Classroom: Why is Fiscal Deficit important for SMEs

Along with important announcements for small and medium enterprises (SMEs), the annual budget also provides numbers on the Indian economy that can impact SMEs. Kicking off our Budget Primer is a look at fiscal deficit, which can impact investments and costs for the SME sector.  
 
What is fiscal deficit?
Every year, the government spends money on a number of heads like social sector schemes, infrastructure, defence and interest payments. Similarly, it earns income mainly through revenue in the form of tax collections and also interest on its investments, dividends and profits from its stake in public sector companies, among other things. Typically, government expenditure exceeds its income, and the difference between the two is called the ‘fiscal deficit’.
The finance minister’s budget speech always mentions the fiscal deficit in the context of the Gross Domestic Product (GDP) target, where GDP is a measure of the size of the whole economy. The fiscal deficit is expressed as a percentage of GDP. In the 2012-13 budget, the fiscal deficit was 5.1 per cent of GDP for the next financial year. 
 
Why is the fiscal deficit important?
While a small fiscal deficit-to-GDP ratio is manageable, it has risen sharply over the last five years. Thus, whereas it is currently around 5 per cent, it was consistently lower than 4 per cent during April 2003 and March 2008. This is because, when the global recession hit, the Indian economy slowed down and also because the government introduced an expenditure stimulus. It thus began to spend more than usual.
 
To deal with a high fiscal deficit, the government can raise taxes, reduce expenditure and/or borrow money. While the first two means are not advisable in times of slow economic growth, such as now, borrowing money is the most suitable option. Much like an individual or a company, the government can also raise funds for its excess expenditure by taking loans. The only difference is that while individuals and companies borrow from banks, the government can borrow from financial institutions, non-finance companies and even the public of India.
 
How does a high fiscal deficit impact SMEs?
For SMEs, this could mean deferring investment plans, which in turn means that revenues that could be realised earlier will have to be postponed.
 
Moreover, a high fiscal deficit can also shake the confidence of foreign investors, who lend money to SMEs. Earlier this year, S&P, the global ratings agency, had said it was looking at a possible reduction in India’s credit rating from investment grade. One reason was that India’s fiscal deficit was worsening. A ratings downgrade can impact foreign investors’ decisions to enter or provide more funding to the country.
 
SMEs might also have to deal with higher costs if the fiscal deficit is high. This would happen if the deficit is allocating money to consumers without any real productive work taking place. Alternatively, if the government cannot repay its debt, it can ask the central bank to print more currency, which can also be inflationary.
 
Orbis Economics