Why India pays higher interests on loans: Economic Survey 2026 points to rising deficits of states

India’s persistently high cost of capital is not merely a financial-sector problem but a structural macroeconomic outcome, driven in part by rising state-level debt and continued dependence on foreign savings, the Economic Survey 2025–26 has warned. The survey cautioned that fiscal slippages at the state level are increasingly casting a shadow on India’s sovereign borrowing costs, raising the hurdle rate for private investment and long-term growth.

With government bonds now globally indexed, investors are assessing India’s finances on a general government basis, rather than looking only at the Centre. The survey pointed out that while India and Indonesia share the same sovereign credit rating of BBB, India’s 10-year bond yield stands at about 6.7 per cent, compared with 6.3 per cent for Indonesia. The divergence, it said, partly reflects concerns over state-level revenue deficits, rising committed expenditures, and unconditional cash transfers, which markets factor into sovereign risk pricing.

The chapter on fiscal developments noted that although the Centre has followed a calibrated path of fiscal consolidation while scaling up capital expenditure, several states have increased reliance on cash transfer programmes. While such transfers serve distributional goals, they have altered expenditure composition and raised concerns over fiscal rigidity and the risk of crowding out growth-enhancing capital spending.

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Persistent revenue deficits at the state level, the survey warned, can push up sovereign yields and narrow policy space for the entire economy. Beyond fiscal mechanics, the survey made a deeper argument on why capital remains expensive in India.

Over the past three decades, between 1995 and 2025, India’s weighted average long-term interest rate averaged 7.61 per cent, far higher than rates in advanced economies such as Canada (3.13 per cent), Italy (2.94 per cent) and Switzerland (1.04 per cent).

While India fares better than some emerging peers like Indonesia (14.1 per cent), Mexico (11.05 per cent) and South Africa (9.08 per cent), the survey said the persistence of high economy-wide capital costs cannot be explained by shallow bond markets or regulatory frictions alone.

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Instead, it linked the cost of capital to India’s structural savings shortfall and current account deficits (CAD). Economies that run persistent CADs, the survey argued, are inherently dependent on foreign savings to finance investment and consumption. This dependence introduces a risk premium, which markets price into interest rates and equity returns. “The cost of capital in CAD economies is not merely a financial-market outcome; it is also a price on macroeconomic risk,” the survey said.

Using panel data from 15 developed and emerging economies between 1995 and 2025, including India, Indonesia, Japan, Germany, and Switzerland, the survey showed a strong empirical relationship between current account balances and long-term interest rates. Countries that generated sustained external surpluses were able to finance investment more cheaply and stably at home, while deficit economies paid higher risk premia.

The survey said India’s long-term challenge is therefore not just managing liquidity or credit cycles but transforming into a surplus-generating economy. Productivity-led growth, especially in manufacturing, sustained export expansion, and deeper integration into global value chains are critical to lowering capital costs durably. Labour productivity, operating margins, and retained earnings determine the pool of domestic savings, which in turn influences dependence on foreign capital.

Rigid labour regulations, sub-scale firm structures, and protectionist responses to import competition have historically constrained productivity growth, the survey noted. While such strategies may preserve margins in the short run, they often weaken downstream competitiveness and fail to generate durable export surpluses. The result is continued reliance on foreign savings, a weaker currency bias, and a persistent risk premium embedded in domestic capital costs.

Financial-sector reforms—such as deeper bond markets, broader institutional participation, and better risk pricing—remain important, but the survey stressed they are most effective when accompanied by rising domestic savings and an improving external balance. “Financial deepening can support and accelerate this transition, but it cannot substitute for it,” the survey said.

The way forward, according to the survey, lies in coordinated action: restoring fiscal discipline at the state level, prioritising capital expenditure over revenue spending, improving logistics and infrastructure, correcting inverted duty structures, and strengthening manufacturing competitiveness. Reforms such as GST 2.0, personal income tax rationalisation and greater use of digital systems are expected to improve efficiency, compliance, and revenue mobilisation, supporting the medium-term debt path.