04 March 2015

The Explainer: Why a high Fiscal Deficit is Dangerous

In the third part of the Understanding the Budget Series, I had explained Fiscal Deficit. This post will focus on the adverse consequences of Fiscal Deficit.

Before that, let me address a pertinent question: Where does the Government of India borrow from?

The three major sources of borrowing for the government of India are: (a) RBI, (b) foreign lenders (sovereign governments and international organisations like IMF and World Bank), and (c) from the general public of this country.

Contrary to popular perception, the government borrows most from the general public, through the issue of bonds (pretty much like fixed deposits).

(Read The Explainer: Budget Terminology - Part I and Part II)

What are the adverse consequences of Fiscal Deficit?
A high and rising Fiscal Deficit is bad for the general state of the economy, trade balance, and currency exchange rate.

Rising interest rates

A high Fiscal Deficit would mean the government’s borrowings are high. When the government borrows money from the general public, it creates demand for money. 

Lending to government carries zero risk, as the government will not default on repayment. However, greater government borrowing would mean less money would be available for lending to industrial and other sectors of the economy. This would push up interest rates for the borrowers from the industry.

Reduced business & economic activity

Higher interest rates would add to overall cost of production, thereby increasing cost of operations. This in turn would render business activity, like increased production and expanding operations, unviable. Hence, a lot of businesspersons would then opt out of such economic activity as they no longer find it profitable.

Reduced income & employment generation

If due to higher interest rates businesspersons opt out of economic activity or close down plants, it would also reduce employment generation. This would in turn mean that the retrenched (those thrown out of jobs) and the unemployed do not earn income, thus reducing their purchasing power.

If purchasing power goes down, then their aggregate demand for goods and services would also go down. This in turn would also reduce industrial activity, thereby depressing overall economic scenario.

Lowers exchange rate & rises trade deficit

Sometimes the government of India would borrow from foreign sources. When the government is lent money, foreign exchange comes into the economy. This would increase the supply of the foreign currency, which in turn would be exchanged for the Indian rupee.

The rise in demand for the Indian currency would increase its value. Simply put, as foreign entities begin to exchange their currency for Indian rupee, the value of the Indian rupee will also increase.

For example, the exchange value of the Indian rupee for each U.S. dollar is Rs61. In this scenario, let’s say, when a foreign entity is exchanging its currency for Indian rupee in large volumes, the exchange value may fall to Rs59 per U.S. dollar.

This means that while earlier one U.S. dollar would have fetched Rs61, now it would fetch only Rs59. This would hurt exports and encourage imports. How?

As an an importer, in the past you were paying Rs61 per U.S dollar of import while now you are paying only Rs59. This means that your cost of operations would also go down.

However, if you are an exporter, then this would mean that you would earn less from your exports; like earlier you were earning Rs61 for U.S. dollar of export while now it is only Rs59!

If exports go down and imports go up, then the trade deficit will also widen, which in turn increases the Current Account Deficit. 

Also, high borrowings now would mean that the country's financial position becomes precarious as it piles higher debt and interest burden on future generations

In short, a high Fiscal Deficit is dangerous in every way possible: for general economic activity, employment generation, exchange rate, and trade balance.


Anonymous said...

But continuously appreciating domestic currency value could be dangerous as far as exports are concerned.

Since it takes more dollars to buy the same domestic good, goods in the international market become less competitive and it hurts the country's exports.

gopal said...

Could u plz elaborate " the trade deficit will also widen, which in turn increases the Current Account Deficit. " ?

gopal said...

Could u plz elaborate " the trade deficit will also widen, which in turn increases the Current Account Deficit. " ?