MUMBAI - A ‍surge in borrowing by Indian states is ‍complicating the central bank's efforts to lower interest rates as officials worry the increased supply of state bonds could affect the yield curve, according to people familiar ​with the central bank's thinking and analysts.

State governments are issuing debt at a pace that increasingly rivals sovereign borrowing, significantly boosting bond supply for a shared pool of investors.

Amid the increased supply ⁠of state debt, which typically offers a modest yield premium over federal bonds, investors are now demanding higher returns on central government securities, making it more difficult for the Reserve Bank of India to ⁠bring down ‌borrowing costs despite recent interest rate cuts.

Sub-sovereign borrowing overtaking central government issuance is a mounting concern since it risks distorting the yield curve and weakening the transmission of monetary policy and liquidity measures, one of the sources familiar with the central bank's thinking said, requesting anonymity because they were not authorised to speak ⁠publicly.

STATE BORROWINGS MAY RISE FURTHER

State borrowings could rise further following the recent revamp of the rural jobs scheme, which shifts more of the financial burden onto state governments, the person said, adding that states may overtake the federal government in borrowings over the next few years.

In the current fiscal year, which runs from April to March, Indian states are set to borrow nearly as much as the central government, with gross issuance of about 12.5 trillion Indian rupees ($137.66 billion) versus 14.6 trillion rupees at the sovereign level.

Net borrowing by ⁠states, at roughly 9 trillion rupees, is approaching the central ​government's 10.3 trillion rupees.

Investors generally view debt issued by Indian states as equivalent to federal government debt, since a reserve pool of funds held by the central bank is used for payouts during periods of financial stress.

This ‍means that while state debt offers investors a spread of 80 to 100 basis points over federal debt, the risk of default remains negligible.

As a result, for bond investors - mostly Indian banks, insurers and pension funds - holding state bonds is ​effectively the same as investing in federal securities.

"Elevated state debt supply has led to renewed pressure on bond yields, especially at the longer end of the curve, leading to further steepening of the yield curve," said Puneet Pal, head of fixed income at PGIM India Mutual Fund.

Higher state borrowings have eroded benefits from the 100 basis points in interest rate cuts this fiscal year and pushed up costs for corporate borrowers, four analysts and traders said.

The yield on the 10-year central government bond has risen by 10 basis points in the current fiscal year, while benchmark yields for top-rated corporates have increased by 30 basis points.

"Elevated state government borrowings are hindering transmission of RBI's rate cuts to the broader interest rate structure," said Michael Wan, an analyst at MUFG Bank.

LIMITED OPTIONS TO REIN IN STATE BONDS SUPPLY

To keep yields in check, the RBI is expected to purchase about 5.7 trillion rupees of central government bonds this year, an amount equivalent to more than half of the government's net borrowing, effectively easing the supply burden.

No such support exists for state bonds, leaving the heavy sub-sovereign issuance to be absorbed ⁠entirely by the market.

One possible way to limit state borrowings could include a larger quantum of long-term infrastructure ‌loans from the federal government, the source familiar with the central bank's thinking said.

In the current financial year, the federal government allocated 1.5 trillion rupees for such loans.

Another option could be to allow them to borrow from a pool of small savings by government savings schemes, currently available only to the federal government.

Any decision on this rests with the federal government.

The central bank has ‌further nudged states to ⁠manage borrowings better by spreading out the tenor of debt issuances.

Sachin Bajaj, executive vice president & chief investment officer, Axis Max Life Insurance, said the federal government should reduce the share of long-tenor borrowings ⁠to limit the rise seen in yields. ($1 = 90.8075 Indian rupees)

(Reporting by Dharamraj Dhutia and Nimesh Vora; Editing by Ira Dugal and Saumyadeb Chakrabarty)