A Tug of War in the Bond Market: RBI's Rate Cuts vs. States' Record Borrowing State governments are on a borrowing spree. Officials and market reports point to a record issuance plan for states in the current fiscal that runs into trillions of rupees

A flood of state government debt, squeezed bank appetite and market jitters are overwhelming RBI's signal for lower rates. The result: India's benchmark 10-year yield has refused to follow the script. Even as the Reserve Bank of India moved to ease policy earlier this year, market borrowing by state governments ballooned to record levels adding supply into an already thin market and keeping yields elevated. Despite the central bank cutting rates by 100 bps the bond yields have stayed elevated. What looks like a classic policy mismatch of central bank easing while long-term rates rise is, in reality, a story about supply, demand and market confidence. The stubbornly higher yields, strained liquidity and rising funding costs for corporations and entrepreneurs.

"This time the government is seems to be frontloading their CAPEX spending in the first half usually they spend more in the second half but this year the government spent Rs 5,80,746 crore in H1 of FY26 which is almost 52 per cent of the total capex outlay in the BE, this is 40 per cent higher than Rs 4, 14, 966 crore in the same period of the previous financial year that is why the government is borrowing record through in addition with state governments," Shalini Shirasat, Economist at Prabhudas Liladhar said.

"More supply of bonds in the market leads to lesser demand and when the demand is less, the prices come down leading to higher yields," Shirasat explained.

Supply Shock From States

State governments are on a borrowing spree. Officials and market reports point to a record issuance plan for states in the current fiscal that runs into trillions of rupees — a surge that has materially increased the supply of longer-dated paper and crowded out traditional buyers. Reuters reported that states planned unprecedented borrowings of roughly ₹12 trillion for FY2026; earlier in the year, a surge of Rs 4.7 trillion in a single quarter alone was flagged as putting acute pressure on markets.

For fixed-income investors, the math is simple: when supply jumps, prices fall and yields rise — unless demand steps up. In India's case, demand has not kept pace. Insurance companies and banks, which traditionally take large slices of state development loans, have been cautious about stretching limits and risk appetites amid stretched balance sheets and regulatory constraints. Traders have warned the RBI that without stepped-up buying, yields will remain uncomfortably high.

"After the June policy, instead of going down, bond yields actually went up. The RBI had cut rates by 50 basis points, but markets are forward-looking — the shift to a neutral stance reduced expectations of further cuts, pushing yields higher. Bond yields are also rising because there's a clear pickup in supply. If you take both Centre and state borrowing, it's set to rise sharply in the second half of the year, led by states," Gaura Sen Gupta, Chief Economist, IDFC Bank said.

"Both Centre and states are facing a slowdown in tax revenue growth as nominal GDP moderates to around 8% in FY26 from 10% last year. The GST and income tax cuts are also weighing on collections. While the Centre may still meet its 4.4% fiscal deficit target, states could see wider deficits in FY26 because they rely more heavily on market borrowing to fund spending," she added further.

According to media reports, the apex bank is asking state governments to reschedule their borrowings to ease the supply pressure on yields and defer it to the period when there is no supply pressure and yield are not that high.

Why a Rate Cut Didn't Do The Trick

Markets expect central banks to backstop liquidity and, when needed, mop up excess supply through outright bond purchases or OMOs (open market operations). But India's recent rate cuts implemented to revive growth have not been matched by large-scale government bond buying from the RBI.

As a result, lower policy rates did little to compress long-term yields that are set by the market's view of future inflation, fiscal risk and supply dynamics. Business Standard and Reuters flagged that the RBI has begun nudging states to reschedule or spread borrowings and even asked them to delay some auctions to reduce supply pressure. Those requests are pragmatic but limited in scope.

"The central bank has urged state governments to defer debt issuance to periods when yields are softer," one report noted a diplomatic signal that the bank's preferred lever is administrative coordination rather than heavy balance-sheet intervention. But coordination only helps if states comply and if the market believes deferrals will meaningfully reduce near-term supply.

"States are more dependent on market borrowings to fund their deficits. There's a growing expectation that state deficits could widen in FY26. Net bond supply from the Centre and states combined is projected to be around Rs 8 trillion in H2, compared to about Rs 6 trillion last year. To put this in context, we've calculated net supply as gross issuance minus RBI's OMO (Open Market Operations) bond purchases.

The RBI bought about Rs 2.4 trillion worth of bonds in H1, and we expect around Rs 2 trillion in H2. Even accounting for this, supply available to the market will be significantly higher," one independent economist said, claiming anonymity.

Clarity Needed

Primary dealers and bank treasuries have also pushed back, warning they are close to internal investment limits on state paper. That limits the natural buyer base. Meanwhile, foreign portfolio investors — sensitive to global rate moves, currency volatility and perceived fiscal risks have been less reliable as a demand source. Bloomberg and other market outlets have highlighted that record state borrowing is already translating into higher spreads and tighter liquidity for corporates.

Several market participants are urging the RBI to step in with bond purchases. Traders told the Economic Times and other outlets that an active central-bank presence in the secondary market could anchor yields and restore confidence. But the RBI faces a dilemma: aggressive bond buying risks complicating its inflation-fighting credibility and FX posture; in contrast, inaction risks higher rates and stress in the real economy.

What Does This Mean for Corporates, Consumers ?

Higher long-term yields feed directly into corporate borrowing costs and capex decisions. Startups chasing lower-cost funding and manufacturers planning expansion will face a higher hurdle rate. For households, the pass-through to retail lending can dampen consumption recovery — the very outcome policy easing aimed to prevent.

Policy options on the table include: (a) more active RBI purchases (OMO or secondary market), (b) stricter coordination to smooth state auctions, (c) incentivising re-issuance and buybacks to manage the maturity profile, and (d) nudges on state fiscal behaviour. Each option comes with trade-offs between short-term yield relief and long-term macro credibility.