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The village road that connects the Union Budget to the stock market

The Indian stock markets reacted positively to Union Budget 2021 – the Sensex soared 5% on Budget Day, and 10% within a week. Why does the Budget have such an impact on the stock market?

The Union Budget is an annual event where the government presents an account of its revenues and expenditure:

• Revenues: The government earns its revenues in taxes, dividends, profits from companies it owns, proceeds from selling its stake in those companies and so on

• Expenses: The government spends money on running the country – salaries of government employees, defence expenditure, infrastructure (roads, bridges, power plants), welfare services and so on

Why government spending is important – The Multiplier Effect

Imagine the government decides to build a road in a village. To build the road, the government employs local labour. The villagers now have a new source of income. They spend their income to buy goods and services from the village shopkeeper. The shopkeeper then spends on expanding his store or buying items like a television set or a refrigerator.

The government also buys construction material like cement and asphalt from a local supplier. He sources it from a factory nearby. The factory must now employ more people to meet the growing demand, again leading to more money for the local people.

The government’s decision to build a road has stimulated considerable growth and increased consumer demand. This also increases the government’s earnings as it collects tax on every transaction – whether it’s a villager buying a bar of soap or the shopkeeper buying a refrigerator.

Fiscal deficit – What happens when income is not enough to cover expenses

Most of us face this problem every month:

Expenses > Income

The government is no exception. The situation where a government’s expenses are more than its earnings is called a fiscal deficit.

A large fiscal deficit is not good for the economy because it reduces a government’s ability to spend.

The government has many options to reduce this deficit:

• Increase taxes
• Borrow from the market
• Sell (or disinvest) its stake in public sector companies (PSUs)
• Reduce expenditure
• Print more money

Each of these methods has its advantages and disadvantages. Increasing taxes will leave less money in the hands of consumers, thus hurting demand; printing more money can push up prices. So the government, just like all of us, has to take a measured approach to managing the deficit.

2021: A pandemic and a balancing act for the government

For the Union Budget 2021, the government faced a particularly difficult balancing act. The economy had slowed down due to the lockdown and the fiscal deficit had increased. It was obvious that the government would have to spend more to kickstart growth.

That is exactly what the Finance Minister announced in Budget 2021. The government’s expenditure will rise by 28% – much of it going towards building infrastructure (roads, rail networks and power projects).

This push is great for stock markets because it will stimulate growth. But equally important was how the government planned to raise the money needed.

A corona cess (or tax) was widely expected, to fund government spending and bridge the gap. When the Finance Minister left taxes unchanged, the markets were happy.

A rising fiscal deficit, no new taxes, and increased spending? Where is the money going to come from?

How the government is raising money to spend

The Finance Minister chose what many market watchers consider the best options: disinvestment and borrowings.

• Disinvestment: The government plans to raise Rs 1.75 lakh crores in 2021-22 by selling part of its stake in several PSUs like Air India and the Life Insurance Corporation of India (LIC).

• Borrowings: In the current financial year, the government is estimated to borrow Rs 12.8 lakh crores. In the next year (FY 2021-22), the government plans to raise a further Rs 12 lakh crores.

So, the government plans to borrow a lot of money and the stock market is happy because…?

The expectation is that the borrowed money will fund the government’s aggressive spending on infrastructure, which should drive growth. The economic growth will translate into higher tax collections and enable the government to repay its loans and lower the fiscal deficit.

Here’s the equation that is making the stock market happy

Government borrows money > Spends on infrastructure > Boosts economic growth > Gets higher tax collections > Uses the money to repay loans > Reduces fiscal deficit

All this connects the village road to the Union Budget and to the stock market!