Budget 2024-25: An aggressive cut in fiscal deficit

1 Feb 2024 , 05:47 AM

BIG NEWS – LOWER FISCAL DEFICIT FOR FY24

As per the budget estimates put out by the government in the previous year’s budget, the fiscal deficit in FY25 was pegged at 5.9% of GDP. That was already sharply lower than the FY23 fiscal deficit, but the markets were broadly sceptical if the government would be able to meet its target of 5.9% fiscal deficit in FY24. The reasons were not far to seek. Revenue flows were likely to get impacted due to lower nominal growth. The nominal growth is the real growth gross of inflation. That is what determines the tax flows. The other issue was that the government could not compromise on capex and hence fiscal deficit may become the casualty. It was even expected that fiscal deficit would veer towards 6%  for FY24.

In reality, as per the revised estimates (RE), the fiscal deficit for FY24 is likely at 5.8%. Now, that is a good 10 bps lower than the original estimate. How did the government manage this feat despite lower nominal growth. The reason was simple. What the government lost in nominal growth, it has made up in higher tax penetration and broadening the tax base by better use of technology. As a result, the direct tax collections showed record growth over last year and the tax buoyancy came in at 1.4X of the nominal growth. that is sharply better than any of the previous year tax buoyancy numbers. But, there is more to come.

BETTER NEWS – FY25 FISCAL DEFICIT SLASHED TO 5.1%

It is said that audacity can be infectious and that is something we have seen in the last few years. This time around, the government audacity even in fiscal prudence. The general consensus expectation of fiscal deficit for FY25 was ranging between 5.3% and 5.5%. After all, India was targeting a glide path towards 4.5% fiscal deficit for FY26. However, the government has decided to go ahead and front-end the fiscal deficit cut, pencilling in an aggressive fiscal deficit target of 5.1% for FY25. That would mean that the government has the leeway, and even the luxury, of cutting fiscal deficit beyond 4.5% in FY26.

According to the estimates put out by the government, total receipts for FY25 (other than borrowings is pegged at Rs30.80 trillion while the total expenditure at Rs47.66 trillion. That implies a fiscal deficit of less than Rs17 trillion, compared to a fiscal deficit of Rs17.5 trillion in FY24. Buta that is not the actual story. For FY24, the actual receipts are expected to be Rs30.03 trillion against the original budget estimates of Rs27.56 trillion. Despite such buoyancy in tax revenues, the government has held the total receipts FY25 at almost the same level at Rs30.80 trillion. That means, the government has not assumed tax buoyancy and that will be the buffer for the government for next year. In short, unless there is a major crisis for the economy, the fiscal deficit of 5.1% for FY25 looks well and truly achievable.

LOWER FISCAL DEFICIT MEANS LOWER BORROWINGS

How is the fiscal deficit (budget deficit) funded? Obviously, it is funded by a mix of market borrowings and small savings inflows. For FY25, the government has pegged gross borrowings at Rs14.13 trillion while the net borrowings are pegged at Rs11.75 trillion. That is already lower than the level of borrowings in FY24 and that in itself is a positive new for bond yields. In fact, the bond yields fell sharply after the announcement of lower deficit and lower borrowings for the upcoming fiscal FY25. However, the actual borrowings could still be lower, and here is why.

As we stated earlier, the government has not factored in the tax buoyancy and in FY24, the tax buoyancy itself contributed 10% to the overall tax revenues. If that happens, even partially, then the borrowings could be much lower. Also, the government has pencilled in dividends of Rs1.50 trillion for FY25; almost the same level as in FY24. That assumes higher dividends from PSUs banks in FY24 and a robust RBI transfer in FY25. That will not only make up for tepid disinvestments, but also reduce the need for borrowings.

WHAT DOES LOWER FISCAL DEFICIT MEAN FOR INTEREST RATES?

A key factor that determines the bond yields (not necessarily the rate trajectory) is the level of borrowings. Higher the fiscal deficit and higher the borrowings, more the government is likely to crowd out private bond issues. Also, if the government has a higher borrowing target, it puts pressure on the base benchmark yields and pushes up the cost of funds for all categories of borrowers, based on risk perception. A lower fiscal deficit and lower borrowings does away with that risk. That means, in FY25, with a combination of lower inflation, the RBI may finally have the leeway to start cutting rates back to the pre-COVID levels. Of course, that would also depend on what the US does.

Would that also impact equities? Lower fiscal deficit impacts equities positively in three ways. Firstly, lower fiscal deficit generally triggers positive flows on the FDI and the FPI front. That is positive for equity markets. Secondly, lower yields bring down the cost of funds for companies. That largely reduces the solvency risk for many companies that have above average level of borrowings in the balance sheet. Lastly, cost of debt is one of the components in the weighted average cost of capital and lower interest rates means lower rate at which the future cash flows get discounted. Using a basic DCF argument, that would directly translate into higher valuations for equities. That completes the circle of reason! Remember, it all began with the government exercising much better restraint over the fiscal deficit number for FY25 as a share of GDP.