Friday, 31 August 2012

Impact of High Fiscal Deficit on Indian Financial Markets

Recent article by S&P rating agency, threatened India to degrade its rating to junk. One of the reasons behind this warring is India’s fiscal deficit and its consequences on Indian economy.

Fiscal deficit measured on two factors in any economy, first total expenditure and second total revenue. Fiscal deficit is difference between government spending and government revenue for particular year, excluding money from borrowing. It is also known as budget deficit. India’s fiscal deficit for FY 2011-12 was 5.9% of GDP and is estimated 5.1% of GDP for FY 2012-13. But poor structured fiscal policies and external factors like, Euro crisis, inflation, slow growth in economy etc. could bring fiscal deficit at 6% or more level of GDP.

In FY 2011-12, Indian government’s revenue was Rs. 8, 44,912 crore, and in Union Budget 2012-13 it was estimated Rs. 9, 77,335 crore for FY 2012-13. In which, major source would be from tax collection, around Rs. 9, 35,685 crore. In total revenue taxes are contributed around 78% of total, and in FY 2012-13 it is estimated to grow around 22.7%. This estimation was made on new tax reform, Direct Tax Code (DTC), but delay in DTC implementation may fall short on estimated figures.

Indian Government’s total expenditure is divided in plan and non plan expenditures through the year. In FY 2011-12, government’s non plan and plan expenditure was Rs. 8, 92,116 crore and Rs. 4, 26,604 crore respectively. For FY 2012-13 is estimated by Rs. 9, 69,900 crore and Rs. 5, 21,025 crore for non plan and plan expenditures. In FY 2011-12 total growths in government spending was 10.1 % against original budgeted 3.4% and non plan expenditure was up by 9% due to high subsidy payments.  It had direct effect on fiscal deficit levels. Total subsidy for FY 2011-12 was Rs. 1, 43,570 crore and for FY 2012-13 estimated Rs. 1, 90,015 crore, these changes are due to high crude oil price and its import which counts 33% of total and rupee depreciation in context of other external factors. Non plan expenditures for FY 2012-13 are Rs. 9, 69,900 crore in which interest payments are Rs. 3, 19,759 crore. This indicates increase in borrowing, which is around Rs. 4.79 lakh crore. This results in government securities and bond market volatility.

Suppose India’s fiscal deficit reach at 6% level of GDP then its consequences could be worst enough to shrink India’s GDP growth by less than 5%.  India could face high inflation, because of rupee depreciation and its impacts. And this could cause exchange rate fluctuation. In FY 2009-10 when fiscal deficit was at 6.9% of GDP, inflation was all time high at average 14%. This would further accelerate to balance of payments crisis.

Increase in fiscal deficit and government spending would necessarily increases interest rate of government securities. And this would induce the rise in net private sector savings to support government borrowing. And consequences would be ‘crowding out’ of private sector.

How crowing out takes shape due to high fiscal deficit? To finance fiscal deficit government will borrow from other countries, and this will result in higher central bank’s rate and will discourage private borrowings.

Bond market would see high volatility because of these events. Bond prices fall and yield increases as market expects a higher supply of government securities. Banks are largest buyers of government securities and bonds, would face losses in particular investments.

Estimations from the macro econometric models suggests that an increase in the budget deficit by 1% of GDP would raise long term interest rate by about 50 basis points after one year and about 100 basis points after ten years. 

In Union Budget 2012-13, Indian Finance Minister estimates to reduce fiscal deficit to 5.1 % of GDP, through reducing total subsidy expenses by 2% of GDP to 1.5% of GDP in next three years. But these steps are not enough. Government can reduce fiscal deficit by increasing revenue or decreasing spending. To increase revenue government can increase tax brackets (including direct and indirect taxes), but by this demand will fall and business investment activities will come down. Is last few years government cut subsidies in sectors like education, health and poverty alleviation and it created inverse effect in booming demand. For FY 2012-13 government target Rs. 30,000 crore incomes by disinvestment activities, but it cause negative impact in long term. The Public Sector Units (PSUs) that the government disinvesting are profit making firms like Oil and Natural Gas Corporation (ONGC), Gas Authority of Indi Limited (GAIL) and Life Insurance Corporation (LIC). From these firms government earns lump sum amount at the end of financial year, and by disinvestment government will lose profit on it.

As growth target remains high, cost of borrowing would be at higher level. To support spending government is limited on money creation because it will fuel inflation and external borrowing because it will increase debt burden.

Implementation of DTC in next year and allowance of FDI in retail and aviation would help India to bring down its fiscal deficit. 

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