India's elevated borrowing costs are often interpreted through the lens of monetary policy—whether the Reserve Bank of India (RBI) has tightened too much or delayed rate cuts. The Economic Survey 2025–26 challenges this narrative by placing the cost of capital within a broader macroeconomic framework. It argues that India's interest rates are structurally high because the economy consistently invests more than it saves, forcing it to rely on foreign capital to fund growth. This dependence on external savings embeds a persistent risk premium into India's borrowing costs, largely independent of short-term policy rate adjustments.
The Savings-Investment Gap
Over the past decade, India's gross capital formation has remained in the 30%–32% range of gross domestic product (GDP), while gross domestic savings have lagged by 2–3 percentage points. This gap manifests as a recurring current account deficit, which has averaged close to 1.5%–2.0% of GDP over long periods, widening sharply during phases of strong domestic demand or high commodity prices. Even in years of favourable global conditions, India has struggled to sustain a current account surplus, underscoring the structural nature of the imbalance rather than a cyclical deviation.
Because India consistently spends more on imports than it earns from exports, it is 'savings-deficient' and must depend on external capital to fund domestic investment. Global investors demand a risk premium to provide this capital, compensating for exchange-rate and rollover risks. Between FY95-96 and FY24-25, India's weighted-average long-term interest rate averaged 7.61%, significantly higher than those of advanced economies such as Canada (3.13%) and Switzerland (1.04%).
The Sovereign Yield Anchor
This external deficit has direct implications for interest rates. India's 10-year government bond yield has consistently traded in the 6.8%–7.4% range in recent years, significantly above yields in peer economies with comparable growth rates but stronger external balances. These yields are not merely a reflection of inflation expectations; they reflect the price at which global capital is willing to fund India's fiscal and external deficits.
Because sovereign yields act as the benchmark risk-free rate, they anchor the entire financial system. Banks price deposits and loans off government bond yields, while non-bank financial companies (NBFCs) raise funds at spreads over the same curve. As a result, even when RBI cuts policy rates or injects liquidity, the scope for sustained reduction in lending rates remains limited. Data from previous easing cycles show that while short-term money market rates respond quickly to policy action, longer-term yields—and by extension retail and corporate lending rates—decline far more slowly, if at all.
Why Borrowers Pay More
This structural rigidity is particularly evident in household and micro, small and medium enterprises (MSMEs) borrowing. Home loan rates, which are closely linked to long-term funding costs, have remained elevated relative to policy rates across cycles. Even during periods when the repo rate was cut aggressively, effective home loan rates rarely fell below levels implied by the sovereign yield curve plus bank spreads.
MSME credit exhibits an even sharper premium. According to banking data, MSME lending rates are often 300–600bps (basis points) higher than large corporate loans, reflecting both credit risk and the high underlying cost of funds. When the base cost of capital is structurally high, riskier borrowers face disproportionately higher borrowing costs. Borrowers—including home-buyers and MSMEs—effectively pay this premium as a "macro-stability tax," a structural cost of doing business in a deficit economy.
Empirical Evidence: External Balance Matters Most
A study of 15 countries over three decades found a direct correlation between the current account balance (CAB) and the cost of capital. A 1% point improvement in a country's CAB leads to 2.8bps reduction in long-term interest rates. Improving the external balance is nearly twice as effective at lowering interest rates as simply increasing financial depth (expanding credit to the private sector). This suggests that while expanding the banking system is helpful, it cannot overcome the structural pressure from a negative trade balance.
The Vicious Cycle
The high cost of capital creates a feedback loop that traps upstream producers—those making steel, machinery, or industrial chemicals—in a cycle of inefficiency. Expensive capital makes it difficult for these heavy industries to invest in scale or modern technology. Instead of competing on efficiency, these producers often seek protection or 'negotiated shelter' from the government, which keeps their output prices high. These high input costs are passed to downstream manufacturers and MSMEs, making Indian exports less competitive globally. Because exports fail to grow sufficiently to fix the current account, the underlying savings imbalance persists, and the cost of capital stays high.
India's services exports and remittance inflows provide partial insulation but do not alter this equilibrium. While these inflows primarily smooth volatility, manufacturing exports—which tend to generate large-scale, repeatable foreign exchange surpluses—remain insufficient to shift India into a sustained surplus position.
The Path Forward
The Survey's conclusion is unambiguous: monetary policy can influence cycles but cannot alter the structural price of capital. As long as India remains a net importer of savings, interest rates will reflect global risk pricing rather than domestic policy intent.
To durably lower the cost of capital, India must transform into a surplus-generating economy through manufacturing competitiveness, productivity gains, deeper financial markets, stronger export competitiveness and sustained fiscal discipline. Until these conditions are met, expensive home loans, costly MSME credit and high business borrowing rates are not policy anomalies but macroeconomic outcomes. India's cost of capital is not merely set in Mint Street; it is determined by the economy's position in the global flow of savings.
