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Home / Opinion / Views /  What’s the twin deficit problem you have started hearing about again?

Ever since the finance ministry’s monthly economic report warned earlier this week about India facing a looming twin deficit problem, there has been much commentary on this double-barrelled threat, accompanied, thankfully, by some sensible explication of the problem. Here is what it is all about.

The twin deficits in question are the fiscal deficit and the current account deficit. Both have a tendency to increase to levels considered risky for maintenance of macroeconomic stability, and especially the rupee-dollar exchange rate, whenever there are external shocks.

The finance ministry report has red-flagged how both have risen at the same time, as the tax cuts it announced as relief on soaring fuel prices, and the likelihood of the fertilizer subsidy bill growing bigger than budgeted owing to the sharp increase in international prices after Russia invaded Ukraine, will make it tougher for it to keep the fiscal deficit under the target level, which in turn, it said, may cause the current account deficit too to widen, creating a cycle of wider deficits and weaker rupee.

To understand these concepts properly, it would be useful to first appreciate some elementary macroeconomics. Gross Domestic Product (GDP) is the value of every final good or service that is produced in the economy in a period of time, normally a year or a quarter (the value of intermediate goods is subsumed in the value of the final good, so to add that would amount to double-counting). Everything that is produced is consumed, invested or exported. What if something is produced but not yet sold for its final use, you might wonder: does it have no value? Inventories are part of investment, and so are taken into account when you count investment.

So, GDP is the sum of total consumption, investment and exports, right? Wrong. Some bits of the things you consume or invest are imported. Many components of your smartphone were imported, the Marvel Comic Universe movie you consumed has a large import component, most of the oil from which domestic refineries produce petrol and diesel is imported, lots of plant and machinery are imported. So, GDP is the sum of consumption, investment and exports, less imports. Call the difference between exports and imports net exports.

So, GDP = Consumption + Investment + Net Exports

Suppose we take away consumption from both sides of the equation (if you subtract the exact same value from both sides, the equality remains intact), we get:

GDP — Consumption = Investment + Net Exports

What is not consumed out of what is produced is what we call Savings.

So, we get:

Savings = Investment + Net Exports

When we include all services, including financial, labour and real estate services, among the traded services, net exports are the same as what is called the current account balance.

Savings = Investment + current account balance

Let’s take away Investment from both sides of the equation, and we have:

Savings — Investment = Current Account Balance

If savings are larger than investment, the left hand side of the equation would have a positive value. That means the right hand side must also have a positive value. In other words, the current account would be in surplus. When a country runs up a current account surplus, it actually exports savings to other nations, instead of using up all domestic savings for domestic investment.

If savings equal investment, the current account would be in perfect balance, exports of goods and services would match imports of goods and services.

If the left-hand side of the equation is negative, that is, if investment is larger than savings, the current account would be in deficit. The economy would be investing more than it has saved and drawing in external savings to make that excess investment possible.

India typically runs a current account deficit. Which actually means that India invests in excess of domestic savings. That excess is identical to the value of the current account deficit.

When you import more than you export, someone has to finance that gap that you cannot pay for using export proceeds. It could be that you are in a position to run down your foreign exchange reserves, or you borrow, including from those eager to finance their exports.

Growth stems from investment. The more you invest, the faster you grow. For a growing economy like India, it is good to have a moderate current account deficit, so that we can invest more than we save and grow faster than we would purely on the strength of domestic savings.

Why be moderate, why don’t we run up a current account deficit as large as we can, supplement domestic savings as much as we can and grow even faster? People are willing to give you capital, either as equity or debt, because they expect that capital to be serviced. If the economy shows signs of borrowing in excess of its debt servicing capacity, not only would further credit dry up, some existing loans might be in trouble, too. Your credit rating would fall, further loans would become more costly or unobtainable, holders of Indian bonds would start dumping them, lowering their price and thus jacking up yield. The rupee exchange rate would come under pressure from speculators in the currency market and capital may be pulled out, meaning a pick-up in outflow of dollars from the economy.

After a prolonged binge, the way to health is through rehab. The macroeconomic equivalent is being put through the wringer of IMF conditionality to regain creditworthiness. Sri Lanka and Pakistan are right now about to enter rehab.

