Issuance Strategy, designed for the issuance of State Development Loans, was recently expanded to nine more states. Market participants believe that it could lead to a one-to-two-basis-point softening in the benchmark 10-year government-security yield.

Under this framework, debt is issued in pre-announced benchmark maturity buckets and according to a pre-announced calendar. This can provide greater clarity to investors, reduce fragmentation, create more liquid benchmark securities and improve price discovery.

India’s public debt is on a consolidating trajectory, but global uncertainties can still hinder monetary policy transmission. In such circumstances, demand-side measures, such as diversifying the investor base, and supply-side measures, such as the Benchmark Issuance Strategy, can soften the impact of government borrowing on yields and reduce risks to growth.

In this manner, the differential between growth and interest rates can be maintained at favourable levels, keeping the debt sustainable. Furthermore, if the debt-to-GDP ratio remains on its forecast trajectory, it should provide a more supportive environment for efficient monetary policy transmission.