Budget 2015: Fiscal consolidation is the most important reform that markets are waiting for

A budget focused on fiscal consolidation will propel the Sensex and Nifty higher, bring down yields on the benchmark ten-year government bond and strengthen the rupee. Fiscal consolidation will drive in FII flows and rein in inflation expectations, allowing the Reserve Bank of India (RBI) to ease monetary policy. Finance minister Arun Jaitley will present the Union Budget for 2015-16 in Parliament on 28 February 2015. Investors speculate on budget numbers and policies that could be positive or negative for the markets in the short term. Taking out the market noise, the budget influences one key constant, which affects the economy and the markets, the most – the fiscal deficit. Put simply, it is the difference between the total revenue and total expenditure of the central government. [caption id=“attachment_2111607” align=“alignleft” width=“380”]  AFP[/caption] Fiscal deficit is a constant as the government consistently spends more than it earns. The deficit may vary in absolute and relative terms (as percentage of GDP), but it is a deficit all the same. Given that the government funds close to 90% of its deficit through issuance of government bonds (market borrowings), the deficit impacts government bond yields, which in turn impacts interest rates in the economy. Interest rates affect both income on savings for households and cost of borrowing for households and corporates. The government has been profligate over the last seven years. Fiscal deficit in absolute terms has gone up 300 percent since 2007-08 and this has led to the government’s stock of outstanding bonds rising by 250 percent over the period. The sharp rise in the stock of outstanding bonds has led to interest costs rising for the government. Of the total government expenditure, 24 percent is now interest costs. Interest costs will only rise every year as the government adds to its debt given its fiscal deficit. The government has to do two things to bring down interest cost on its debt. The first is to keep down inflation expectations, which, in turn, will lower its borrowing cost. The second is to allocate more resources for creation of capital assets, which, in turn, will improve output in the economy, increase supply and also create primary, secondary and tertiary demand. However, for the government to spend more on value creating assets, it has to raise revenues and reallocate scarce resources from non-productive expenditure such as subsidies to productive expenditure. The government has the ability to both bring down inflation expectations and spend more on value creating assets by following the fiscal consolidation path of containing fiscal deficit to 3 percent of GDP in 2016-17 from current levels of 4.1 percent of GDP. Focus on improving the tax-to-GDP ratio from current 10.6 percent levels, lowering the subsidy bill from over 2 percent of GDP and spending on creation of assets will help the government on its fiscal consolidation path.