MC EXCLUSIVE High borrowing, crowding out private investment fears may limit capex push in upcoming Union Budget

In FY24, central capex accounted for 3.1 percent of the GDP and in FY23, 2.8 percent of the GDP.

Since FY22, Central government’s capex has played a key role in driving growth in the economy. The Union Budget presented in February 2021 had announced a strategic pivot towards a public investment-led growth strategy, with the capex target for FY22 being 35% higher than Budget Estimate of FY21.

A higher capex involves spending on creating long-term assets like infrastructure (roads, railways, ports), and it has a higher fiscal multiplier compared to revenue expenditure (like salaries or subsidies). The direct spending on construction and infrastructure immediately creates demand for raw materials (cement, steel), machinery, and labor, stimulating multiple industries.

Additionally, the wages paid to workers and profits earned by contractors are then spent on consumption, creating further rounds of demand and boosting overall economic activity.

'Higher borrowing increases cost of capital'

Meanwhile, the Centre’s gross market borrowing target for FY26 is Rs 14.72 lakh crore, and net borrowing target is Rs 11.54 lakh crore. Net borrowing is the money borrowed after deducting the amount used to pay back previous debt.

Market borrowing essentially is the primary method used by the Centre to raise large sums of money from the public and financial institutions to finance its fiscal deficit (the difference between total government spending and total government revenue). A higher borrowing amount directly translates into a larger outstanding debt, which requires the government to pay more in interest payments (debt servicing).

The third official said that there is a "hard-fiscal limit" to how much the Centre can raise capex.  "Capex cannot keep rising indefinitely when the government is already running a persistent revenue deficit. At some point, higher borrowing starts weakening the fiscal balance rather than supporting growth," the official added. "Higher borrowing requirements raises sovereign bond yields, and that increases the cost of capital across the economy."

In an exclusive interview with Network18 Group Editor Rahul Joshi on September 5, Finance Minister Nirmala Sitharaman had said that high bond yields is "not affordable". "At a time when interest rates are otherwise low, bond yields becoming unsustainably high has a big bearing on government and states."

On December 12, the Centre’s 10-year benchmark bond yield closed at 6.59 percent. And on September 5, when the FM made the remark, the yield was at 6.47 percent.

The yield on a bond is the effective rate of return an investor gets. Bond prices and yields have an inverse relationship: when bond prices fall, yields rise, and vice versa. When yields rise, the government is forced to pay a higher interest rate to attract investors to buy its new debt. This directly increases the government's interest payment burden, raising the revenue expenditure part of the budget. Higher interest payments reduce the funds available for productive Capex (infrastructure) and crucial social sector spending.

Also, a high G-Sec yield forces banks and corporations to offer even higher interest rates to attract funds. This makes borrowing more expensive for businesses and consumers, leading to higher costs for corporate projects and discouraging new private investment (the "crowding out" effect).

India’s benchmark bond yield had eased to 6.45 percent on December 5, following Reserve Bank of India’s announcement of policy rate cut and liquidity injection measures. But since then, the yield has soared by nearly 15 basis points.

Bond yields typically soar when the price of existing bonds falls sharply in the market. Since bond prices and yields have an inverse relationship, a drop-in price means the effective return (yield) for a new investor buying that bond goes up.

For instance, when the government announces a higher-than-expected Gross Market Borrowing (GMB) program, it means the market will be flooded with a large supply of new securities. To successfully sell this huge volume of new bonds, the government must offer them at a higher yield (lower price) to clear the market. This increased supply pushes yields higher.

According to Vikas Goel, former CEO at PNB Gilts, record borrowing by states (about Rs 12 trillion in FY26) and subsequent surge in their yields; attractive US bond yields due to external uncertainties and FPI outflows from India; and core inflation staying around 4 percent are the three key reasons why bond yields are high and unlikely to fall significantly from current levels.

"With states issuing long-term bonds, the demand for state bonds have risen sharply. That has led to higher yields of states, which is adding pressure on the central government bonds," Goel explained. Most state bond yields are currently in the range of 7-7.1 percent. State bonds are generally considered a riskier than the Central bonds, and that’s why they offer higher yields.

'Limited fiscal headroom for additional capex'

Government officials said that a large share of tax revenues is now pre-committed through Finance Commission transfers, leaving the Centre with limited fiscal headroom, and this structurally caps how much additional capital spending can be undertaken.

“When central government yields harden, state government borrowing immediately becomes more expensive because their bonds are benchmarked to the Centre,” the third official said.

“If overall public investment has to rise, it cannot come only from the Centre. States – especially fiscally stronger ones – will have to shoulder a larger share of capital spending,” added the person.

Gaura Sen Gupta, chief economist, IDFC FIRST Bank said that over the last few years central government capex, as percentage of GDP, is beginning to hit a ceiling. "This reflects execution constraints of how much capex can be implement in a year. More than half of the capex is focused in just two sectors roads and railways."