India’s Emerging Twin Deficit Problem

Why in the News?

In its latest ‘Monthly Economic Review’, the Ministry of Finance report highlights two key areas of concern for the Indian economy: the Fiscal Deficit and the Current Account Deficit.

Key Points:

About Fiscal Deficit

• The word ‘fiscal’ refers to annual government account statements and the word deficit stands for ‘shortage’

• Therefore, the fiscal deficit is the term used to define the difference between what a government spends and what it collects as revenue

• The fiscal deficit of a country is calculated as a percentage of its GDP or simply as the total money spent by the government in excess of its income

• In either case, the income figure includes only taxes and other revenues and excludes money borrowed to make up the shortfall

How is the Fiscal Deficit Calculated? 

• The fiscal deficit calculations are based on two components — income and expenditure. 

• Income Component: 

  • The income component is made of two variables, revenue generated from taxes levied by the Centre and the income generated from non-tax variables

  • The taxable income consists of the amount generated from corporation tax, income tax, Customs duties, excise duties, GST etc

  • Meanwhile, the non-taxable income comes from external grants, interest receipts, dividends and profits, receipts from Union Territories, among others

• Expenditure Component: 

  •  It comprises — revenue expenditure, capital expenditure, interest payments, and grants-in-aid for the creation of capital assets. 

• The deficit is calculated by taking out the difference between the government’s total income or receipts and its expenditures. 

Is the Fiscal Deficit bad? 

• A moderate fiscal deficit is considered good for the economy if the money is spent on infrastructure projects like highways, roads, ports and airports as these constructions boost economic growth and create job opportunities

• Higher levels of fiscal deficit typically imply the government eats into the pool of investible funds in the market which could have been used by the private sector for its own investment needs

How is the fiscal deficit balanced out?

• To balance the fiscal deficit  in short-term macroeconomics, the government looks at market borrowings by issuing bonds and selling them in through banks

• Banks buy these bonds with currency deposits and then sell them to investors. Government bonds are considered an extremely safe investment instrument, so the interest rate paid on loans to the government represents risk-free investment

• The government also sees a deficit situation as an opportunity to expand policies and schemes, including welfare programmes, without having to raise taxes or cut spending in the Budget

Current Account Deficit (CAD)

• Current Account Deficit or CAD is the shortfall between the money flowing in on exports, and the money flowing out on imports

• Current Account Deficit (or surplus) measures the gap between the money received into and sent out of the country on the trade of goods and services and also the transfer of money from domestically-owned factors of production abroad

Reasons for CAD:

• CAD exists due to a host of factors including:

  • Existing exchange rate

  • Consumer spending level

  • Capital inflow

  • Inflation level

  • Prevailing interest rate

• For the Current Account Deficit in India, crude oil and gold imports are the primary reasons behind high CAD. 

Understanding CAD

• To understand CAD in detail, it is essential to learn about the Current Account

• A nation’s Current Account maintains a record of the country’s transactions with other nations, in terms of trade of goods and services, net earnings on overseas investments and net transfer of payments over a period of time, such as remittances

• This account goes into a deficit when money sent outward exceeds that coming inward which in turn, implies that the demand for the foreign currency (say the US dollar) is more than the demand for the Indian rupee

Current Account Deficit vis-i-vis Balance of Trade:

• Current Account Deficit  is slightly different from Balance of Trade, which measures only the gap in earnings and expenditure on exports and imports of goods and services
• Whereas, the current account also factors in the payments from domestic capital deployed overseas
• For example, rental income from an Indian owning a house in the UK would be computed in Current Account, but not in Balance of Trade

Calculating Current Account Deficit:

• The current account constitutes net income, interest and dividends and transfers such as foreign aid, remittances, donations among others. It is measured as a percentage of GDP

Trade gap = Exports – Imports

Current Account = Trade gap + Net current transfers + Net income abroad

Tackling CAD:

• The Current Account Deficit could be reduced by boosting exports and curbing non-essential imports such as gold, mobiles, and electronics

• Currency hedging and bringing easier rules for manufacturing entities to raise foreign funds could also help

• The Government and RBI could also look to review debt investment limits for FPIs, among other measures

Significance of CAD:

• A country with rising CAD shows that it has become uncompetitive, and investors are not willing to invest there

  • They may withdraw their investments

• Current Account Deficit may be a positive or negative indicator for an economy depending upon why it is running a deficit 

  • Foreign capital is seen to have been used to finance investments in many economies

• A Current Account Deficit may help a debtor nation in the short-term, but it may worry in the long-term as investors begin raising concerns over adequate return on their investments