Early signs of fiscal stress – Opinion News | The Financial Express

Clipped from: https://www.financialexpress.com/opinion/early-signs-of-fiscal-stress/4156187/

Firming treasury yield warrants a relook at the fiscal arithmetic

Why Long-Term Yields are Rising Despite the RBI’s ₹6.5 Lakh Crore Infusion

By Renu Kohli, Senior Fellow, Centre for Social and Economic Progress

Since early February, banks have been flush with surplus liquidity—so much so that more than Rs 3 lakh crore is being parked at the Reserve Bank of India’s (RBI) Standing Deposit Facility (SDF), pushing the tri-party repo rate below the SDF rate (5%). Since December 12, 2025, it is creating market perceptions of “shadow easing” beyond the 125-basis-point (bps) policy rate cut since February 7, 2025, largely due to the RBI’s durable liquidity infusion exceeding Rs 6.5 lakh crore—Rs 4.2 lakh crore open market operations and Rs 2.3 lakh crore ($25 billion) of buy/sell FX swaps.

Strangely though, there’s been an insignificant impact upon long-term yield—the 10-year benchmark G-sec is trading at 6.77% currently, almost same as at the start of this easing cycle last year (see graph). The 10-year yield that fell to 6.26% at end-May 2025 climbed back to 6.77% last week, nearly 50 bps higher and steepening the yield curve.

More disturbing is the sharper rise in the 10-year state government securities yield—for example, Tamil Nadu’s weighted average yield touched 7.44% on February 17, almost 80 bps higher than 6.65% eight months ago (June 10, 2025).

Given perceptions of improved financial conditions and a sharp fall in headline consumer price index (CPI) inflation since January 2025 (old series) to below 2% lower bound in July 2025, the reference yield rate should have slipped below 6%. Ironically though, it began rising—almost coinciding with the surprise 50-bps rate reduction on June 6. Seemingly, the market failed to capitalise on India’s inclusion in the JPMorgan emerging markets bond index and completely dismissed S&P’s ratings upgrade in August 2025. In the event, a 50-bps increase in the nominal long-term yield may not sound alarming, but compared with a falling inflation rate the real rate increase is stronger than a few foresaw. In fact, CPI-adjusted real interest rates in FY24 and FY25 were relatively lower!

The obvious question is, why has the market gone against the tide? Notwithstanding the hardening long yields across advanced economies, domestic factors dominate market commentary, particularly the gigantic central and state government borrowings against weaker appetite, i.e. excess supply. Beneath this simplistic equation, however, lie complex market dynamics and broader reasons. On the supply side, states’ planned borrowing in the second half (FY26) exceeded market expectations and was perceived by some as the chief villain.

The trigger, however, was lower tax revenue realisation—a fallout of fiscal actions initiated by the central government, viz. raising income tax exemption limits and lowering effective GST rate. While the Centre could fill the gap from higher RBI dividend, the states had no such luck and were forced to borrow. Private corporate bond supplies, though subdued, also muddied the bond market. On the demand side, foreign portfolio investor debt inflows are tepid—Rs 0.35 lakh crore in FY26 so far. Pension and insurance funds are reportedly investing more in shorter-tenure bonds. But more critically, banks’ investment appetite for government bonds has decreased because private credit picked up after the GST rate reduction.

Will the trend persist in FY27?

This will surely depend on how supply-demand factors unfold. The market is already frightened by higher-than-expected gross and net borrowings in this year’s Budget.

But one development we would like to flag is potential crowding out in play. As the G-sec (central and states) supply submerged the market, funds raised in the corporate bond market tapered off. Data from the Securities and Exchange Board of India shows that private corporates raised a record Rs 9.9 lakh crore via bonds in FY25, but fresh corporate bond issues declined sharply since the second quarter of 2025-26, consequent to the 10-year yield hardening more than 60 bps since June 2025. It would be damaging if private corporate investment, lying dormant for more than a decade, faced an unlikely headwind at the very early signs of revival. It remains to be seen if commercial banks will be able to meet corporate credit demand without raising lending rates, especially when constrained by slower deposit growth.

A critical look at the broader macro framework for allocation of financial savings already showed signs of stress. Back in 2017, the Fiscal Responsibility and Budget Management Review Committee Report suggested that the estimated pool of financial saving—10% of GDP (7.6% domestic and 2.3% external savings)—be equally divided at 5% each between the government and private sector to avoid potential crowding out. Accordingly, it recommended targeting the general government fiscal deficit at 5% of GDP (2.5% each for the Union and state governments). With the sharp drop in financial savings to 6.5% of GDP in recent years—domestic and external savings averaged 5.4% and 1.1% respectively between FY23 and FY25—and remarkably below the consolidated general government deficit of 7.5% of GDP, the pressure on interest rates could have been immense if not for the unimpressive business investment demand.

The question is, if private investment demand gathered force ahead, would the limited financial savings turn into a binding constraint, causing significant crowding out?

A pertinent policy question in this light is if the 16th Finance Commission’s recommendation to target a general government fiscal deficit at 6.5% of GDP by 2030-31 (3.5% and 3% for the Union and state governments each after adjusting for special assistance to states for capital investments) is not synchronised with the emerging constraints. Even more disturbing is the central government’s decision to excuse itself from setting any road map for fiscal deficit consolidation, confining its promise to keep debt on a declining path towards attaining a debt-GDP level of about 50±1% by FY31. Policymakers should recognise that the resurfacing of fiscal dominance could force a monetary policy reset by pushing up r*, the real equilibrium interest rate. Let alone creating a fiscal buffer, in the current framework, there would be very little financial resources left for the private sector, risking higher cost of capital vis-à-vis China and an overall drag on private investment.