Budget 2012 primer: Tackling the fiscal deficit

(This story is the fourth in a multiple-part series explaining the government’s sources of revenues, expenditure and fiscal deficits. For earlier stories, click here and here and here )

The end result of expenditures being greater than revenues is the fiscal deficit.

The fiscal deficit is financed predominantly by market borrowings (around 85 percent). Market borrowings refers to the issue of marketable government securities, including dated government bonds and treasury bills, to raise money for funding the fiscal deficit.

Bond, equity and currency markets will takes their cue from the total market borrowings of the government, as the quantum of borrowing directly affects interest rates in the economy.

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Watch out for these figures

Headline budget numbers will drive markets on budget day. The following are the primary headline numbers to note as the budget is being read out. Positive numbers will drive up markets and vice versa.

Fiscal deficit: The headline fiscal deficit should be below the expected revised 2011-12 deficit of 5.6 percent of GDP. There have been sound bytes from the finance ministry that the deficit for 2012-13 will be around 5.1 percent of GDP. Markets will take a deficit of close to 5 percent of GDP reasonable well, though any number close to 5.5 percent of GDP will be taken negatively.

Government borrowings: The gross borrowing for 2012-13 is estimated at Rs 5,50,000 crore, and net of bond redemptions of around Rs 90,000 crores, borrowings will be Rs 4,60,000 crore.

[caption id=“attachment_242280” align=“alignleft” width=“380” caption=“The headline fiscal deficit should be below the expected revised 2011-12 deficit of 5.6 percent of GDP. Reuters”]  [/caption]

The key factor to the borrowing will be bank deposit growth. The deposit base is around Rs 58 lakh crore. A 16 percent growth in deposits will translate into a net demand of Rs 2,20,000 crors for government bonds assuming a statutory liquidity ratio of 24 percent.

Banks taking up more than half of the government borrowings will be positive for bond yields as the other half will be taken up by insurance companies, provident funds and trusts, primary dealers, mutual funds and the Reserve Bank of India (if required).

The RBI is expected to cut interest rates in the new financial year starting 1 April. If rates are cut, bullish sentiment will drive up demand for government bonds and yields can fall from current levels of around 8.25 percent on the ten-year benchmark government bond.

Gross borrowings: Gross borrowings significantly above Rs 5,50,000 crore will be negative for the markets as investors will worry about demand for the extra government bonds, and bond yields will move higher, pushing interest rates higher in the economy.

Financing the fiscal deficit

The fiscal deficit for 2011-12 was projected at Rs 4,13,000 crore, which was to be financed by market borrowings via the issue of dated securities estimated at Rs 3,43,000 crore (83 percent of deficit) and the issue of treasury bills estimated at Rs 15,000 crore (3.5 percent of the deficit).

The issue of securities against the NSSF (National Small Savings Fund) was estimated at Rs 24,000 crore (5.9 percent of the deficit).

The external debt of Rs 14,500 crore (3.5 percent of the deficit) and drawdown of cash balances of Rs 20,000 crore (4.8 percent of deficit) were the other two sources of financing.

Implications of overshooting estimates

The government has overshot its fiscal deficit projection of 4.6 percent of GDP for the current financial year by at least one percentage point, leading to higher-than-budgeted market borrowings.

The government borrowed an extra Rs 92,800 crore by issuing dated securities and a further Rs 1,00,000 crore by issuing treasury bills to finance its fiscal deficit.

In other words, a result of the higher fiscal deficit, the issuance of dated securities jumped 22 percent, while treasury bill issuance soared six-fold over budgeted estimates.

The RBI was forced to step in to address rising government borrowings by infusing liquidity into the system through the purchase of government bonds.The central bank has bought Rs 1,25,000 crore of government bonds through OMOs (open market operations) in the current financial year ending March.

That helped absorb the higher borrowings of the government, but a central bank stepping in to finance the fiscal deficit is inflationary in nature. Indeed, the RBI has been consistently warning the government about its fiscal deficit, since it hampers the central bank’s monetary policy operations.

The central bank is forced to keep monetary policy tight on the back of inflationary effects of a higher fiscal deficit and this tight policy is leading to a growth slowdown as firms cut investment spending on the back of high interest rates.

Higher government borrowings also crowds out the private sector, which is seen as more productive, from the loan market. Banks use most of their resources to buy government bonds leaving less money to lend to the private sector. That hikes the borrowing cost for the private sector. Banks have bought Rs 1,67,000 crore of government bonds between April 2011 and February 2012, which is around 35 percent of their total deposits raised in the period.

Beware of nominal GDP

Nominal GDP growth, as opposed to real GDP growth, factors in inflation. All the deficit estimates are based on nominal GDP growth.

Higher inflation helps boost nominal GDP growth leading to lower deficit estimates even if the absolute quantum of deficits is higher than the previous year.

The government has projected a GDP growth of Rs 89.80 lakh crore for the current financial year, 14 percent higher than a year ago. Real GDP growth was pegged at 8.6 percent and inflation (or the GDP deflator) was estimated at 5.4 percent for 2010-11.

Given the higher inflaiton, nominal GDP could actually be higher than estimates even if real GDP is forecast at around 7 percent (revised from 9 percent). Hence, deficit numbers for 2011-12, while higher in absolute terms may not be alarming. This is called “inflating away the fiscal deficit”.

Arjun Parthasarathy is the editor of www.investorsareidiots.com, a web site for investors.