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IDFC AMC

Funding The Fiscal Deficit

By: Punam Sharma

Living it up with borrowed money … ReWISE shows us how India Does it

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IDFC AMC

What is fiscal deficit?
 
Fiscal Deficit

 

  • Fiscal deficit is when government’s total expenditure exceeds its receipts (excluding borrowing).
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  • It indicates government’s borrowing requirement from all sources to finance
    its expenditure.
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  • Fiscal deficit is expressed as a percent of GDP which indicates capacity of a country to borrow in relation to what it produces. High % to GDP means government is borrowing beyond its capacity in relation to what its producing which is its income.
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Fiscal Deficit as % of GDP

 

 

  • Tax revenue (net to center) means tax revenue to government after adjusting for tax
    revenue to states as around 30% of tax revenue is shared with states and 70% is retained by central government.
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  • Other receipts under capital receipts is basically disinvestments. Borrowings which is part
    of capital receipts is excluded while calculating fiscal deficit as it is for funding the deficit.
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What is fiscal deficit?
 

  • Chart below gives snap shot break up of government receipts and % contribution to its
    sub heads.(% contribution as per data given in FY13 Budget Estimates (BE).
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Budget Estimates

 
Government Receipts

 

  • From both the above charts, its seen government draws its receipts primarily through tax
    which is part of revenue receipts.
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  • Revenue receipts are operating revenue which occurs in normal course of business. It’s
    divided into tax and non tax revenue.
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  • Over the years contribution from direct tax has been increasing over indirect tax.
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  • Corporate tax contributes to around 66% of direct tax while excise duty contributes
    around 42% to indirect tax (as per FY13 BE).
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  • Over the years’ service tax contribution towards indirect tax has been increasing from
    around 4% in 2000 to 23% 2013(BE) which depicts contribution of service sector in GDP has been increasing.
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  • Non Tax revenue is interest receipts, dividends or receipts through railways etc.
    Government receives interest or dividends on back of its investments or loans its gives.
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  • Capital receipts do not occur during normal course of business. It’s when government
    sells assets or borrows and is divided into debt and non debt capital receipts.
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  • Non debt is when government sells its assets or stakes or recovers loans which doesn’t
    result into repayment of receipt while debt capital receipt are government borrowing and is mainly incurred to fund the fiscal deficit.
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  • Though disinvestments shows contributing 72% towards capital receipts, to total receipts
    it contributes only around 2%.
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  • Also when government disinvests, it does get one time amount but loses out on regular
    income it receives from the companies it has stake which contributes towards it non tax revenue receipt.
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Government Expenditure
 
Government Expenditure

 

  • India follows a plan based model of economy and therefore expenditure is divided into revenue and capital plan and non plan expenditure.
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  • Plan expenditure is expense on schemes, projects which is budgeted by the government while non plan expenditure is towards maintenance and support activities.
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  • Revenue expenditure is routine government expenditure and does not create any asset for the government.
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  • Revenue expenditure is basically consumption expenditure of government.
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  • Revenue plan expenditure is expense towards various schemes and services provided by government while non plan expense includes interest payments, subsidies, grants to states etc.
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  • Interest payment forms around 37% of revenue non plan expenditure while subsidies (major one includes food, petroleum, and fertilizer) form around 22% of non plan expense.
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  • Capital expenditure creates asset for the government. It doesn’t include operating expense and is taken as expense for investment which will reap benefits in future.
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  • Capital plan expense is basically expense on development related to infrastructure, machinery etc which develops the economy as whole. Non plan part is expense on defense, loans to states etc which will provide income and benefits to government in future.
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  • Fiscal deficit on back of higher capital expenditure is not as bad as it creates assets for the government which will in future increase its receipts. However fiscal deficit on back of revenue expenditure is not good sign as it indicates government is using its receipts and borrowing to finance its consumption rather than investing which in turn hurts
    economic growth and adds to government debt.
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  • Charts below shows breakup of government expenditure on plan and non-plan basis and further plan and non-plan is divided into revenue and capital expenditure on absolute basis.
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Plan & Non Plan Expenditure

  • From above charts, its evident government is incurring higher revenue expense under both plan and non-plan.
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  • This depicts government is spending more on consumption rather than investing.

 

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Interest Rate
 

  • RBI controls inflation by managing interest rate (Repo Rate).
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  • Interest rate impacts cost of borrowing thereby directly impacting credit growth (loans).
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  • When inflation is increasing, RBI raises interest rates which increases cost of borrowing of banks. Higher cost of borrowing of banks is passed on to consumers in form of higher interest on loans thereby
    reducing consumer spending. Reverse takes place when inflation is low.
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  • Chart below shows correlation between Inflation and interest rate.
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Inflation & Repo rate

 

  • From the above chart, it’s evident there is correlation between interest rate and inflation and RBI controls inflation via interest rate.
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  • When inflation had surged to 11.25% in July 2008, RBI raised interest rate to 9%.
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  • Once inflation started declining, Repo rate too was reduced.
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  • With declining inflation (December 2012 at 7.18%), RBI in its last monetary policy reduced repo rate by 25bps to 7.75%.
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Bond Prices and Yields
 

