In August 2025, India celebrated a milestone with its sovereign rating upgrade. This was achieved on the back of a sharp fiscal correction from the FY21 peak deficit of 9.2% to 4.5% of GDP (Gross Domestic Product).
Looking ahead, however, the pace of fiscal consolidation is expected to slow. Since FY26, the government’s focus has shifted from fiscal consolidation to managing overall debt levels, aiming to bring the debt-to-GDP ratio down from around 56% today (FY25 and FY26BE) to roughly 51% by FY31.
This means deficit reduction will likely follow a gradual, measured path ~ 15–20 basis points (bps) per year through FY27–31.
Our estimate for the FY27 deficit is at about 4.3%. That said, the government could opt to keep the deficit closer to 4.4% to boost near-term growth. Such a move would be a positive signal for equities, though it might keep long-term bond yields on the higher side.
But how is the government likely to meet its fiscal deficit target for FY 26 despite moderation in tax revenues?
RBI Dividend Adds a Key Fiscal Cushion
One of the key enablers for meeting the FY26 fiscal target, despite significant shortfalls in tax collections, has been a record dividend from the Reserve Bank of India (RBI). To recap, the RBI’s dividend to the Centre for FY25 stood at Rs 2.69 trillion against the BE (Budget Estimate) of Rs 2.5 trillion.
Looking ahead, we expect the FY27 RBI dividend to rise by another 10–15% to approximately Rs 2.8 – 3.0 trillion, driven in part by the higher depreciation of the rupee, which boosts the RBI’s earnings on its foreign exchange assets. Interestingly, while the overall dividend inflow is expected to rise, the yields on these FX assets are likely to be slightly lower compared with the previous year.
This additional fiscal support will provide the government with flexibility in budgetary allocations without derailing its deficit trajectory.
Under Capex – Defence likely to be in the Driver’s Seat
Government capital expenditure is projected to grow by around 10% in FY27, reaching roughly Rs 12+ trillion. However, defence spending is likely to dominate the narrative.
With FY26 year-to-date growth in defence capex already around 57%, we anticipate a robust but moderated increase of about 25% in FY27, reflecting the government’s priority of modernizing and resetting India’s military capabilities.
Non-defence capital expenditure, by contrast, is expected to grow more modestly, in the 5–10% range.
This trajectory would see India’s defence spending rise to around 1% of GDP by FY31, levels reminiscent of the period following the Kargil conflict, up from the current central government capex share of 0.5% in FY25 and an estimated 0.6% in FY26.
Even at this pace, India’s overall defence expenditure still leaves room for growth compared with global peers. In 2024, India spent 1.9% of GDP on defence, compared with 7.1% for Russia, 3.4% for the US, 2.7% for Pakistan, and 1.7% for China.1
Central Pay Commission Hikes – Another key variable
Attention is also likely to turn to government salaries. The decadal Central Pay Commission reset (potentially exceeding Rs 7 trillion) was due in January 2026, though delays in forming the commission have pushed timelines.
There is a strong possibility that the government may front-load the central pay commission hikes in the upcoming budget, rather than delaying them to CY 2027, with arrears spread into the following fiscal year.
These central government pay hikes alone are expected to add roughly 20–30 basis points to the fiscal deficit, highlighting the government’s challenge of balancing fiscal discipline with political and social priorities.
What else can we expect?
Foreign Investors will be monitoring the possibility of capital gains tax relief for select Foreign Portfolio Investors (FPIs), which could support equities, although this is not our ‘base-case’ expectation.
Meanwhile, long-term government bond yields remain stubborn despite a 125 basis point cut in the repo rate, reflecting a structural demand challenge. Any measures that incentivize flows into deposits or debt markets, could be positive for the bond markets.
Other areas where we may see some regulatory reforms or reliefs could be – Pay-hike provisions from the pay commission may boost middle-class consumption, benefiting consumer durables and vehicle sales, while expansions in interest subsidy schemes like CLSS could strengthen affordable housing lenders.
(The Credit Linked Subsidy Scheme (CLSS) is a significant initiative under the Pradhan Mantri Awas Yojana (PMAY) aimed at making affordable housing accessible to all families across India).
Any tax incentives for data centers and policy support for GCCs could benefit power equipment companies.
What Opportunities Does the FY27 Budget Offer for Equity and Debt Investors?
We believe the FY27 budget could strike a careful balance, supporting near-term growth through defence and middle-class consumption while maintaining fiscal discipline.
For investors, this creates both clarity and opportunity, with sectors aligned to government priorities such as consumer durables, affordable housing, banking, life insurance, renewable energy, and select technology likely to see positive momentum, underpinned by a stable macro environment.
For debt investors, the FY27 budget signals a need for caution and agility.
Bond supply is likely to rise, particularly from state development loans (SDLs), keeping India’s total debt-to-GDP ratio (Centre plus States) elevated next year. Meanwhile, the delay in Bloomberg index inclusion has dampened market sentiment, and we expect yields to remain rangebound with a slight flattening bias along the curve.
With no further rate cuts anticipated, the repo rate is likely to stay steady for an extended period.
Persistent demand-supply mismatches could continue to put upward pressure on yields. In this environment, we believe an agile duration approach could be effective, allowing investors to actively manage interest rate risk.
At the same time, layering multiple risks in a debt portfolio like keeping credit and liquidity risks minimal while navigating interest rate volatility can help maintain stability and protect capital.
Investors may need to recalibrate return expectations from debt funds in today’s lower-rate and volatile market environment.
Overall, we see the FY27 budget not just as a statement of fiscal strategy, but as a roadmap for investors to identify growth drivers and align portfolios with India’s evolving policy priorities.
Sneha Pandey is Fund Manager for Fixed Income and Multi-Asset Allocation Funds at Quantum AMC
Source: Bloomberg, RBI, MOSPI, India Budget Documents, CGA.
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