The budget and the markets: The pain is already in the price

The budget and the markets: The pain is already in the price

The reaction of the markets to the budget depends entirely on whether it measures up to expectations. To be sure, there are a whole lot of items whose excise or customs duties will be tinkered with, and that will affect individual stocks. But, for the market as a whole, the big concerns are overall changes in taxation and the fiscal deficit.

But there are times when the fiscal deficit matters a lot for the markets. One of them was in 2009-10, when a larger deficit helped prop up growth at a time of crisis. It also matters now, when the fiscal deficit threatens to crowd out private sector investments.

The logic is simple—if the government borrows too much, it raises interest rates and this leads to a reassessment of the investment plans of the private sector. This hurts growth, leading to lower growth in corporate earnings, which in turn affects the markets.

Consider what happened to the fiscal deficit in the current fiscal year. In spite of receiving a windfall from the sale of spectrum, all that happened was that the government trimmed its borrowing programme only slightly. So a huge amount of money went out of the system in addition to the budgeted government borrowing, leading to the liquidity crunch we’re seeing today.

Everyone has pointed to the fact that government spending has been tardy, and that is the reason for the lack of liquidity. While that is true, the crux of the matter is that the government should have scaled back its borrowing programme once it received the funds from the spectrum auction. Instead, it chose to ramp up spending plans, thus leading to a jump in bank deposit and lending rates.

Currently, State Bank of India term deposit interest rates range from 8.25% to 8.5% for the three-five year period. Many banks pay interest rates of 9%. According to Reserve Bank of India (RBI) data, interest rates on deposits of three-to-five years maturity ranged from 7.5% to 9% in 2007-08.

The point is that interest rates are already at levels seen at the very top of the business cycle. Under these circumstances, the government must curtail its fiscal deficit if it is not to crowd out private investment.

One reason why the boom of 2003-07 lasted so long was because the government pruned its fiscal deficit drastically during that time. The deficit fell from 5.91% of gross domestic product (GDP) in 2002-03 to 2.56% of GDP in 2007-08. Lower government borrowing led to less upward pressure on interest rates, allowing strong growth in the private sector. The reason why interest rates are high currently although growth is not so strong is simply because of the high fiscal deficit.

The government’s fiscal problem will become even worse in the financial year that begins 1 April. It will no longer have the benefit of the windfall gains from the sale of spectrum. Growth will not be as strong as in the current year. Nor is it at all certain whether it will be able to go in for a large disinvestment programme.

But the government has indicated that it will, in terms of its road map, have a fiscal deficit of 4.8% of GDP next fiscal. Very probably, it will go in for some sleight of hand and provide lower amounts as subsidies, just as it did in the last budget.

That brings me to the other reason why the fiscal deficit is so important for the markets now. Although global growth is still not as strong as it was during 2006 and 2007, commodity prices have recovered very quickly from the crisis. The International Monetary Fund forecasts that crude oil prices will rise 13.4% this year, after a gain of 27.8% in 2010. Non-fuel commodity prices are expected to increase by 11% this year, on top of a 23% rise in 2010.

India is heavily dependent on oil imports, and any rise in oil prices hits it hard. Oil subsidies are likely to increase. Higher fiscal deficits also lead to inflation, when the output gap is low or non-existent, as it is at present. And the markets, as we are seeing, are spooked by the persistence of high inflation.

For all these reasons, a credible pruning of the fiscal deficit will be very important from the markets’ point of view. As RBI’s third-quarter review of monetary policy put it, “The real measure of fiscal consolidation lies in improving the quality of expenditure. If the government is able to commit more resources to capital expenditure, it will help deal with some of the bottlenecks that contribute to supply-side inflationary pressures."

There’s one final point. One of the reasons being given for the current sell-off is that the Indian market doesn’t deserve a premium, simply because the hopes of reform from the second tenure of the United Progressive Alliance government at the Centre have been dashed. If the government uses the budget to make some of the long-awaited announcements on reform, it might help, although even that, given the track record, may be greeted with a healthy dose of scepticism.

The good news is that the markets are very weak and little is expected from the budget. The pain is already in the price.