How Budget 2026 straddles debt, discipline and India's delicate balance of growth

As finance minister Nirmala Sitharaman presented the Union Budget 2026 on February 1, eyes turned immediately to the debt numbers.

Gross market borrowings are estimated at Rs 17.2 lakh crore, with net borrowings of about Rs 11.7 lakh crore after accounting for redemptions of old securities. The fiscal deficit has been targeted at 4.3 per cent of the Gross Domestic Product (GDP), slightly lower than the revised estimate of 4.4 per cent in 2025-26, reflecting a cautious approach to fiscal management.

India’s debt-to-GDP ratio is projected to moderate slightly to 55.6 per cent. Capital expenditure, at Rs 12.2 lakh crore, forms a substantial part of the borrowing programme, showing the government’s focus on productive investment in infrastructure, technology and manufacturing.

Amidst global volatility and domestic pressures, the government has adopted a measured path, opting for moderate deficit reduction rather than abrupt cuts. Analysts note that while Budget 2026 is broadly growth-neutral, high debt levels and continued reliance on borrowing would require careful monitoring by markets and rating agencies, underscoring the need for sustained fiscal prudence.

Over the next four months, two big developments will shape the fiscal landscape. On February 27, the country will enter a new GDP series, and on April 1, the awards of the 16th Finance Commission, led by economist Arvind Panagariya, would take effect. The new GDP series, with a base year of 2022-23, would reflect the dynamics of the digital and services-driven economy. It is expected to lift nominal GDP levels and thereby improve the debt-to-GDP ratios of both the Centre and the states.

The Finance Commission’s framework, on the other hand, will set new targets for fiscal consolidation, mandating limits for both tiers of government to maintain debt sustainability. Sitharaman’s Budget has quietly acknowledged that neither the Centre nor the states have met the debt-reduction trajectory envisioned by the N.K. Singh-led 15th Finance Commission, which had earlier set a 40 per cent central debt-to-GDP target.

For 2026-27, the debt ratio is estimated at 55.6 per cent of the GDP, compared to 56.1 per cent in the revised estimates for the previous year. The government has reiterated its medium-term goal of bringing this closer to 50 per cent by 2030-31. This is a significant recalibration of expectations. The N.K. Singh-led commission’s target of 40 per cent has proven too steep in an era of global shocks, Covid pandemic recovery spending and rising interest costs.

Nominal GDP growth sits at the heart of this fiscal calculus. Budget 2026 assumes a nominal GDP expansion of around 10 per cent in the coming year, a number that directly shapes fiscal ratios. If nominal growth exceeds projections, debt and deficit measures improve mechanically, even if absolute borrowing remains the same. The upcoming revision of GDP statistics could therefore alter the fiscal conversation.

The ministry of statistics and programme implementation’s revised GDP series is expected to widen the base, particularly in services and digital sectors. While this will likely lower debt ratios statistically, it also underscores how macroeconomic datasets evolve in response to structural changes in the economy. The revision will introduce a brief period of uncertainty as policymakers and markets recalibrate expectations. However, on paper, it could offer India’s fiscal managers more headroom.

At the same time, India’s federal fiscal architecture is entering a new phase. The 16th Finance Commission has reportedly retained the states’ share of the divisible tax pool at 41 per cent, applicable for the five-year period up to 2031. It has also recommended the removal of revenue deficit grants and maintained a 3 per cent cap on state fiscal deficits relative to Gross State Domestic Product (GSDP).

These moves are aimed at strengthening fiscal discipline at the state level and ensuring more predictable borrowing behaviour. However, several states have criticised the decision to maintain the 41 per cent share, arguing that rising cesses and surcharges, excluded from the divisible pool, have effectively reduced their share of central revenues. This debate will likely intensify as the new award period begins on April 1 and state budgets adjust to tighter conditions.

For the first time, Budget 2026 set clear targets to expand India’s municipal bond market, offering a Rs 100 crore incentive for any city raising over Rs 1,000 crore through bonds. Urban local bodies account for nearly 16 per cent of public expenditure but generate less than 1 per cent of public debt and only 0.4 per cent of the GDP. Fewer than 20 cities have investment-grade ratings, and cumulative municipal issuances so far total under Rs 4,000 crore.

The finance ministry expects 25-30 major cities to mobilise up to Rs 25,000 crore in two years, easing states’ borrowing needs. If implemented effectively, the initiative could reduce fiscal pressure on states, create a new class of quasi-sovereign debt and deepen India’s still-shallow bond market.

