State-level freebie culture is negating Central fiscal discipline, raising capital costs for all

 It is a well-established fact that the cost of capital has a big impact on the private sector’s ability and willingness to invest. In the recent past, the government has stuck to its fiscal deficit targets to avoid crowding out private investment, and the Reserve Bank of India has cut both repo rates and banks’ cash reserve ratio by one percent each, but market interest rates continue to remain stubbornly high. The government’s benchmark 10-year bond yield is around 6.7 percent, much higher than Indonesia, which has the same BBB credit rating.

Why are interest rates stuck at high levels when inflation is tamed, and may continue to remain tamed over the next year?

The Economic Survey 2025-26 gives two main reasons why this may be so. 

First, the states’ fiscal indiscipline is impacting the Centre’s borrowing costs. The Union government’s fiscal discipline has not been matched by state fiscal discipline, thanks to the tendency to promise unconditional freebies to the electorate. 

Second, as long as goods exports vastly underperform imports, the pressure on the current account will remain despite robust growth in services exports, forcing India to pay a premium on risk capital.

Says the Survey: “India’s high cost of capital is a structural macroeconomic outcome. A country that persistently runs current account deficits (CAD) and depends on foreign savings must, by definition, pay a risk premium to global capital. By contrast, economies that generate sustained external surpluses - through exports, productivity and financial depth - can finance investment cheaply and stably at home. India’s long-run challenge, therefore, is not merely to manage liquidity or credit cycles, but to transform itself into a surplus-generating economy. Only then can its cost of capital fall  durably.”

In short, the RBI alone cannot make capital cheaper.

But even as India continues to fix other factors that impact export competitiveness, including deepening the capital market and lowering logistics costs, the survey hints that states are making things worse by giving away freebies they cannot afford.

The chapter on fiscal developments expresses concerns over “fiscal populism, the crowding out of capital expenditure by cash transfers, and the rise of revenue deficits in states…”. The Survey adds: “While the Centre has achieved consolidation alongside record public investment, rising revenue deficits and unconditional cash transfers in several states pose emerging risks by crowding out growth-enhancing spending. With Indian government bonds now globally indexed and  investors increasingly assessing general-government finances, weak fiscal discipline at the state level can no longer be treated as locally contained - it increasingly affects the cost of sovereign borrowing”.

Put simply the Survey is saying that state-level profligacy is making the Centre’s own borrowing costs higher, despite the Centre’s good fiscal management.

“Between FY19 and FY25, 18 states saw a deterioration in their revenue balances, of which 10 slipped into revenue deficit from revenue surplus, five worsened their revenue deficit and three managed to stay in revenue surplus despite a deterioration…A key driver of this renewed fiscal stress has been lagging revenue growth relative to nominal GDP growth, compounded by the incurring of expenditures such as discretionary unconditional cash transfers.”

One argument is, of course, chicken-or-egg. The CAD will not improve till manufacturing exports improve, but that won’t improve significantly if the cost of capital and overall competitiveness remains weak.

The other argument, of profligate states, is directly related to politics. With the BJP posing a threat to many regional parties and also the Congress, there is a trend towards competitive populism and freebies. The only solution to curtailing this profligacy is a multi-partisan agreement on avoiding endless freebies. 

The hope is that with India signing many trade deals, including the two big ones with the European Union and the US, exports will get a fillip as input costs become cheaper when duty structures are lowered. But as we have seen with China, our trade deficit with the Dragon has soared even as our exports of final products (mobile phones, electronic goods) have zoomed to the US. The jury is out on how the trade deals will pan out for India’s CAD.

On interest rates, the structural problems thus remain.