All investment does not lead to growth. So, just adding to investment to increase the saving-investment gap and, thereby, the current account deficit, does not ensure the economy would generate the wherewithal to service the capital that came in to finance the larger current account deficit.

Now, we have an idea of why the Current Account Deficit can be a problem.

How is the fiscal deficit related to the current account deficit?

The fiscal deficit is, on the face of it, the borrowing the government undertakes to finance expenditure in excess of its non-borrowed receipts. Non-borrowed receipts include capital receipts (loans repaid, assets sold) and current receipts (tax revenues, dividends from state undertakings, interest earnings from past loans made, spectrum usage charges, etc).

The government borrows to spend. Its expenditure is on the very same goods and services the private sector spends on. If government expenditure is limited to the goods and services that remain after the private sector has bought up all its requirements, then, government borrowing would not cause any problem. However, if government spending is in excess of what the private sector can spare after meeting its own needs, the combined demand for goods and services would be in excess of what is produced. This excess demand would be resolved in two ways: one, prices would rise, and two, more imports would take place to meet the demand, widening the current account deficit.

The government needs to borrow because its investment plans are in excess of its savings. The government of India runs a revenue deficit, meaning its current expenditure is in excess of current earnings. So, it has dissavings, rather than savings (suppose the government were to suddenly discover all the black money in the economy and tax it, it would have a revenue bounty and large savings left over after meeting its expenses, with which to finance its investment). This borrowing represents a claim on the non-government sector’s savings.

It is vital to appreciate that saving here represents the goods and services produced but not consumed and not just their financial counterpart in terms of so many rupees.

That government borrowing represents a claim on non-government savings is not obvious to us, because government consumption and investment are transacted through money. Suppose the government commandeered the goods and services it needed, as taxation in kind. If the goods and services so taken over are what the non-government sector could spare after meeting its needs, there would be no strain. But if the government wanted goods and services that the private sector also wanted, and took them away, in any case, the private sector would have to cut back their requirements. But in real life, the government does not do taxation in kind. The credit system generates enough credit to let the government and the private sector both raise demand for the same set of goods and services, and bid up their prices or force additional imports. A large fiscal deficit can, in effect, crowd out private investment, as the government outcompetes private players for goods and services. That would be undesirable.

In a situation of slack private sector demand for goods and services, a robust fiscal deficit would give a fillip to the economy, instead of creating excess demand. When the private sector sees buoyant demand, it can start expanding capacity. This is what is meant by the fiscal deficit crowding in private investment.

Whether a fiscal deficit is good or bad, that is too much or too little, depends on the level of private investment in the economy. If the fiscal deficit is large at a time of soaring ‘animal spirits’ among entrepreneurs, who want to invest big, the result of unrelenting government demand would be to curtail private investment, create inflation and widen the current account deficit, to bring in additional savings to meet the excess demand for savings posed by government borrowing and private demand.

There is nothing sacrosanct, in terms of economic sense, about the 3% of GDP target for the fiscal deficit. The desirable level of the fiscal deficit depends on the strength of private sector investment appetite.

An excessive fiscal deficit, one that takes away more goods and services than the private sector has to spare after meeting its own needs, can lead to a wider current account deficit, as the economy seeks to augment domestic savings with other nations’ savings (someone’s current account surplus has to be balanced by someone else’s deficit).

As oil and food turn expensive in the wake of the Ukraine war and supply glitches, India’s import bill would go up. If exports do not keep up, the current account deficit would widen —unless investment slackens, to shrink the investment-saving gap. Keeping the twin deficits in check is the art of macroeconomic management. India's twin deficits typically rise in tandem whenever there are external shocks. It last happened in 2013 when the 'taper tantrum' phase triggered by the US Fed's indication that it would wind down its post-global financial crisis of 2008 quantitative easing programme ahead of time. Both the deficits widening raised concerns about India's macroeconomic stability, leading to a run on the rupee, and India being bracketed as a 'Fragile Five' economy, before the Manmohan Sing-led government and the Reserve Bank of India took steps to compress them, in the process sacrificing GDP growth. But averting crisis.

 

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