Wednesday, 4 September 2013

Fiscal Deficit - Ringside View to India's Economic Problems

India is facing the problem of high fiscal deficit. Many economists feel that this is the root cause of India’s present economic woes as the government’s populist policies and the RBI’s monetary policies are not exactly in-sync with each other. In this post we present a simplistic explanation of fiscal deficit and what is the problem with high fiscal deficit in the Indian context.

Understanding Fiscal Deficit :

It is the deficit generated when Govt. spending/expenditure exceeds Govt. income/revenue in a financial year.

On the other hand if the Govt. revenue were to be more than the Govt. expenditure, then we say that there was a fiscal surplus in that financial year.

Fiscal Deficit/Surplus is said to be one of the main indicators of financial health of any government.

To understand better we will look into the components of Govt. expenditure and income.

Govt. Expenditure :

It comprises of the following :

  • Govt. subsidies in various sectors (eg. LPG subsidy, subsidised food items through PDS etc.)
  • Social spending on welfare schemes etc. (eg. MNREGA, Food Security Bill etc.)
  • Govt. spending for various administrative needs internally.
  • Pension & medical/healthcare concessions for various govt. employees.
  • Spending on research & development in various govt. establishments like Space research (ISRO).
  • Defense spending.
  • Interest cost on deficit accumulated as debt from earlier years.

Govt. Income :

It comprises the following :

  • Tax revenue (Direct and Indirect Taxes)
  • Fees charged for various services by the Govt.
  • Revenue from disinvestment/privatisation in govt. held establishments.
  • Revenue from various auctions, grants, licences etc. (eg. revenue from auctioning telecom spectrum).
  • Royalty incomes.

Why Fiscal Deficit is a problem?

Many economists feel that some amount of fiscal deficit is good. This is because, a fiscal deficit means that Govt. is spending more and a govt. spending reasonable amount on various social and welfare schemes will give a stimulus to growth and push demand. This, in normal situations will lead to growth of the economy as production increases to meet the demand. It is useful at this point to refer our post on Economic Ecosystem to get a complete picture of the economic cycle.

The problem arises when the fiscal deficit becomes unmanageable or is wrongly timed. For India, the ideal fiscal deficit number is believed to be below 3% of GDP. Presently, we are facing a fiscal deficit of 4.9% of GDP for the year 2012-13, which is very high.

Investors’ nerves got frayed due to panic when the govt. went ahead with its ambitious food security bill which has the potential to add significantly to the already high fiscal deficit. The govt.’s trials to assure the investors failed to break ice and there is still a lot of scepticism if the govt. can meet its fiscal deficit target of 4.8% GDP for the year 2013-14.

What exactly is the problem with having a high fiscal deficit? Here are some pointers to understand the adverse effects :

  • Contributes to CAD adversely due to unsustainable subsidies.
  • Leads to high inflation when demand is pushed by govt. spending with no proportionate increase in supply.
  • Govt. may borrow money at high interest rates intending to spend it for boosting economic growth. But doing so in an already high fiscal deficit scenario will lead to high interest rate regime and will not have the desired effect as corporates will not have capacity to grow in a high interest rate regime.
  • Hardening of bond yields due to increased deficit funding.
  • Higher deficit funding leads to routing of money to fund govt. spending instead of more productive economic activities which will lead to lower domestic savings.
  • Low apetite of corporates to invest in high interest regime will ring alarm bells for FIIs leading to outflow of foreign capital.
  • Massive outflow of foreign capital through bond and capital markets will lead to falling markets and Rupee depreciation which is pretty much the case now. An unstable currency will further panic FIIs which may lead to further outflow of foreign capital starting a vicious cycle.
  • Not able to control and bring down the level of high fiscal deficit may lead to a downgrade of rating by sovereign rating agencies. As these sovereign ratings are seen as the indicators of economic health of a nation, a downgrade of rating will mean further reduction in investments by foreign companies and agencies in India.

Conclusion :

The govt. has repeatedly given its commitment to curtailing the fiscal deficit to 4.8% of GDP and capping the CAD to $70bn in 2013-14. This will need increasing govt. revenue, through either increasing taxes or increasing revenue through non-tax sources. This may also mean a cut in subsidies or partially lifting the subsidy burden by increasing the prices of fuel, LPG etc. Even as we write the post and understand the fiscal deficit issue, it is a given that the govt. may be mulling these and other steps to keep its word on curtailing fiscal deficit. Now, what will the magic machinery of the govt. pull out of its hat remains to be seen.