Economic Survey 2025-26 Raises Alarm Over State Finances and Borrowing Surge
The Economic Survey 2025-26 has delivered a stark warning about the deteriorating fiscal health of Indian states, emphasizing that the forthcoming Union Budget must carefully balance fiscal discipline with federal equity. The Survey's findings indicate that while the Centre has made progress in fiscal consolidation, state governments are embarking on an unprecedented borrowing spree, raising serious concerns about overall debt sustainability and market stability.
Unprecedented State Borrowing in Final Quarter
According to the Survey, Indian states are poised to raise close to Rs 5 trillion from the bond market during the January-March quarter of the current financial year. This marks the largest quarterly state borrowing programme on record, with the Reserve Bank of India's indicative calendar for State Development Loans estimating total market borrowings at Rs 4,99,821 crore through 13 weekly auctions. If fully realized, this would push total state market borrowing for the year to an all-time high, with the fourth quarter alone accounting for nearly two-fifths of the annual total.
Shift in Fiscal Assessment: From Union to General Government
A central empirical contribution of the Economic Survey 2025-26 is its explicit shift from assessing Union government fiscal performance in isolation to evaluating general government finances as the relevant unit of market scrutiny. While the Union government achieved a fiscal deficit of 4.8 per cent of GDP in FY25, outperforming its budgeted target of 4.9 per cent, and has committed to further consolidation to 4.4 per cent in FY26, this credibility is increasingly being offset by the fiscal behavior of state governments.
The Survey highlights that several states are exhibiting rising revenue deficits financed through market borrowings, a compositional shift that weakens debt sustainability despite stable headline deficit ratios. This mismatch between responsibilities and resources is becoming increasingly pronounced as states take on greater welfare delivery roles while facing constraints on revenue-raising powers.
Market Pricing of State-Level Fiscal Risks
The Economic Survey provides a revealing cross-country comparison to substantiate concerns about state-level fiscal risks. Despite India and Indonesia sharing the same BBB sovereign credit rating, India's 10-year government bond yield stands at approximately 6.7 per cent, compared to 6.3 per cent for Indonesia. Traditional explanations such as inflation differentials, growth prospects, or monetary policy stance are insufficient to explain this spread.
Instead, the Survey argues that markets are pricing in latent fiscal risks emanating from state-level finances, including expanding unconditional cash transfers and weakening expenditure quality. This represents a significant shift in market behavior, where investors are no longer passively absorbing state borrowing but are actively evaluating general government borrowing pressures.
Concentration of Borrowing Among Major States
The borrowing calendar reveals a concerning concentration among India's largest states. Several major states including Karnataka, Maharashtra, Tamil Nadu, Madhya Pradesh, Rajasthan, West Bengal and Uttar Pradesh appear repeatedly across the calendar, often tapping the market for Rs 4,000-10,000 crore in a single auction. Karnataka and Maharashtra alone are scheduled to borrow almost every week, highlighting how a small group of large states now account for a significant share of total market borrowing.
This front-loaded and persistent supply of state paper through the quarter, with weekly auction sizes rising from about Rs 30,000 crore in early January to nearly Rs 48,000 crore in the second half of March, creates additional yield pressures at a time when the Union government is expected to emphasize fiscal restraint and consolidation in the Budget.
Structural Constraints on State Finances
The RBI's Financial Stability Report (December 2025) helps explain why state borrowing has risen so sharply. While the report maintains that India's overall economy and financial system remain stable, it points out that state governments continue to face strong fiscal pressure, mainly because a large share of their spending is fixed and difficult to cut. These include:
- Salaries and pensions
- Interest payments
- Subsidies
Together, these fixed expenditures now account for roughly one-third of states' revenue expenditure, leaving limited room for adjustment in times of stress. Meanwhile, states have become the primary agents of welfare delivery, running food distribution systems, cash transfers, health schemes, housing programmes, and infrastructure projects—many of which are politically salient and difficult to scale back.
Revenue Limitations and Growing Responsibilities
The fundamental problem lies in the mismatch between states' growing responsibilities and their limited revenue-raising powers. While GST and tax devolution have stabilized revenues, states have little control over tax rates and face constraints on non-tax revenues. The result is an increasing reliance on borrowing to fill the gap between responsibilities and resources.
India's general government debt-to-GDP ratio remains elevated at around 82 per cent, with state government debt forming a significant and rising component. This structural imbalance creates long-term sustainability concerns that extend beyond immediate borrowing pressures.
Changing Demand Dynamics for Government Paper
Compounding the problem of rising supply is a significant shift on the demand side. Traditionally, insurance companies and pension funds absorbed large quantities of government and state bonds. However, in recent years, many institutional investors have begun rebalancing portfolios towards equities and higher-yielding assets, reducing their appetite for long-term government paper.
This means states are issuing more debt at a time when their most reliable buyers are becoming more selective, creating additional challenges for debt management and potentially pushing yields higher.
Policy Implications and Budget Considerations
Taken together, the Survey's findings suggest that the forthcoming Budget will need to address several critical issues:
- Stronger incentives for capex-oriented state spending to improve expenditure quality
- Tighter scrutiny of revenue-deficit financing to ensure sustainable fiscal practices
- Greater reliance on market-based signals such as SDL spreads for fiscal discipline
- Balanced approach to federal equity that recognizes states' growing responsibilities while ensuring fiscal sustainability
The Economic Survey 2025-26 thus presents a comprehensive picture of India's evolving fiscal landscape, where state finances have emerged as a critical concern requiring immediate attention in the upcoming Budget. The evidence supports the need for coordinated fiscal management between the Centre and states to ensure long-term economic stability and sustainable growth.
