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Budget Deficits, Surpluses & Impacts on Investors

How to Effectively Analyze Government Budgets

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Government budgets are extremely important for traders and investors to consider, because they impact everything from sovereign credit risk to corporate tax codes. With structural deficits persisting in many developed economies around the world, these issues are also growing in importance, particularly in the United States and European Union.

What are Budget Deficits & Surpluses?

Budget deficits - also known as fiscal deficits - occur when a government's spending is higher than its tax revenues. Conversely, budget surpluses - also called fiscal surpluses - occur when a government's tax revenues exceed its spending. Government budgets with revenue and spending levels that cancel each other out are said to have balanced budgets.

Two other terms commonly used when talking about government budgets are primary balances and structural balances. Primary balances exclude interest payments from spending side of the equation, while structural balances adjust for the impact of real gross domestic product (GDP) changes in the national economy, since higher growth rates make debt more manageable.

Keynesian economists believe that government budget deficits are acceptable during economic downturns, as long as the structural government budget runs at a surplus. To put this in perspective, many economists use the so-called fiscal gap measure that compares the difference between spending and revenues as a percentage of gross domestic product.

Using Structural Primary Balances

Perhaps most reliable way to measure government budgets is using structural primary balances, which remove the part of the deficit or surplus attributable to business cycles and consider only program expenditures on the spending side. These factors make the measure a better long-term predictor of budget deficits and budget surpluses, incorporating the most important elements.

The removal of business cycle data ensures that economic booms and recessions are treated appropriately, while program expenditures tend to be the cause of budget imbalances, as opposed to accumulated debt that's largely the result of past decisions. Other minor changes include the inclusion of all levels of government and adjustments for one-off budget operations.

In the end, traders and investors should remember that a government's debt must remain stable as a percentage of GDP in order for it to remain stable. Otherwise, interest payments alone would eventually use up all tax revenue. However, such sustainability doesn't mean governments should stop borrowing altogether, as it could put a strain on the economy.

Impacts for International Investors

Government budgets are extremely important for traders and investors to monitor, from sovereign debt holders to currency traders. Monitoring these levels can be easily accomplished using the World Bank's easily accessible database or using a variety of other websites publishing data from either the World Bank or International Monetary Fund (IMF).

Some common impacts of government budgets include:

  • Sovereign Debt - Budget deficits can lead to lower sovereign debt ratings, if structural balances remain in negative territory for too long, while budget surpluses can lead to lower interest rates on sovereign debt due to an improved credit rating.
  • Tax Code Change - Structural deficits necessitate changes to either revenues or spending, with the former being the easiest to implement. Tax increases aimed at improving these deficits can negatively impact corporations/equities.
  • Currency Valuation - Financial markets can quickly lose faith in countries unable to resolve structural deficits, resulting in potential currency devaluations, while increased confidence in a country can lead to higher currency valuations.

Analyses of these impacts can be easiest found in reports issued by ratings agencies, like Standard & Poor's, Moody's Investors Service and Fitch Group. These bodies commonly issue sovereign debt ratings on various countries around the world, which contain in-depth analysis of budget deficits or budget surpluses and their potential effects on the financial markets.

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