State Debt Surge Complicates RBI Rate Strategy

The Reserve Bank of India (RBI) is unable to cut interest rates because of the increased state level borrowings. 
Increased borrowing activity from states has coincided with that of the sovereign government (the State), creating a situation where investor interest has shifted from looking at lower interest bearing state bonds and instead toward chasing the higher yields of the federal debt market. 
This is due to the effect of recent policy changes, weakening the transmission of monetary policy, which are sources of evidence from the RBI. This fiscal year, state governments are borrowing at the same rates as other sovereigns. 

Yield Curve Pressures Build

The yield on State bonds is between 80-100 basis points (1.80% - 2.01%) greater than that of sovereigns and is considered a similar risk because both have access to central bank support during times of stress. Increased state borrowing has led to a steepening of the yield curve, particularly at the longer end. 
This year the average 10yr central government yield has increased by 10 basis points, while the average corporate yield has risen by 30 basis points, even though banks have cut the benchmark interest rate by 100 basis points. 
The difference (spread) between the 3 month and 10-year bond has widened as a result of state borrowing increasing.

Borrowing Trends Escalate

States have issued ₹12.5 trillion in gross through FY26 against ₹14.6 trillion by the centre.
States will likely fund most costs relating to 'Rural Jobs Scheme' in the near future as federal funds limit state investment to below 10%. Investors will be buying into a complete state market without any RBI purchases, while the centre's bought into five years back with a target of ₹5.6 trillion for this year. 
This year the central government allocated ₹1.5 trillion to state governments for infrastructure loans.

Policy Response Options

First, if the RBI suggests longer maturities and issuance in smaller tranches to reduce market strain, states may find themselves in need of additional funds from the centre. In addition, if the centre wants to provide convenience to states, they can provide alternative sources of finance, including long-term loans under small savings programs, which are currently available only from the centre. Furthermore, with no direct support for state bonds, banks, insurance companies, and pension plans must absorb state debt.
As a result of these developments, there are now higher costs to corporations borrowing. The interest from the pressure of yield deflation offsets the benefit of higher rates, prompting scrutiny of broader liquidity mechanisms.