State Finance: A Growing Challenge for the Debt Market

Post Covid‑19, market appetite for government debt has weakened globally amid a sharp rise in debt levels. Even the US, which has long benefited from reserve‑currency status, is losing some of its gilt‑edge appeal as markets increasingly question fiscal sustainability. The West Asia crisis has added to these pressures through higher fuel costs and wider fiscal stress.

Against this backdrop of dwindling global demand for sovereign debt, India faces a quieter challenge from state governments. Unlike the Centre, whose fiscal performance is closely scrutinised by markets, state governments are harder to track. Their fiscal position is inferred largely from borrowing patterns, as consolidated and timely fiscal data are less readily available.

From a macroeconomic perspective, state government finances are as important as the Centre’s. States account for nearly half of general government capital expenditure, and from a debt‑market standpoint, their gross bond issuance is almost 90% of central government issuance.

Despite their importance, a key divergence has emerged in fiscal performance. Since 2023-24, state government fiscal deficits have steadily widened even as the Centre has consolidated. Based on data from 17 states, the 2025-26 fiscal deficit is on track to rise to 3.6% of GSDP, well above the budget estimate of 3.1% and the 2024-25 outcome of 3.2%. This deterioration reflects slower tax collections and declining grants from the Centre.

State tax revenue growth has slowed to 5.7% in April–February, compared with 12% a year ago. The Centre has also seen a marked deceleration in tax revenues, driven by slower nominal GDP growth and GST rate cuts. In addition, grants from the Centre—both Finance Commission transfers and scheme‑related spending—have continued to decline. Since 2023-24, grants have fallen sharply due to the end of GST compensation, tapering of revenue‑deficit grants, and just‑in‑time management of scheme expenditures. As a result, grants declined from 1.9% of GSDP in 2022-23 to 1.0% in 2024-25 and an estimated 0.8% in 2025-26.

To limit fiscal slippage, states have moderated revenue expenditure while largely protecting capital spending. Interest‑free loans from the Centre have played a crucial role in supporting state‑level capex. However, states have also faced criticism for targeted income schemes, which restrict fiscal space, are difficult to roll back, and crowd out productive spending. Scope for cutting revenue expenditure remains limited, as a large share is pre‑committed to interest payments, salaries, pensions, and subsidies.

Weakening fiscal metrics have led to a surge in state government bond borrowings, intensifying competition with the Centre and the private sector for funds. In 2025-26, gross state bond issuance rose 19% year-on-year to ₹12.8 trillion. States rely more heavily on bond markets than the Centre, as they lack access to small savings and short‑term instruments like treasury bills. In 2025-26, 73% of the fiscal deficit was financed through bonds, compared with 63% for the Centre.

Borrowings have also been driven by cash‑surplus accumulation. State governments held cash balances of ₹3.7 trillion as of March 2026, largely invested in 14‑day treasury bills yielding very low returns. Improved cash management could have reduced borrowing needs.

For 2026-27, states project ambitious fiscal consolidation, targeting a deficit of 3.0% of GSDP versus 3.6% in 2025-26. Given recent trends and optimistic revenue assumptions, this appears challenging. States budget a 13.1% YoY increase in tax revenues, far above the Centre’s projected 7.2% rise. The West Asia crisis also poses downside risks to economic activity and tax collections.

At best, state deficits in 2026-27 may remain unchanged at 3.6% of GSDP, implying gross bond issuance could rise further to ₹14.5 trillion, competing with the Centre’s budgeted issuance of ₹16.1 trillion. The surge in supply comes at a time when the sources of funding remain limited. This was evident in 2025-26 also with RBI absorbed 47% of the net bond supply of Centre and state governments.

In 2026-27, continued RBI support will be necessary to absorb the government bond supply. The West Asia crisis could lower gross savings rate due to wider government deficits, weaker household and corporate savings, and persistently low foreign capital inflows. Given the growing demands of the economy, it is paramount that state governments regain control over their fiscal deficit and improve their cash management.