Fiscal deficit: Go easy or pull back? What markets are likely to reward

Rate Markets: The rate market is generally wary of excess government spending as it generally leads to higher market borrowings. Higher government spending, especially if it is consumption-related, may lead to higher inflation in the short term. Further, prolonged periods of loose fiscal policy may entrench inflation and lead to tighter monetary policy.

Currency Markets: The currency might depreciate if the policy leads to concerns about inflation or long-term fiscal sustainability.

Pulling Back on Fiscal Deficit:

Market Reaction: Financial markets might view a decision to pull back on fiscal deficit as a sign of fiscal discipline and responsibility. This can lead to confidence in the government’s ability to manage debt and economic stability.

Equity Markets: In the short term, the stock market may respond negatively as lower fiscal policy leads to lower consumption and investments, hence impacting company profitability. However, fiscal discipline over the longer term may attract long-term capital as investors favor a stable economic environment. This may lead to better performance in equities over the long term.

Rate Markets: Bond markets tend to react positively to fiscal prudence, as it reduces the risk of default and inflation. Fiscal prudence may reduce overall government market borrowing, which may be favorable for rate markets from a supply-side perspective. Reduction in fiscal deficit over longer periods can lead to lower interest rates, which are likely to benefit long-term economic prosperity.

Currency Markets: A stronger fiscal position could support the currency, as it signals stability and attractiveness for foreign investors and will likely favor long-term capital asset allocators.

Factors Influencing Market Response:

Economic Conditions: In times of economic downturn or recession, markets may favor a more lenient approach to fiscal deficits to stimulate growth as a short-term measure to shore up consumption expenditure and support the economy. Markets welcome government dynamically managing fiscal policy to manage downturns as a sign that fiscal policy is driven by economic factors rather than politics. If fiscal profligacy is due to political reasons, market sentiment may turn negative.

Inflation Expectations: Consistently high deficits can lead to inflationary pressures, which might worry markets and lead to negative reactions. Over the longer term, higher inflation can lead to economic instability.

Investor Confidence: Market sentiment plays a crucial role; if investors perceive that a government’s fiscal policy is sustainable and growth-oriented, i.e., investment-related fiscal push, they are likely to react positively. If the deficit is used for consumption-related expenditures, it is likely to be perceived negatively by investors.

The Union Budget 2024-25 continues to follow fiscal consolidation efforts, budgeting a fiscal deficit at 4.9% of GDP for FY2025. The aim is to reach 4.5% of GDP by FY2026. This should create positive sentiment for investors as fiscal consolidation, in the wake of strong economic growth, is likely to temper inflationary pressures and be conducive to long-term sustainable growth, as the Indian economy endeavors to become a developed economy. Markets are likely to reward such an outcome.

In conclusion, both approaches to fiscal deficit management can potentially be rewarded by markets depending on the prevailing economic conditions and the perceived impact on economic growth, inflation, and overall stability. Flexibility and alignment with broader economic goals are key to gauging market reactions accurately.