India’s Bond Market Faces Harsh Reality as Fiscal Pressures Mount 

The euphoria over India’s sovereign rating upgrade by S&P Global lasted no more than a weekend. Traders cheered as the benchmark 10-year bond yield slipped from 6.50% to 6.40%, only to reverse swiftly on the back of the government’s announcement of GST rate rationalisation. What promised relief soon hardened into despair: fiscal support was necessary, but it has come at a cost bond markets won’t ignore. 

India’s economy is caught in a complex bind. Urban households are deleveraging, which is a reflection of stagnant real wages and dimmer employment prospects. Corporates, still scarred by the IL&FS crisis, have spent the past seven years unwinding debt rather than investing. Even the government has demonstrated fiscal restraint, keeping deficits in check post-COVID. 

Add to this the threat of 50% tariffs, and the blow of artificial intelligence to labour-intensive IT firms focused more on dividends than on innovation. The cumulative effect is a sharp weakening of India’s capacity to generate employment, not only in IT but also in sectors like gems, jewellery, and textiles. 

Monetary policy has reached its natural limits. Lower EMIs may offer temporary relief, but central banks cannot conjure up investment where corporate confidence is lacking. Only fiscal measures can address this cocktail of structural and cyclical challenges. GST reforms, alongside income tax cuts, is the government’s bid to revive growth, with 2025-26 projections now at 6.5-6.8% and headline inflation expected to remain comfortably below 3%.

Fiscal Squeeze 
Yet the fine print tells a harsher story. GST rate rationalisation effectively reduces the average rate from 11.4% to 10.5%, implying a revenue shortfall of ₹1.5 trillion against budgeted estimates for 2025-26. Of this, states will bear nearly two-thirds of the hit, pushing their already strained fiscal deficit of 3.3% even higher. The Centre’s losses are similar, cushioned by revenue-sharing arrangements, but its books, too, look increasingly tight. 

Bond markets, already unsettled by weak direct tax collections, now face another layer of uncertainty. Even with buffers from RBI dividends, possible spending cuts in the fourth quarter, and additional T-bill borrowing, the fiscal deficit is likely to overshoot the budgeted 3.4%, drifting towards 3.6%. That prospect was enough to send yields back up to 6.5% on the 10-year government bond on August 18, wiping out all the gains from the upgrade euphoria. 

The message is clear: Bond markets don’t wait for data to confirm what they already suspect. Traders are quick to price in a widening fiscal gap, just as central banks set policy by looking ahead. Even if GST rationalisation trims headline inflation by 40-50 basis points, bond vigilantes remain sceptical. Policy rates are likely to remain on status quo for next 1 year. 

Hence the baton for sustaining growth has clearly shifted from monetary to fiscal hands. Relief will come not through rate cuts or clever liquidity tweaks, but through decisive budgetary moves. GST rationalisation may only be the first in a series of such measures. Foreign investors may trickle back into local bonds at 6.5% and USD/INR near 88, but the bigger challenge lies in the domestic demand-supply mix. With no room for rate cuts and little prospect of OMOs since a CRR cut calendar is already in place, investors are reduced to playing auction-to-auction, pushing yields upward during the week before temporary stabilisation on auction days. 

This uneasy equilibrium suggests that Indian bonds are now firmly in a “higher for longer” cycle. Traders, burnt by losses after the June and August MPC meetings, are steering clear of duration. Bond vigilantes, who have already roiled markets of the US, UK, and Japan, seem to have found a new hunting ground.

By the time policymakers respond, 10-year government bond yields may already be pressing 6.75%. Markets won’t stand still waiting for clarity. Relief rallies, if any, will be fleeting. The cost of growth, for now, will be higher yields that persist for longer.