What Happened
- Despite the RBI's monetary easing cycle, government borrowing costs have not declined proportionately, with bond yields remaining elevated due to twin pressures of high debt supply and tight liquidity conditions.
- State government market borrowings rose 21% year-on-year during the first half of FY2025-26, with state debt increasing almost 20% from FY24 to FY25 at Rs 12 trillion.
- The spread between state government bonds and central government securities has widened to approximately 40 basis points.
- Heavy state issuance has absorbed much of the liquidity the RBI has injected, blunting the transmission of rate cuts to the broader economy.
- The RBI announced a USD 32 billion liquidity injection programme via government bond purchases and dollar-rupee swaps to ease conditions.
Static Topic Bridges
Monetary Policy Transmission and Bond Market Dynamics
Monetary policy transmission refers to the process by which changes in the RBI's policy rate (repo rate) translate into changes in market interest rates, bank lending rates, and bond yields. In India, transmission has historically been incomplete due to structural rigidities: banks' reliance on deposit-funded lending (sticky deposit rates), the government securities market absorbing bank liquidity (SLR requirement), and excess government borrowing crowding out private borrowers. The benchmark 10-year government bond yield is the key indicator of long-term borrowing costs.
- RBI repo rate: the rate at which RBI lends overnight to banks (policy rate)
- Transmission channels: interest rate channel, credit channel, exchange rate channel, asset price channel
- Current 10-year G-sec yield: approximately 6.50-6.75%
- SLR requirement: 18% of NDTL (banks must hold government securities)
- MCLR system: Marginal Cost of funds-based Lending Rate (for bank transmission)
- External Benchmark Lending Rate (EBLR): linked to repo rate (better transmission for retail loans)
Connection to this news: Despite RBI rate cuts, the 10-year yield has not declined commensurately because the massive supply of both central and state government bonds has overwhelmed the demand-side effect of easier monetary policy, creating what economists call a "fiscal-monetary tug of war."
Government Borrowing Programme and Fiscal Deficit
The central government's gross market borrowing for FY27 is projected at approximately Rs 16.5 trillion (11% higher than FY26), driven by large debt maturities of Rs 5.5 trillion. States' borrowing adds another Rs 8-10 trillion, creating a combined supply of Rs 25-30 trillion in government bonds. The Fiscal Responsibility and Budget Management (FRBM) Act, 2003, targets a fiscal deficit of 3% of GDP for the central government, but the actual deficit has consistently exceeded this target since the pandemic.
- FRBM Act: 2003 (targets 3% fiscal deficit for Centre, 3% for states)
- Central government gross borrowing (FY27 budget): ~Rs 16.5 trillion
- State market borrowing: approximately Rs 8-10 trillion additionally
- Combined government bond supply: Rs 25-30 trillion annually
- Fiscal deficit (FY26): approximately 4.4% of GDP (Centre)
- Government debt-to-GDP: approximately 81-83%
Connection to this news: The "twin issues" of debt and liquidity arise because the sheer volume of government bonds flooding the market creates a supply-demand imbalance. Even as the RBI cuts rates and injects liquidity, the government's borrowing programme absorbs these flows, keeping yields elevated.
RBI Liquidity Management Tools
The RBI uses multiple instruments to manage banking system liquidity. These include: Open Market Operations (OMOs) — buying/selling government securities; Liquidity Adjustment Facility (LAF) — repo and reverse repo operations; Standing Deposit Facility (SDF) — floor of the LAF corridor; Marginal Standing Facility (MSF) — ceiling of the LAF corridor; Variable Rate Repo/Reverse Repo Auctions (VRRR/VRR); and forex swaps (dollar-rupee swaps that inject/drain rupee liquidity). The RBI has recently used a combination of OMO purchases, CRR cuts, and dollar-rupee swaps to inject liquidity.
- OMO purchases: RBI buys government bonds, injecting rupee liquidity
- Dollar-rupee swaps: RBI buys dollars spot and sells forward, injecting rupees
- CRR: Cash Reserve Ratio (currently 4% of NDTL)
- LAF corridor: SDF rate (floor) — Repo rate — MSF rate (ceiling)
- RBI liquidity injection programme: USD 32 billion (via bond purchases and forex swaps)
- Liquidity deficit/surplus: measured by net LAF absorption/injection
Connection to this news: The RBI's USD 32 billion injection programme is a response to the liquidity crunch caused by heavy government borrowing. The challenge is that states are "soaking up" injected liquidity by issuing their own bonds, creating a cycle where RBI injections are offset by state borrowing, limiting the net impact on market interest rates.
Key Facts & Data
- State market borrowing growth: 21% YoY in H1 FY26
- State debt increase: ~20% from FY24 to FY25 (to Rs 12 trillion)
- State bond spread over central securities: ~40 basis points
- Central gross borrowing (FY27): ~Rs 16.5 trillion
- RBI liquidity injection: USD 32 billion programme
- 10-year G-sec yield: 6.50-6.75% range
- FRBM target: 3% fiscal deficit (Centre and states each)
- Combined government bond supply: Rs 25-30 trillion annually