Rising state borrowings complicate Indian central bank’s rate playbook

MUMBAI: A surge in borrowing by Indian states is complicating the central bank’s efforts to lower interest rates as officials worry the increased supply of state bonds could affect the yield curve, according to people familiar with the central bank’s thinking and analysts.

State governments are issuing debt at a pace that increasingly rivals sovereign borrowing, significantly boosting bond supply for a shared pool of investors.

Amid the increased supply of state debt, which typically offers a modest yield premium over federal bonds, investors are now demanding higher returns on central government securities, making it more difficult for the Reserve Bank of India to bring down borrowing costs despite recent interest rate cuts.

Sub-sovereign borrowing overtaking central government issuance is a mounting concern since it risks distorting the yield curve and weakening the transmission of monetary policy and liquidity measures, one of the sources familiar with the central bank’s thinking said, requesting anonymity because they were not authorised to speak publicly.

State borrowings could rise further following the recent revamp of the rural jobs scheme, which shifts more of the financial burden onto state governments, the person said, adding that states may overtake the federal government in borrowings over the next few years.

In the current fiscal year, which runs from April to March, Indian states are set to borrow nearly as much as the central government, with gross issuance of about 12.5 trillion Indian rupees (USD137.66 billion) versus 14.6 trillion rupees at the sovereign level.

Net borrowing by states, at roughly 9 trillion rupees, is approaching the central government’s 10.3 trillion rupees.

Investors generally view debt issued by Indian states as equivalent to federal government debt, since a reserve pool of funds held by the central bank is used for payouts during periods of financial stress.

This means that while state debt offers investors a spread of 80 to 100 basis points over federal debt, the risk of default remains negligible.