  • Bond prices and yields correlate with inflation in two ways i.e. through interest rates and value of money.
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  • Yields have direct and bond prices have inverse relation to interest rates.
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  • When interest rates are raised by RBI to control high inflation, yields increase as bond
    issuers must pay higher interest to be in line with the increased market interest rate in order to attract investors.
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  • Bond prices and yields move in opposite direction, therefore increase in yields will result
    fall in bond prices as older bonds with lower yields become less attractive.
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  • In case of interest rate cut by RBI on back of low inflation will have reverse impact on bond prices and yields.
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  • High inflation reduces value of money over time. Therefore investors consider real interest rate and not nominal interest rate (not adjusted for inflation) when investing in bonds.
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  • Suppose a bond has a nominal interest rate of 7% and inflation is 4%, then real interest
    rate is 3%.Therefore bond investors feel that the current yield paid will not be worth same value in the future and demand higher yield to compensate inflation risk. Increase in yield will result in bond prices to fall.
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  • Chart below shows yield tends to rise with increase in inflation and vice versa.
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Inflation & Yield

 
GDP
 

  • GDP and inflation are correlated.
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  • When an economy faces increasing inflation trend, interest rates are raised. This makes
    borrowing expensive thereby reducing investments in economy by corporate and individuals.
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  • Fall in investments reduces overall productivity which slows down the economy.
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  • At the same time, consumption is increasing which puts added pressure on economy.
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  • This again can cause increase in inflation as demand is increasing and production is not.
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  • Chart below shows Consumption (Private and Government) and Investment as % of GDP and inflation.
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Consumption & Investment

 

  • It’s observed from above high inflation decreases investments.
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  • Over the years investment as % of GDP has declined while consumption has increased
    which also adds to inflation.
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  • Asper the advance estimates released by CSO, FY13 growth for consumption is
    4%YoY while investments growth at 2.5%.
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Rural Consumption or Urban Consumption?
 
Rural Vs Urban Inflation

 

  • We can see rural inflation has been increasing compared to urban inflation.
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  • It shows rural consumption has been increasing as there is increase in disposable
    income on back of increase in minimum support prices, wage increase and various government policies supporting rural economy.
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  • Major contributor to increase in rural inflation is increase in food inflation specially protein content food items.
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  • However with increase in rural demand, agricultural productivity has not increased which adds to overall inflation.
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  • Agriculture sector grew by 3.8% in FY12 and FY13 to register growth of 1.8% (Advance
    estimates released by CSO).
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Currency Exchange Rate
 

  • Relationship between currency rate and inflation can be explained through purchasing power parity.
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  • Purchasing power theory is economic theory that cost of goods in one country should
    be equivalent to cost of goods in another country.
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  • Inflation reduces purchasing power of a country which means it will earn less as its
    goods become expensive to other countries.
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  • To make prices equivalent the country will have to adjust its currency leading to
    currency depreciation. Suppose annual India inflation is 8% and US inflation 3%, India will have to depreciate its currency by 5% to maintain purchasing power parity.
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  • Chart below shows currency rate change (YoY) and inflation.
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Currency Rate change

 

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Inflation Indices

By: Punam Sharma

Measure of Inflation in India
 

  • Main measures of inflation are WPI and CPI.
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  • India uses WPI as a measure of inflation as against most countries using CPI as measure of inflation.
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  • India prefers WPI over CPI as WPI measures price change at early stage of distribution system.
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  • WPI has broader coverage in terms of number of commodities. India didn’t have a single CPI index to rely on.
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  • However with launch of new CPI index, RBI has started monitoring CPI inflation in its Monetary Policy.
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Wholesale Price Index (WPI)
 

  • WPI measures change in commodity prices at wholesale level i.e. price paid by
    wholesalers or producers.
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  • Headline WPI inflation includes all commodities while Core WPI Inflation
    excludes volatile items food and fuel.
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  • Headline and core WPI inflation for December 2012 is 7.18% and 4.20%
    respectively.
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  • Chart below shows broad break up of components comprising the index
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  • From the chart above, its seen major driver for inflation has generally been primary
    articles particularly food articles and fuel & power.
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Consumer Price Index (CPI)
 

  • CPI measures change in prices of goods and services at consumer level.
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  • India earlier had four CPI namely CPI-Industrial workers, CPI-Rural Labourer, CPIAgricultural Labourer and CPI-Urban Non-Manual Employees.
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  • However CPI-Urban Non-Manual Employees has been discontinued and a new index was launched.
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  • New CPI index (base 2010) was launched in January 2011 which measures changes in prices of goods and services consumed by rural and urban population.
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  • Chart below shows broad breakup of the index.
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Breakup of Index

 
% of CPI

 
Gap between WPI and CPI Inflation
 

  • Chart below shows gap between WPI and CPI inflation in the last calendar year.
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Gap between WPI & CPI inflation

 

  • From chart above, it’s seen there is around 2-3% difference in WPI and CPI inflation.
    There is variation between WPI and CPI inflation with CPI being higher.
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  • This is primarily due to differences in base year, commodity compositions and weights.
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  • Base year for WPI is 2004-05 while CPI is 2010.
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  • Food which has been major contributor to inflation has higher weight in CPI than WPI.
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  • Most important difference is CPI captures price changes in service sector (contributing 60% of GDP) which is not included in WPI.
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Base Effect
 

  • Inflation rate is calculated as percentage change in current month against corresponding previous month (which is also known as a base).
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  • Base effect reflects the impact of a high or low base on inflation.
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  • High base will show low growth depicting decline in inflation even though the index has risen in absolute term.
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  • Similarly low base will show high inflation even with a small rise in index.
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  • Chart below shows WPI value over the years.
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Base Effect

 

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