Eco Basics: Dangerous Effects of High Fiscal Deficit

This post will focus on the negative consequences of a high 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 organizations like IMF and World Bank), and (c) from the general public of our country.

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

What are the adverse consequences of Fiscal Deficit?

A high Fiscal Deficit is bad for the general state of the economy, foreign trade balance, and currency exchange rate.

Rising Interest Rates

A high Fiscal Deficit means the Government of India’s (GOI, or just government) 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 would not default on repayment (it has not defaulted till date!). However, greater government borrowing would mean less money is available for lending to industrial and other sectors of the economy. This would push up interest rates for the borrowers from the industry and other sectors of the economy.

Reduced Business & Economic Activity

Higher interest rates would add to overall cost of production, thereby increasing the cost of operations. This in turn would render business activity, like increased production and expanding operations, unviable. Hence, a lot of businesspersons would 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 lead to reduction in 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 & Increases 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 ₹72. 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 ₹70 per U.S. dollar.

This means that while earlier one U.S. dollar would have fetched ₹72, now it would fetch only ₹70. This would hurt exports and encourage imports. 

How?

As an importer, in the past, you were paying ₹72 per U.S dollar of import while now you are paying only ₹70. This means that your cost of operations would also fall.

However, if you are an exporter, then this would mean that you would earn less from your exports; like earlier you were earning ₹72 for every U.S. dollar of export, it is only ₹70!

If exports go down and imports go up, the country's trade deficit would rise. 

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.