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The fiscal deficit and you
September 18, 2013

What really is the fiscal deficit? How does it impact the investor? Read on...


Author : Content Team



 Investing and the high fiscal deficit

Quantum Mutual Fund has decoded the jargon to explain what a fiscal deficit is, why it has such a great significance to India’s economic welfare and what this means for you as an investor.

Every year, the government puts out a plan for it's income and expenditure for the coming year. This is the annual Union Budget. The Budget is said to have a fiscal deficit when the government's expenditure exceeds its income. The fiscal deficit is the difference between the government’s total expenditures and its revenues (excluding money from borrowings). A country’s fiscal deficit is usually communicated as a percentage of its GDP. According to a report by the IMF, it would be challenging for India to achieve the medium-term target of 3% of GDP by 2016 due to substantial slowdown and revision to potential growth. The outlook, therefore, is for large fiscal deficits (about 7-8% of GDP) to persist albeit narrowing gradually, as expenditures remain too high, while revenues too low.

Causes

Payment of interest
One of the main causes of fiscal deficit is the interest paid by the government on both the domestic and foreign loans. The Indian government’s debt-to-GDP ratio has been forecasted to 67.53% for the calendar year 2013. This has resulted in increased interest burden on the government.

Increase in subsidies
Subsidies directly increase the fiscal deficit. Therefore, the subsidies provided by the government in various consumables like oil, gas, food etc. directly increases the fiscal deficit.

Defence expenditure
The defence budget has also seen an upward trajectory in recent years due to the security concerns for Indian borders and the government has a very limited possibility to reduce it. Hence, defence expenditure also increases the fiscal deficit.

More recently, the news has reported how the Food Security Bill and the slide of the rupee against the dollar will increase the fiscal deficit.

Consequences

A fiscal deficit is not necessarily a bad thing. However, a large and persistent fiscal deficit can be an indication of several worrying signs in the economy. It can mean that the government is spending money on unproductive programmes which do not increase economic productivity. It can mean that the tax collection machinery is not effective so that a significant proportion of people get away without paying their due taxes. In any case, a large fiscal deficit significantly increases the chances of inflation in the economy which is an invisible tax on every citizen.

A high fiscal deficit may lead to inflation and also increase interest rates. High inflation and a large fiscal deficit lead to a weaker national currency (imports become expensive) and reduce the credit-worthiness of the country. This, in turn, will discourage the foreign investments in India. The government may borrow additional money from both internal and external sources to solve the fiscal deficit which in turn puts more pressure on the government as they have to pay more interests on loans. A high fiscal deficit may also stop the government from increasing expenditure in education, healthcare, infrastructure or welfare policies.

Growing figures of fiscal deficit is definitely a challenge to the Indian economy. It’s time that the government takes the bull by the horns to reduce the fiscal deficit. They should bring policies to galvanize foreign investments in India, rethink on the provision of subsidies, widen the tax net etc.

The new RBI governor, Raghuram Rajan stated in his latest speech that "can all be fixed by means of modest reforms." India needs to come up with reforms, and quickly, to address its financial issues, lest they become too big to handle.

Implications

A spiralling, out of control fiscal deficit has an adverse impact on investors. Due to high inflation and the country’s falling credit rating, the stock markets will take a huge hit as FIIs will shy away from investing in India. Thereby, affecting those with a strong equity orientation in their portfolios.

On the debt side, the instruments released by the government will lose their value as yields will be adversely affected due to higher inflation and a burgeoning fiscal deficit.

As investors, we would request you not to panic and stick to your investment plans and remain disciplined financially.

IMF: International Monetary Fund / GDP: Gross Domestic Product / FII: Foreign Institutional Investors / RBI: Reserve Bank of India

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