The Reserve Bank of India (RBI) has issued a significant call to state governments across the country, urging them to follow the Central government's example by establishing a "clear glide path" to reduce their debt burdens. According to the central bank's latest analysis, high levels of debt at the state level present substantial obstacles to investment and economic growth throughout India.
State Debt Levels Remain Concerning Despite Recent Improvements
In its comprehensive study of state budgets for the 2025-26 fiscal year, the RBI revealed that while combined state debt had decreased to 28.1% of GDP by March 2024 from a peak of 31% in March 2021, this figure is projected to rise to 29.2% by the end of the current fiscal period. The bank's report highlighted significant disparities among states, with debt-to-GSDP ratios ranging from 17.8% to as high as 46.3% by March 2026.
"Several states continue to maintain debt levels exceeding 30% of their Gross State Domestic Product," the RBI noted, emphasizing that this situation demands immediate attention. The central bank pointed to recommendations from the Fiscal Responsibility and Budget Management Review Committee, which suggested 20% of GSDP as the appropriate upper limit for state debt.
Central Government's Debt Framework Sets Precedent
Beginning in the 2026-27 fiscal year, the Central government will shift its focus from fiscal deficit targets to debt-to-GDP ratio objectives, aiming to reduce this figure to 50% by 2030-31 from the current 56.1% estimated in the 2025-26 Budget. The RBI has suggested that highly leveraged states should adopt similar frameworks, creating transparent and time-bound plans for debt consolidation.
The issue of elevated debt at both central and state levels—collectively referred to as general government debt—has been repeatedly identified by global ratings agencies as a significant weakness in India's public finances. While debt levels surged during the peak pandemic year of 2020-21 amid economic contraction and increased public expenditure, the ongoing interest payments on borrowed funds continue to strain state budgets.
Interest Payments Crowding Out Productive Expenditure
The RBI's analysis revealed a troubling pattern: states with debt-service ratios (interest payments relative to revenue receipts) exceeding 15% typically allocate less than 2% of GSDP to capital expenditure, significantly below the national average of 2.7%. "This situation necessitates comprehensive fiscal reforms in affected states, with particular emphasis on improving expenditure quality," the central bank emphasized.
For the 2025-26 fiscal year, state budget estimates indicate a gross fiscal deficit of 3.3% of GDP, unchanged from the previous year. Notably, sixteen states have budgeted for fiscal deficits exceeding 3% of their GSDP, with thirteen projecting deficits above 3.5%. States are generally required to maintain annual fiscal deficits within 3% of GSDP, though those implementing power sector reforms may receive leeway up to 3.5%.
Borrowing Patterns and Market Concerns
The increase in states' fiscal deficits during 2024-25 was primarily attributed to 50-year interest-free loans provided by the Centre for capital expenditure purposes, which operate outside normal borrowing ceilings. States have budgeted to borrow approximately Rs 12.45 lakh crore from markets in 2025-26 on a gross basis, representing a significant increase over the past two decades.
During the first half of the current fiscal year, state borrowings surged by 21% compared to the same period in 2024-25, with an additional Rs 5 lakh crore slated for borrowing in the quarter ending March 31. "Fiscally profligate states should reconsider their market borrowing strategies through fiscal consolidation, exploring alternative financing options and implementing improved cash management practices," the RBI advised, noting reduced market demand for long-term government bonds.
Welfare Expenditures and Fiscal Priorities
While not explicitly using the term "freebies," the central bank expressed concerns about several states introducing measures such as free electricity and direct cash transfers to women in their current budgets. The RBI acknowledged that social welfare programs remain essential in a country with significant economic disparities, but warned that such expenditures risk crowding out critical investments in physical and social infrastructure.
"It is crucial to conduct thorough impact assessments to evaluate the effectiveness of welfare schemes in achieving their intended outcomes," the report stated, suggesting a more balanced approach to fiscal management.
Positive Outlook with Revenue Recovery Potential
Despite these concerns, the RBI maintained a generally positive outlook for states' fiscal positions during the second half of 2025-26. The central bank suggested that temporary revenue losses resulting from GST rate rationalization might be offset by increased private consumption in coming months, potentially easing some fiscal pressures.
The RBI's comprehensive analysis serves as both a warning and a roadmap for state governments, emphasizing the interconnectedness of fiscal discipline, economic growth, and sustainable development across India's diverse states and union territories.
