Home Financial responsibility The Indian economy has a double deficit problem. To counter it, the government must juggle between growth and stability

The Indian economy has a double deficit problem. To counter it, the government must juggle between growth and stability


In his recent publication monthly economic reportthe Ministry of Finance expressed concern about the re-emergence of the twin deficit problem in the economy due to rising commodity prices and increased subsidy burden.

While tariff cuts and increased subsidies have raised the possibility of a deviation from the budgeted fiscal deficit, rising crude oil and commodity prices amid continued selling off by foreign investors may cause an increase in the current account deficit.

The government will have to strike a difficult balance between maintaining growth and macroeconomic stability by keeping fiscal and current account deficits within manageable limits.

Blow to the budget deficit

The budget projected a fiscal deficit of 6.4% to GDP for the current fiscal year. The resulting geopolitical conflict and supply disruptions posed an upside risk to the fiscal deficit. The reduction in excise duties on gasoline and diesel and the increase in fertilizer subsidies to cushion the impact of rising international prices pose a risk to the budgeted fiscal deficit.

A rise in the budget deficit (excess of expenditure over revenue) would require more government borrowing. Higher government borrowing would absorb more of the savings, which could have been used by the private sector for its own investments. Higher government borrowing will also drive up interest rates, which would negatively impact private sector investment.

At a time when the government is focusing on investment spending to stimulate growth, the only way to reduce the budget deficit is to limit non-capex spending.

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Sharp rise in the current account deficit

The ongoing war has led to a sharp rise in the prices of crude oil and other raw materials. India imports nearly 85% of its domestic crude oil needs. The sharp rise in import prices will widen India’s current account deficit. A wider current account deficit will put downward pressure on the rupee as demand for dollars increases. A weaker rupee will increase the risk of imported inflation.

As a net importer of oil and other commodities, while India has traditionally run a current account deficit, large capital inflows have enabled it to finance its current account deficit. But over the past six months, foreign portfolio investors have also withdrawn a large amount of money from the capital market, making India’s external sector more vulnerable.

Aggressive US Fed tightening drives US bond yields higher, leading to continued selling off of REITs. For FY22, India’s current account deficit was at a three-year high due to the rise in world commodity prices and the recovery in economic activity. It is expected to widen further to reach 3% of GDP.

2013 double deficit and tantrum episode

Twin deficits increase vulnerability to external shocks. India was among the hardest hit countries when the Federal Reserve slowed its bond purchases in 2013, known as the taper tantrum.

The indication by then Fed Chairman Ben Bernanke that the Federal Open Market Committee (FOMC) could soon start to slow down its bond purchases sparked a wave of capital flight from emerging economies – particularly from South Africa, Brazil, India, Indonesia and Turkey – dubbed the “fragile five” in because of their high current account deficits and their dependence on foreign capital inflows.

These capital outflows put pressure on the rupee. India was one of the hardest hit due to its underlying macro vulnerabilities.

Policies after the global financial crisis

During the global financial crisis of 2008, the Indian economy participated in the global downturn due to its trade and financial ties with the rest of the world. India’s policy response after the 2008 crisis focused on reviving growth, but at the expense of macroeconomic stability.

The government has announced a coordinated program monetary and fiscal policy package in 2008-09 to relaunch growth. For example, the government has introduced fiscal stimulus in the form of tax cuts and increased spending to stimulate consumer demand. The Fiscal Responsibility and Management (FRBM) Act 2003 (under which the government is required to exercise fiscal prudence to reduce its deficits to a target rate) was suspended in 2009 in order to adapt to the stimulus policies.

On the monetary side, the Reserve Bank of India has introduced measures, such as rate cuts, to boost liquidity and facilitate credit to stimulate investment. The rate-cutting cycle continued until March 2010. Fiscal spending alongside low interest rates led to higher inflation and higher imports. Rising imports led to a deterioration in the current account. The growth-enhancing policy has led to the neglect of macroeconomic stability.

Focus on macro-stabilization

As inflation takes hold, a calibrated normalization of monetary policy is needed to anchor inflation expectations. On the fiscal side, while some measures should be taken to mitigate the impact of rising prices, the government needs to find a glide path for fiscal consolidation.

While the government has set itself the target of achieving a budget deficit of 4.5% of GDP by 2025-26, a roadmap to achieve this target should also be specified. Sound macroeconomic stabilization requires setting debt and deficit reduction targets for the coming years. Adjustment of the rupiah market to control the current account deficit should be part of the macro-stabilization strategy.

Radhika Pandey is a consultant at National Institute of Finance and Public Policy.

Views are personal.

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