Bond Market Funds 76% of States’ Deficit, Increasing from 50% in FY17
A recent study by the Reserve Bank of India (RBI) reveals that while the fiscal deficit of Indian states has seen a modest increase in recent years, funding patterns have become more market-oriented and disciplined. The consolidated gross fiscal deficit peaked at 4.1% of GDP during the pandemic in 2020-21 but has since fluctuated, dropping below 3% for three consecutive years before rising to an estimated 3.3% in 2024-25. The RBI attributes this widening deficit to weaker revenue receipts and increased capital spending, with significant variations in fiscal health among different states.
Fiscal Deficit Trends and Projections
The RBI’s analysis indicates that the consolidated fiscal deficit of Indian states reached a peak of 4.1% of GDP in the fiscal year 2020-21, primarily due to the economic impact of the COVID-19 pandemic. Following this peak, the deficit decreased to below 3% for three years, reflecting a period of fiscal consolidation. However, projections for 2024-25 suggest a rise to 3.3%. This recent increase is largely attributed to declining revenue receipts, which have been affected by reduced grants from the central government, coupled with heightened capital expenditures. For the fiscal year 2025-26, states have budgeted for a deficit of 3.3% of GDP, indicating a balancing act between rising revenues and expenditures.
Despite the increase, the consolidated deficit remains within the central government’s ceiling of 3.5% of GDP, which includes a 0.5% allowance related to power sector reforms. However, the fiscal landscape varies significantly across states. Sixteen states are projected to have deficits exceeding 3% of their Gross State Domestic Product (GSDP) for 2025-26, with thirteen of those surpassing 3.5%, highlighting the uneven fiscal space among different regions.
Market Borrowing as a Key Funding Source
Market borrowing has become the primary source of funding for state finances. According to the RBI’s findings, it is anticipated that market loans will account for approximately 76% of the consolidated fiscal deficit in 2025-26, a significant increase from just over half prior to 2016-17. In the fiscal year 2024-25, gross market borrowing rose by 6.6% to reach Rs 10.7 lakh crore, with a budgeted increase to Rs 12.5 lakh crore for 2025-26. By the end of September 2025, states had already raised Rs 4.7 lakh crore, reflecting a 21% increase compared to the previous year.
The borrowing profile has also shown improvement, with states increasingly issuing longer-maturity securities. There has been a notable rise in the issuance of bonds with maturities extending beyond 10 and 15 years, and some states have even issued bonds with terms exceeding 20 years. Additionally, borrowing costs have eased, with the weighted average yield decreasing from 7.5% in the previous year to 7.2% in 2024-25, while the spreads over central government securities have narrowed to 30 basis points.
Improving Quality of State Finances
The quality of state finances has seen a positive transformation, as evidenced by a significant reduction in the share of revenue deficit within the gross fiscal deficit. This share has decreased from 46.1% in 2020-21 to a projected 6.9% in 2025-26. Concurrently, the proportion of capital expenditure in total spending has increased from 13.4% to 18%, indicating a shift towards more productive investments.
Demographic factors are emerging as a crucial differentiator among states. Younger states like Bihar, Uttar Pradesh, and Madhya Pradesh have greater potential for revenue expansion, driven by a growing working-age population. In contrast, intermediate states such as Maharashtra and Karnataka face the challenge of balancing growth with the need to prepare for an aging population. For states like Kerala and Tamil Nadu, which are experiencing demographic aging, fiscal pressures are expected to intensify as tax bases narrow and costs related to pensions and healthcare rise. This situation necessitates a reevaluation of revenue strategies and workforce policies to ensure sustainable fiscal health.
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