FY26 fiscal policy: Higher borrowing, deficit cut, and the bond yield conundrum

By: Shantanu Bhattacharji

The fiscal roadmap will face scrutiny, with the ability to balance borrowing without destabilising debt markets depending on revenue growth and expenditure discipline, especially in an increasingly uncertain global environment.

The Centre’s fiscal policy for FY26 reflects a delicate balancing act—higher gross borrowing offset by a firm commitment to deficit cut. The Union Budget 2025-26 sets fiscal deficit target of 4.4 per cent of GDP (gross domestic product), down from a revised 4.8 per cent this year, signals prudence, though the government’s gross market borrowing has climbed to Rs 14.82 lakh crore, up from Rs 14.01 lakh crore in FY25.

More significantly, net borrowing is projected to dip marginally to Rs 11.54 lakh crore from Rs 11.63 lakh crore, easing concerns about an unsustainable debt trajectory. This measured approach, while accommodating funding needs, reassures investors that the government remains aligned with its fiscal consolidation roadmap.

Bond markets have responded with cautious optimism. While the borrowing figure slightly exceeded expectations, market participants interpret the government’s fiscal stance as a stabilising factor. Early indicators suggest a modest decline in yields, with the 10-year benchmark bond yield, which settled at 6.69 per cent on January 31.

Analysts say the fiscal roadmap will remain under scrutiny, and the ability to sustain this delicate equilibrium—managing borrowing without unsettling debt markets—will hinge on revenue buoyancy and expenditure discipline in an increasingly uncertain global environment.

With the Budget largely meeting expectations, market participants are now closely watching the Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) meeting on February 7 for further signals.

The prevailing market consensus expects a 25-basis-point cut in the repo rate, which would mark the first reduction since May 2020, when the central bank slashed rates in response to the coronavirus pandemic. A rate cut would likely boost expectations of a more dovish interest rate stance, pushing the benchmark 10-year bond yield closer to 6.60 per cent.

Also, the move is likely to provide fresh momentum to the debt markets, particularly as the government’s fiscal deficit continues to narrow and economic growth prospects remain closely tied to the central bank’s policy actions.

The RBI more than doubled its purchases of bonds in the secondary market, with net bought bonds worth Rs 20,850 crore in the week ending January 24, after purchases of Rs 10,175 crore in the prior week. Last week, the RBI bought bonds worth Rs 20,000 crore through an open market auction, and the benchmark bond accounted for one-fourth of that purchase.

The yield will fall to 6.60 per cent if rate cut happens. Furthermore, if additional liquidity measures are announced, the market is likely to respond positively, pushing yields even lower.

The Centre’s budget deficit has steadily narrowed from a peak of more than 9 per cent in FY2020-21. The government’s fiscal strategy has been notably adept at slashing the fiscal deficit from 4.8 per cent of GDP in FY25 to 4.4 per cent in FY26, all while introducing income tax concessions and maintaining a healthy public investment outlay. Much of this progress has been driven by a windfall from the RBI dividends and expectations of strong income tax receipts.