India’s banking sector is facing increasing strain from mounting exposure to state government bonds.
Some of the country’s biggest lenders have informed the Reserve Bank of India (RBI) that their investment portfolios are nearing internal limits for state debt, raising questions about future funding access for state governments.
The development comes at a time when states have borrowed only a fraction of their planned amount for the current financial year, and investors are showing weaker appetite for such securities.
The warnings highlight the delicate balance between state financing needs and banks’ ability to absorb more debt.
Banks signal pressure on state bond market
According to people familiar with the matter, several Indian banks have recently approached the RBI, warning that the share of state bonds in their holdings has risen sharply and is now close to internal caps.
While there is no regulatory ceiling on how much state debt banks can purchase, lenders use internal prudential limits to manage risk.
For state-run banks, this threshold typically falls between 45–55% of their total investments, while private banks usually keep exposure within 15–20%.
The concerns raised underline banks’ crucial role in India’s state bond market, where they remain the primary buyers.
A slowdown in purchases could put significant pressure on state governments, particularly as they have so far completed just 26% of their estimated borrowing for the current fiscal year.
Auctions show weak demand for state debt
The growing caution among banks has already reflected in recent state bond auctions. Last week, some issuances struggled to attract sufficient bids, highlighting waning demand.
States managed to raise 288.9 billion rupees ($3.3 billion), falling short of the 341.5 billion rupees target. The shortfall underscores the challenge states may face in completing their borrowing programmes if banks reduce their participation.
The RBI has limited scope to intervene in easing these limits, since such thresholds are determined by individual bank boards rather than regulators.
The central bank has also not publicly commented on the matter, despite reports that lenders have sought its assistance to prevent a broader bond selloff.
Impact on government bonds and yields
Weak sentiment in the state bond market has spilled over to central government securities. In August, the yield on India’s benchmark 10-year government bond rose by 19 basis points, marking its sharpest monthly increase since September 2022.
The selloff was partly triggered by concerns that the federal government may step up borrowing to cover revenue shortfalls following recent consumption tax cuts.
With both central and state governments competing for funds, the risk of higher borrowing costs looms larger.
Any prolonged decline in demand for state debt could make it harder for local administrations to access capital markets, potentially delaying planned projects and infrastructure spending.
Future risks for state borrowing
The strain on bank investment portfolios highlights a broader concern about the sustainability of India’s borrowing patterns.
States still need to raise the majority of their targeted funds this fiscal year, but bank demand is weakening at a critical juncture.
If alternative investors do not step in, capital access could tighten further, complicating fiscal management at the state level.
At the same time, fears of increased central government borrowing are adding to the pressure on yields, potentially making it more expensive for both states and the federal government to borrow.
For India’s financial system, the interaction between bank prudential limits and government borrowing needs is emerging as a key challenge in maintaining stability in debt markets.
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