States are beneficiaries of softening interest rates

interest rates

Softening bond yields bring cheer to governments as they are the largest borrowers in the bond markets.  During FY2022-25, the combined issuances of state government securities (SGS) grew at a compound annual growth rate (CAGR) of 15%, more than double the CAGR of Government of India’s securities (G-secs). In FY2026, we estimate the gross issuances by the state governments in a range of Rs. 11.9-12.5 trillion, versus the Rs. 14.8 trillion budgeted by the Government of India (GoI).

With the expected onset of monetary easing commencing in February 2025, the weighted average cost (WAC) of the State Government Securities (SGS) issued in FY2025 declined by 32 bps to 7.20% relative to FY2024. The WAC has further eased to 6.7% in the auctions of SGS held in April 2025, and is likely to continue to dip over the course of the year.

The cost of borrowings of states is impacted by various factors, including prevailing market interest rates, proportion of borrowing in various tenors, quantum and timing of issuance by a state etc.

Uneven pattern of borrowings by states

Unlike GoI’s borrowings, which are typically front-loaded, SGS issuances tend to, in aggregate, be back-ended, amidst a fair bit of variation across the states. In terms of the monthly trends of SGS issuances in recent fiscals, heavy borrowing in March has been followed by a lackluster April with actual borrowings trailing the planned issuances in the remaining 10 months. Back-ended clearance of bills, a desire to fully utilise the net borrowing ceiling (NBC), and /or a possible anticipation of a delay in receipt of borrowing permission for the next fiscal in the initial weeks of Q1, could be some of the reasons for higher actual issuances in March relative to other months.

The WAC of the papers issued by states in the above 10-year maturity (longer tenor) and 10-year clustered around 7.2% in FY2025, indicating a flat yield curve. This was around 31 bps lower than the WAC of 7.5% each for both these maturity buckets in FY2024. The WAC of the papers in the less-than-10-year segment fell slightly more sharply to 7.12% in FY2025 from 7.47% in FY2024.

Weighted average cut-off of SGS issuance for all states/UTs

Source: Reserve Bank of India; ICRA Research

Most states shifted to longer tenors

Over a period, many states have displayed a clear preference for longer tenor papers, with their share in total borrowing rising to 65% in FY2025 from about 25% in FY2020. Simultaneously, the proportion of issuances in the 10-year bucket declined to a low 13% in FY2025 from 55% in FY2020. While borrowings of most states were skewed towards the longer tenor, a few states followed a different approach.

Tenor-wise SGS issuance of all states/UTs

Source: Reserve Bank of India; ICRA Research

Gujarat issued 79% of its total issuances in the less-than-10-year bucket in FY2025, in line with the previous fiscals. At 7.05%, the WAC of Gujarat’s SGS in FY2025 was the lowest among the large borrowers. However, in a reversal of strategy, Karnataka raised more than half of its total issuance in shorter tenors in FY2025 compared to raising nearly three-fourths of its total issuances in longer tenor papers in FY2024, perhaps to take advantage of the aforesaid accentuated easing in yields in this bucket.

With the shift in the tenor and other factors, the WAC of SGS issued by Karnataka declined sharply to 7.10% in FY2025 from 7.60% in FY2024. This 50-bps decline in Karnataka’s WAC of SGS was the highest among the large borrowers. Bihar and Tamil Nadu followed a different approach, with borrowings nearly evenly spread out across each of the three buckets.

Attractiveness of GoI’s Special Assistance as Loan

To boost capital spending by state governments, the GoI has allocated Rs. 1.5 trillion for FY2026 under the Special Assistance as Loan to States for Capital Expenditure’ scheme or capex loan scheme. An early offtake of the funds under the capex loan scheme by states in FY2026, relative to the highly back-ended releases in FY2025, can impact the quantum of actual gross issuances. Notably, the funds provided by the GoI to the states under the capex loans are interest-free and are above the Net Borrowing Ceiling (NBC) of each state affixed by the GoI at the start of the fiscal.

State governments have the option to utilise the entire NBC for a fiscal in that very year or to carry forward any unutilised borrowing limit to the next fiscal within the five-year award period of the Finance Commission (FC).

Since FY2026 is the last year of the 15th Finance Commission’s award period (FY2022-FY2026), any unutilised borrowing limit for FY2026, cannot be carried forward to FY2027. Therefore, those states that typically borrow below the permissible limit, may want to exhaust that space in FY2026. However, an assessment of the cost of borrowing of the unutilised amount and the option to avail the interest-free capex loan, may lead to most of the states opting for the latter.

Aside from the NBC, the 15th FC had recommended an additional borrowing space of 0.5% of gross state domestic product (GSDP) for the states, until FY2025, on a conditional basis linked to completion of prescribed power sector reforms.  During FY2022-FY2025, Andhra Pradesh, Kerala, Rajasthan, Sikkim, Tamil Nadu and West Bengal had availed additional power-sector related borrowings in three to four years while few other states (Odisha, Punjab, Uttar Pradesh etc.) have borrowed in one or two years. The combined conditional borrowing by a select number of states added to Rs. 1.35 trillion during FY2022-25.

Encouragingly, the GoI has extended the availability of the additional borrowing of 0.5% of GSDP to the states in FY2026 as well.  It would be interesting to see if the flexibility to carry forward the unutilised borrowing in a fiscal to the next year, which has been in place since the award period of the 14th FC, continues during the award period of the 16th FC as well.

With 50 bps of rate cuts underway, we now expect another 50 bps of monetary easing over the next two-three policy reviews. With this, the WAC of SGS could come down to 6.3-6.5% over the course of the year, maintaining a spread in a range of 30-50 bps over G-sec, over the course of the year.