Indian economy faces fiscal deficit challenge

You must have noted that every time economists sense that Indian economy is or will be in trouble, the phrase “fiscal deficit” often comes up. The latest example to this trend is the news over the Food Security Bill or the slide in rupee against USD and how it will increase fiscal deficit.

So, we thought to decode this jargon for you and give you an insight on what actually fiscal deficit means and why it has such a great significance to India’s economic welfare and what this means for you as an investor.

What is fiscal deficit?

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 gross domestic product (GDP).

Causes of fiscal deficit

Some of the causes of fiscal deficit are as follows:

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. According to Trading Economics 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 Budget

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.

Consequences of high Fiscal Deficit in India

A high fiscal deficit is an indicator that the economy is in trouble. A high fiscal deficit may lead to inflation in the economy and may also increase interest rates. It also degrades the country’s credit rating which 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.

According to government data, India's fiscal deficit during the period of April-July, 2013 was Rs. 3.41 lakh crore and has reached 62.8% of the full-year target set by the government. (Source: NDTV Profit)

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.

What does this mean for Investors?

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

On the debt side too, 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.

All is not gloomy however, as our new RBI governor, Raghuram Rajan states in his latest speech that "can all be fixed by means of modest reforms." (Referring to the record current account deficit and slowing growth).

"This is not to say that ambitious reform is not good, or is not warranted to sustain growth for the next decade. But India does not need to become a manufacturing giant overnight to fix its current problems."

Yes, India does not need to become a manufacturing giant overnight, but India also needs to come up with reforms, and quickly, to address its financial issues, lest they become too big to handle.

As investors, we would request you not to panic (View Subbu's thoughts on investing in volatile markets) and stick to your investment plans and remain disciplined financially.

Data Source: NDTV Profit.

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