All of us would have listened to the recent appeal made by the Indian Prime Minister to cut spending on gold and travelling both domestically and internationally amid the ongoing war between Iran and the US. This appeal was made because India imports most of the gold and crude oil for consumption and this will affect the finances of the Indian government and it will increase the deficit. But what is a deficit? Is there only one type of deficit or different kinds of deficits? Let us understand about deficits and know how it affects the overall economy and market sentiments. 

What is fiscal deficit? 

Fiscal deficit is a metric that measures the difference between a government’s revenue and its expense in a given financial year. When the government spends more than it receives as revenue in a financial year then fiscal deficit occurs. This deficit or shortfall must be managed by selling government securities to big financial institutions and market participants.

The formula to calculate fiscal deficit is as follows: 

Fiscal deficit = Total expenditure – Total revenue 

This total revenue is the revenue collected in the form of taxes, fees, dividends from state-owned enterprises and proceeds from disinvestments (example sale of Air India to Tata Group).

Total expenditure is the expense incurred by the government on public services, infrastructure development, defense spending in terms of procurement, salaries and pensions to government employees, healthcare and welfare programs.

Let us assume a country has a budget Rs 5 lakh crore for infrastructure, healthcare, defense, subsidies, etc. Through direct taxes, indirect taxes, dividends from state-owned enterprises, etc., it collects only Rs 4.2 lakh crore then the Rs 80,000 crore is the shortfall in the financial year and that is the fiscal deficit. This deficit must be funded by selling government securities to financial institutions (both domestic and international) and other market participants. 

If the fiscal deficit is high for a very long time, it will weigh on the government to spend on developmental activities. It will push up the long-term interest rates and increase sovereign debt burden. Rising fiscal deficit often indicated a shift in bond yield and potential changes in government policies including taxes. Rising fiscal deficits often signal a shift in bond yields, potential tax policy changes, and sector-specific opportunities for investors. 

Trade deficit explained

Trade deficit pertains to goods and services and trade deficit occurs when the import bill of  a country is higher than the export bill during a given quarter or year. The formula to calculate trade deficit is as follows:

Trade deficit = Total value of imports – Total value of exports

A trade deficit is not bad inherently as it could indicate strong domestic consumer demand and higher purchasing power. A reliance on imported raw materials for export-oriented manufacturing or even a strong currency that makes imports cheaper. 

On the flip side, if the trade deficit is due to uncompetitive domestic industries or overconsumption without any investments for improving productivity, it can weigh on the domestic currency, lead to higher foreign debt and also higher unemployment rate, if the country’s economy keeps weakening. 

Understanding current account deficit (CAD)

The current account deficit (CAD) metric is a comprehensive way to measure a country’s international transactions. It includes:

• Trade in manufacturing and physical goods 
• Trade in services (IT, tourism, consulting, shipping)
• Primary income (dividends, interest payments, repatriated profits)
• Remittance and transfers (remittances by expats/NRIs, foreign aid, grants)

A current account deficit will happen when a country’s total outflows of foreign currency for imported goods, services, interest payments, etc. exceed its total inflows from exports, investments, remittances ( money sent back by citizens working overseas), etc. In other words, the country is spending more money abroad than it’s bringing in.

Using the CAD numbers you will know whether a country is a net borrower or a lender to the rest of the world. If the CAD keeps widening then the country is depending heavily on foreign capital inflows like FDI, portfolio investment, external commercial borrowings to bridge the deficit. If those inflows dry up during any global economic downturn or recession, the domestic currency of that country can fall, forcing sharp interest rate hikes and economic contraction.

How are the three deficits are linked 

When a government is running a large fiscal deficit and it injects stimulus into the economy, household and corporate incomes rise. This will lead to extra spending and higher consumption that includes higher importing of goods like electronic items, crude oil, luxury items, etc. resulting in widening the trade deficit. 

If exports, foreign investments and remittances do not offset that trade deficit, the CAD will increase. To finance the current account deficit, the country will have to attract foreign capital, but if global interest rates increase or investors feel it is risky to invest in a particular country then that foreign capital will flee the country. 

It will lead to currency depreciation, increased imported inflation and the country’s central bank (RBI in the case of India) will have to increase interest rates, slowing down growth and the government may be forced to take drastic measures with respect to fiscal consolidation.

For instance, India’s CAD breached 4.8% of GDP amid heavy gold and oil imports and weak export growth during the financial year 2012-13. When the Fed hinted at tapering Quantitative Easing, foreign investors pulled out and the Indian rupee plummeted. These events forced the Indian central bank, RBI, to step in and it was forced to implement emergency interest rate hikes and the government imposed restrictions on gold imports. Therefore, investors must understand how these deficits will impact currencies, commodities like gold, oil, domestic economy, foreign inflows and outflows and also the stock market. 

How will the deficits affect various financial assets

Bonds & Fixed Income: Rising fiscal deficits typically push bond yields higher and flatten the yield curve. Shorten duration or favor floating-rate instruments when borrowing accelerates.

Equities/Stocks: CAD pressure favors export-oriented companies, IT services and domestic substitution plays. Fiscal expansion benefits infrastructure, defense and public-sector undertakings. Plan to invest in different sectors by following sector rotation accordingly.

Currency & Forex: If you are dealing with currencies as a currency trader or an importer or exporter, you must monitor CAD and how much is CAD as percentage of the country’s GDP. If the CAD to GDP ratio is higher with respect to the reserves of the country, then it indicates currency depreciation risk. To protect yourself, you must use forward contracts or currency-hedged funds for forex exposures.

Real Assets & Gold: If a country faces inflation due to deficits and currency depreciation, it will give a fillip to gold, real estate sector and commodities. You must allocate strategically when twin deficits (fiscal deficit + CAD) coincide with loose monetary policy.

Conclusion

Fiscal deficit, trade deficit and current account deficit (CAD) are three different indicators of a country’s economic health and how strong is their currency against other currencies like the US dollar, euro, pound sterling, etc. 

These signals indicate if the consumers are overspending domestically, how competitive they are in the international economy and how much the country is dependent on big foreign financial institutions for external funding. 

Not knowing what they mean, how they interconnect and what to watch out for puts your investments at the mercy of news headlines. Poor asset allocation, poorly timed exits, and unhedged currency exposures end up eroding your investment value.