AI Insights

Does Fiscal Deficit influence Asset Classes?

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This post has been authored by Aniket Raj, the Economic Research Intern at Arthashastra Intelligence.

A fiscal deficit is a shortfall in government income compared to its spending. During the pandemic, our fiscal deficit shot up drastically, which can be seen in our graph as well. This sparked a debate about whether India should focus on growth or on keeping our fiscal deficit under control. The significant hike during the pandemic period was supported by the friendlier monetary policy.

Source: RBI; Compilation and Visualization By Arthashastra Intelligence.

The government also deferred the FRBM act, which says to keep the fiscal deficit at 3.5%.  If we look at the graph carefully we will find that we were not able to reach this target but we\’re close to achieving it. This was derailed by the pandemic and we see a significant hike of 9.2%. In this article, we will analyze the impact of a high fiscal deficit on our asset class and will also try to look at whether a fiscal deficit always has a bad influence. We will look at 3 asset classes in particular – equity, debt, and currency.

Impact on equity- Discounted cash flow model is a method through which we estimate the value of an investment based on its expected future cash flows. This model suggests that the current price is a function of expected cash flow, and if we have a high fiscal deficit, it will increase the interest rate,  which is visible today. This, in turn, will cause a reduction in real cash flow expectations. The other tool which the government uses to control fiscal deficit is to increase future tax rates, which will again impact the overall demand.

But this is rather theoretical. The impact on equity also depends on the reasons for the high fiscal deficit. If it is due to higher capital expenditure, it adds to overall demand and corporate earnings. But if it is because of higher subsidies, which is the case with India, it will hurt the equity market.

Impact on Debt- Theoretically, a high fiscal deficit hurts bond prices because the government issues more bonds, and there is a supply-demand mismatch which results in lowering the prices. Again this is uncertain. If the central bank absorbs the excess supply, there are chances that bond prices may not fall, which our central bank was doing. Along with this, it also depends on the movement of global asset classes. Suppose the fiscal deficit of a country is increasing in isolation. In that case, it isn’t good for its asset class as it will be downgraded by the rating agency, reducing foreign inflows. Still, the recent hike in fiscal deficit, as shown in the graph, was not in isolation but instead a result of the pandemic. This could be one of the reasons why our bond yield didn’t fall much despite a 50bps rate hike. Our 10-year bond yield is 7.43, which is still higher than the benchmark of 6.54.

Impact on currency- Higher fiscal deficit impacts currency negatively, which can be felt by citizens. Today our currency is at a record low of 79.05. A higher fiscal deficit also injects more money into the domestic market, increasing liquidity and devaluing currency further. Also, a higher fiscal deficit leads to a downgrading of credit rating and brings down foreign inflows.

This shows that the impact of fiscal deficit on asset class is not influenced by a single factor and there are multiple factors at play. We cannot rule out the threat that a sustained fiscal deficit creates to the economy. If we look at the graph, the revised estimate shows that we are on a path of fiscal consolidation. Still, we are far from our target and need to monitor our fiscal deficit carefully. Also, with the world moving away from a low-interest rate regime, it becomes more important to look after our fiscal deficit. We need to keep a watch on what is driving our fiscal deficit. If it’s a more productive expenditure, then we are on the safer side. But if it is driven by our subsidy and other non-productive expenditures, it will pose more problems to macroeconomic stability and affect growth.

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