State finances themselves present a mixed and uneven picture. According to the Reserve Bank of India’s (RBI) latest ‘State Finances: A Study of Budgets’ report, the consolidated gross fiscal deficit of states rose to 3.3 per cent of the GDP in 2024-25 after remaining below 3 per cent for three consecutive years. For 2025-26, states have budgeted a similar deficit, though some have improved the composition of spending by restraining revenue outgo.

The outstanding liabilities of states declined from about 31 per cent of the GDP at the end of March 2021 to 28.1 per cent by March 2024. However, this progress may be short-lived. The RBI projects that state liabilities could rise again to nearly 29.2 per cent by the end of the current fiscal year. The central bank has urged states to adopt medium-term debt reduction strategies, noting that many continue to breach the recommended ceiling of 20 per cent of GSDP. Persistent fiscal stress, particularly in states with large subsidy commitments and weak revenue bases, remains a structural concern.

Disaggregated data shows striking differences. States such as West Bengal, Punjab, Kerala and Rajasthan have debt levels far higher than their economic output justifies, while Gujarat, Maharashtra and Odisha maintain more sustainable ratios. Rising liabilities have implications that reach beyond state treasuries. Power distribution companies in several states add to fiscal stress with chronic losses and growing debts, often prompting fresh state guarantees or bailouts. High welfare spending and limited tax buoyancy further erode the fiscal space for productive capital expenditure. This pattern is not uniform, but collectively it weighs on the national debt profile.

The combined picture underscores that India’s fiscal challenge is not just a central government issue. Aggregate public debt, combining central and state liabilities, gives a truer sense of vulnerability. Even as the Centre attempts to nudge its debt ratio downward, state borrowing trends can offset much of that progress, influencing the overall sustainability of public finances. A coordinated fiscal strategy between the Centre and states, anchored in shared targets and transparent data, would be crucial in restoring balance.

For financial institutions, the year ahead will bring both opportunity and risk. The large issuance of government securities at the central and state levels guarantees a steady supply of risk-free instruments but also raises the possibility of yield pressure if demand softens or liquidity tightens. Banks, insurance companies and mutual funds will remain the primary investors in these securities, making duration management critical.

The RBI’s liquidity operations, including open market purchases and sales, will play a vital role in maintaining stability in yields. A rise in global interest rates or domestic inflation could complicate this picture by pushing up borrowing costs, potentially crowding out private investment or compressing returns for long-duration investors.

Expanding the investor base will be key to deepening India’s debt markets. Pension funds, sovereign wealth funds and foreign portfolio investors can play larger roles if supported by improved market infrastructure and simplified regulations. The development of retail-friendly bond products and government bond exchange-traded funds can democratise access and improve liquidity.

Enhanced secondary market trading, standardised documentation and better risk disclosure are necessary to build confidence and efficiency. Similarly, state development loans need modernisation. Transparent pricing, regular issuance calendars and robust data disclosure can help make SDLs more attractive to a broader class of investors and better reflect credit differentiation across states.

Beyond market structure, policy reform is essential. Rationalising subsidies and reducing non-merit spending will release resources for productive investment. States that expand their tax bases, strengthen Goods and Services Tax (GST) compliance and improve revenue efficiency will be better positioned to meet debt sustainability goals without sacrificing development priorities. At the national level, improving tax buoyancy and maintaining consistent nominal growth remain the most effective levers for stabilizing debt ratios. Sustained real growth above 6.5 per cent, accompanied by 10 per cent nominal expansion, would allow India to manage its fiscal position even without drastic cuts in borrowing.

There are risks that could disrupt this delicate balance. A slowdown in growth, higher global rates or elevated domestic inflation could raise the cost of borrowing and increase interest obligations, which already consume a large portion of government expenditure. The fiscal space for capital spending could narrow if servicing costs rise faster than revenues. Effective coordination between fiscal and monetary authorities will therefore be essential to maintain macroeconomic stability.

Despite these risks, the outlook retains an undercurrent of cautious optimism. Budget 2026, with its emphasis on steady consolidation and productive investment, shows a preference for pragmatism over austerity. By signalling clear debt targets, prioritising capital formation and maintaining credible communication, the government has positioned India as a relatively stable economy amid global uncertainty.

The task ahead is to sustain this balance—using borrowing as a lever for growth rather than a liability for the future. The success of that effort would determine whether this period is remembered for responsible ambition or as another missed opportunity in India’s long quest for sustainable fiscal strength.

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