27 May 2020 20:37 IST

How India can address its twin deficit challenge

Attracting more FDI and creating an enabling business environment could bridge budget, trade deficits

Most of us are familiar with what a budget deficit is — it is created when the government’s expenditure exceeds the revenue it received in the form of taxes. It has a ‘twin’ deficit — the trade deficit, which occurs when the nation’s import value exceeds its export value.

Here, we will try and understand what this twin deficit is in the Indian context, and why the country must overcome this.

Looking back

In 1991, the government was compelled to airlift its national gold reserves to the IMF and World Bank in exchange for a loan to cover the balance of payment dues, as imports burgeoned due to the ongoing Gulf War, leaving India with a budget deficit and trade deficit at the same time. This formed a twin deficit. Rating agencies like Moody degraded India’s credit rating, and the value of the rupee depreciated sharply, which ultimately spurred the liberalisation move.

The pair of deficits has had a significant effect on the Indian economy. Because of the budget deficit, the government is restricted in its spending on development projects like infrastructure and manufacturing, which in turn leaves the supply side more brittle. As a percentage of GDP, India’s budget deficit, vis-à-vis those of other Asian countries such as Thailand, Bangladesh and Indonesia, is very high. Both inflation and trade deficit can increase because of the huge budget deficit, impeding macro- and microeconomic management.

India’s budget deficit stood at 5.07 per cent of GDP in February 2020, and is expected to shoot up to 6.2 per cent of GDP in FY21, according to a Fitch Ratings report. This is a worrying factor for the government, which needs to meet its fiscal deficit target of 3.8 per cent of GDP in FY20.

To address the budget deficit, the government has issued bonds, with public sector banks playing a significant role.

Trade deficit challenge

The trade deficit is the largest component of the current account deficit (CAD). It’s evident from the numbers that India is one of the developing nations that are highly dependent on foreign investments. In 2013, Morgan Stanley, one of the major global financial institutions, coined the term ‘Fragile Five’ for India, Turkey, Brazil, South Africa and Indonesia, which are highly dependent on FDI. The list, however, was revised in 2016 and India was moved out of it, thanks to significant improvement in CAD, inflation and reserves.

According to an RBI statement, India’s FDI stood at $10 billion in Q3 2019-20, compared to $7.3 billion in Q3 2018-19. Foreign portfolio inflow (FPI) stood at $7.8 billion, against an outflow of $2.1 billion in Q3 2018-19, considering both debt and equity market purchases. Because of a rise in net service receipts by $21.9 billion, and with a lower trade deficit of $34.6 billion, India’s CAD reduced to 0.2 per cent of GDP in Q3 2019-20, from 0.9 per cent in Q2 2019-20 and 2.7 per cent from in Q3 2018-19. These numbers speak a lot.

One factor India must focus on in the present situation is crude oil prices and imports of the same. India is a net crude oil importer — it is highly dependent on other nations for oil, and the demand has always been inelastic. Macroeconomic stability factors like CAD are highly influenced by the movement in crude oil prices. A rise in crude price leads to a rise in CAD.

As per a survey by a financial institution, with an average rise in crude oil price by $10/barrel globally, India’s CAD widens by $15 billion, which is around 0.5 per cent of GDP.

Also, if the domestic fuel prices remain unchanged, the same situation widens the budget deficit by $3 billion, which is 0.1 per cent of GDP.

Though India is progressing well in handling CAD as well as trade deficit, at the end of the day, with a negative CAD, India needs to maintain the balance of payments with its net capital inflow, which means it should focus more on FDIs rather than FPIs as a stable source of income.

Amid the pandemic, as many leading economies are on the verge of a recession, India must work to overcome the twin deficit issue. In order to do that, the government should focus more on attracting more FDI, create a better environment for businesses, relax some regulations, and build the necessary infrastructure.

(The writer is a second-year MBA Finance student from IFMR Graduate School of Business, Krea University, Chennai)