Fiscal Deficit – The question for the government is; how much is too much?

fiscal Fiscal Deficit   The question for the government is; how much is too much?

In its Feb-21 budget, the government did make a number of brave statements on the fiscal deficit front. It has pegged fiscal deficit at 9.5% for FY21 and at 6.8% for FY22. It is OK to argue that FY21 is a unique case, but the question is how much fiscal deficit is too much?

Well above estimates

The consensus estimate for fiscal deficit for FY21 and FY22 were in the region of 7% and 4.5% ahead of the budget. The actual number announced is nearly 250 bps above these estimates. For growing economies like India, too much fiscal deficit is never a good idea. Economies like the US and Japan with high levels of per capita income can continue to run huge fiscal deficits for a longer period of time. India, however, does not have that kind of luxury available.

Fiscal deficit has a cost

Apart from the issue of solvency and ratings, which we will touch upon later, there is a more immediate concern on the interest payout front. If you look at FY21 over FY20, there has been a huge surge in interest payouts on loans. The total borrowing for the Indian economy between FY21 and FY22 will be close to Rs.25 trillion or about $330 billion. That is the additional debt that has to be serviced on a regular basis. The FRBM did manage to bring India’s interest outgo under control. Too much laxity can push the economy back in the rut.

Bond yield risk is for real

In the last few months, the fiscal deficit spike was already well known. However, the bonds yields continued to remain under 6% on the benchmark debt. But, that can be quite deceptive as the bond markets are flush with liquidity at this time and that is keeping the yields on bonds low. The normal effect of sharply higher fiscal deficit is that it crowds out private borrowers and forces the RBI also to borrow at higher yields on behalf of the government. This pushes up the yields in the market and has a negative impact on bond prices. This could have larger repercussions for banks and debt funds that are holding on to bonds in their debt portfolios.

Don’t forget rating angle

While rating agencies have warned India about the risks of higher fiscal deficit, they are likely to gloss it over for now due to the global stress. However, if in the next few quarters, Chinese growth picks and Indian growth does not pick up, then the rating agencies are likely to ask some serious probing questions. India has currently pegged a target of 4.5% fiscal deficit by 2026, but that may be sailing too close to the wind. Ideally, the budget has prepared the financial markets for higher levels of fiscal deficit, but the real smart move would be to consistently better these targets in the next few years. Laxity in fiscal prudence is never a good idea!

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