Two data points released on the last day of 2012 should worry both policymakers and investors. The current account deficit—the difference between import and exports of goods and services—in the second quarter of the current fiscal (July-September 2012) reached an alarming level of 5.4% of the gross domestic product (GDP), while fiscal deficit reported to have touched 80% of the full year target by the end of November. The government is trying hard to restrict the fiscal deficit to 5.3% of the GDP. Numbers on the fiscal and current account not only reinforce policy priorities for 2013, but also highlight the biggest macroeconomic risk that the country faces—that of financial instability because of higher twin deficit.
Dangers of twin deficit
Twin deficit basically refers to a situation where the country runs relatively large current account and fiscal deficits. Higher twin deficit is inherently destabilizing and was the primary reason why India faced a currency crisis back in 1991.
Higher current account deficit means higher demand for foreign currency, which results in depreciation of the domestic currency. It also discourages capital inflow and leads to capital flight from the country. Although all the signs are not yet visible in India as of now, the vulnerability has only increased. For example, at the current quantum of current account deficit at $22.3 billion in July-September 2012, India needs foreign capital inflows to the tune of about $7.5 billion per month to fund the deficit. Such high dependence on capital flow naturally results in higher appetite for short-term and risky flows.
According to the Reserve Bank of India’s Financial Stability Report, December 2012, the ratio of volatile capital flows to foreign exchange reserves was 81.3% at the end of June 2012 compared with 67.3% at the end of March 2011. Rising dependence on short-term flows is risky as any reversal could pose serious challenges in financing the deficit and may lead to a sharp fall in currency. The problem is magnified due to the presence of higher government deficit. Higher fiscal deficit, apart from affecting savings and growth, affects business confidence.
Further, as is being argued in the Indian case, higher government deficit is resulting in higher demand, which is pushing imports, or not allowing it to correct in line with slowing exports due to adverse demand conditions in the overseas markets.
Therefore, for India, addressing the issue of twin deficit will possibly be the biggest policy challenge in 2013, and the way the issue is approached will decide numerous outcomes such as business confidence, investments and economic growth.