Twin deficits cloud growth prospects

The country is facing a problem of twin deficits. It is having had to tackle simultaneously a growing current account deficit and a fiscal deficit. These two problems are critical in themselves, but when they occur together, there is a chance that they may reinforce each other and, thus, cause the economy to spiral into a crisis. If that happens, then say goodbye to any post-pandemic growth recovery prospects.

The current account deficit measures the extent to which the country is overspending in its economic transactions with the rest of the world. The total value of goods and services that it is importing is exceeding that of the total value of what it is exporting. This results in a net dollar outgo, which has to come from the country’s foreign exchange reserves.

A persistent and growing current account deficit, reflected in the falling foreign exchange reserves, is a signal to the markets that the domestic currency, the rupee, is likely headed downwards. There is an excess demand for dollars from importers than the supply of dollars from exporters which the country’s central bank — the keeper of the reserves — tries to stem by making the dollar costlier that is devaluing the rupee.

This is what is happening right now with the rupee having breached the

Rs 78-mark against the US dollar. Seeing this, businesses will try to speculate against the rupee. Exporters will try to delay bringing in their hard currency earnings in the expectation that over time they will get more rupees per dollar because of the gradual devaluation and importers will find deferred payment arrangements less attractive.

At its extreme, this leads to a run on the currency, rendering it nearly valueless, with reserves dwindling to near zero and the country unable to pay for the most essential imports, as is happening in Sri Lanka, and to a lesser extent, in Pakistan (reserves below $10 billion). India has for a time prided itself on its reserves exceeding $600 billion. But recently, this landmark has been breached and the reserves have gone down to $591 billion.

The fiscal deficit measures the extent to which the government (Centre and the states) overspends — earnings exceeding expenditure. For this purpose, earnings include the government’s revenue earnings plus net borrowing, i.e., what is left over from fresh borrowings after meeting repayment obligations on past borrowings.

Expenditure is incurred on the revenue account which covers what the government spends to keep itself going (like paying salaries) and interest on past borrowing. Plus, what is perhaps most important, it includes what is spent on the capital account, that is to create assets like roads and railways and also plants and machinery of departmental undertakings.

The fiscal deficit influences the amount of liquidity in the system consisting of cash and cash equivalents. If it is high, we have a situation of too much money chasing too few goods and we get a high level of inflation. The fiscal deficit is expressed as a percentage of GDP or the size of the economy. If the economy keeps growing fast, then it needs more and more liquidity and can bear a higher level of nominal fiscal deficit.

To find money to pay for the fiscal deficit, the government has to borrow. When it does this through the market, it tends to crowd out private borrowing, that is mostly business borrowers who are thereby left to cut down on their capital expenditure budgets because a large government borrowing programme has sent interest rates upwards.

The other way for the government to borrow is straight from the central bank by issuing what amounts to IoUs and which results in the system effectively printing money. All this leads to excess money chasing a given supply of goods — a recipe for high inflation.

When the rupee devalues in response to a burgeoning current account deficit, it makes imports costlier and if they are essential imports like food (edible oil), fertilisers and fuel (petrol, diesel, LPG) whose consumption cannot be curtailed over much, then the consumer’s pocket begins to pinch. He cuts down on savings and this, in the aggregate, results in less resources being available for investment in modern plants and equipment incorporating new technology.

If simultaneously the government has over-borrowed to meet its expenditure requirements and there is a high level of fiscal deficit, the net upshot is low investment across the board and high input costs which tend to make the economy globally uncompetitive. This reduces the export potential of the economy and adds to the current account deficit. Thus, the twin villains of the piece are lax government control on spending and high international commodity prices, all leading to high inflation and loss of global competitiveness.

The Union Finance Ministry recently publicly warned that a twin deficit problem is emerging. This is partially due to essential imports becoming costlier as a result of the Ukraine war and the country’s rising subsidy bill. The war and rise in international fuel prices, in particular, have forced the government to reduce taxes on fuels so that they do not become unaffordable. This has reduced revenue intake and pushed up the fiscal deficit. As the rupee is simultaneously depreciating, there is now the risk of a “cycle of wider deficit and weaker currency”.

One solution the government has in mind is relooking at revenue expenditure. Two items in particular engaging its attention are fertiliser subsidy and food subsidy under the PM Garib Kalyan Anna Yojana which has been extended, thus raising the food subsidy bill. All these issues are being examined in order to address the cardinal need to maintain macroeconomic stability, if need be even at the cost of setting aside the pursuit of economic growth in the short term.

Macroeconomic stability goes hand in hand with keeping a tight rein on inflation, which after reaching record highs is now expected to peak. While noting the action being taken by the RBI to make money costlier by taking out the liquidity pumped in during the peak of the Covid-19 infection, the government is clearly aware that ensuring there isn’t too much money going around is half the story. The other half — the really intractable one — is trying to ensure that there is an adequate supply of goods. This is not in Indian hands, but depends on how long the Ukraine war-induced disruptions linger. Till then, it is best to keep our fingers crossed as to whether the economic recovery, which is still on, will last out through the rest of the financial year.