Market experts predict that India's revamped rural employment guarantee program will significantly increase the financial burden on state governments, leading to higher borrowings and putting upward pressure on bond yields. The shift in funding responsibility from the central government to the states is expected to strain their finances and impact the broader debt market.
Funding Shift Triggers Fiscal Pressure
The recently passed Viksit Bharat-Guarantee for Rozgar and Ajeevika Mission (Gramin) Act, which replaces the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS), alters the core funding model. The central government's contribution will drop, changing the Centre-state funding ratio to 60:40 from the previous 90:10. This move effectively triples the financial obligation of state governments for the program.
According to a report from Mint on December 20, this change could saddle states with an additional expenditure of ₹30,000 to ₹40,000 crore. For the 2025-26 fiscal year, the Centre had allocated ₹86,000 crore to MGNREGS, one of its major budget items. Under the new rules, if a state fails to provide work within 15 days of a request, it must pay unemployment benefits. The Centre will set budget allocations for each state, and any spending beyond that limit must be borne entirely by the state itself.
Implications for State Borrowings and Bond Markets
This increased fiscal burden comes at a challenging time for state finances, which are already under pressure from populist schemes, modest nominal GDP growth, and weak tax revenue buoyancy. Paras Jasrai, an associate director and economist at India Ratings and Research, highlighted that states might be forced to increase non-GST taxes, rationalize user charges, or reduce capital expenditure.
The direct consequence will be a rise in state market borrowings through State Development Loans (SDLs). A senior treasury official from a private bank, speaking anonymously, suggested state borrowings could surge by as much as 20%. In the 2024-25 fiscal year, states borrowed ₹10.73 trillion, which was 7% higher than the previous year. The pipeline for 2025-26 is already heavy, with states having raised ₹6.84 trillion from the market as of the December quarter, accounting for over 81% of their planned borrowing.
Killol Pandya, head of fixed income at JM Financial Asset Management, stated plainly, "Willy-nilly, states will have to borrow more. On a net basis, borrowings will rise, and that will again have implications for yields." He warned that while higher yields might initially attract investors, an excessive supply of SDLs could eventually lead to market illiquidity and even higher yields to entice buyers.
Market Reactions and Widening Yield Spreads
The anticipation of increased supply is already affecting the bond market. The spread or yield gap between 10-year benchmark government bonds and SDLs widened to 65-98 basis points in last week's auction, significantly higher than the historical range of 30-40 basis points. One basis point is one-hundredth of a percentage point.
Simultaneously, the benchmark 10-year government bond yield itself has been climbing, touching a nine-month high of 6.68% on December 22, and trading at 6.57% this Wednesday. This yield represents the risk-free borrowing rate in the economy.
Another private bank treasury official noted that hopes for a bond market softening in the March quarter, driven by demand from pension funds and returning foreign investors, now look difficult. Factors like higher SDL supply, a strong US dollar, and the depreciation of the Japanese yen are creating headwinds. The official added that the upcoming Union Budget will be crucial in determining the direction of yields, suggesting the 10-year G-sec yield could potentially touch 6.75%.
Even efforts by the Reserve Bank of India (RBI) to inject liquidity into the banking system may be offset by this increased supply. The RBI recently announced large-scale open market operations of ₹2 trillion and a $10 billion dollar-rupee swap auction to ease tight liquidity.
While some view the scheme revamp as a step toward greater fiscal discipline for the states, the immediate market consensus points to higher state borrowing calendars and sustained pressure on bond yields in the near term. The situation is further complicated by uncertainties surrounding the recommendations of the 16th Finance Commission and ongoing debates about resource devolution, particularly involving southern states like Tamil Nadu and Karnataka.
