Of deficits, falling rupee, good economics and mindless austerity

Vivek Kaul
The UPA government is now talking about austerity. Has the cookie finally crumbled? But let’s try and understand why the words of the finance minister in the Rajya Sabha on May 16,2012, should not be taken very seriously. The argument is slightly long so kindly stay with me.
The fiscal deficit
The fiscal deficit of the government of India has been going up over the last five years. Fiscal deficit is the difference between what the government earns and what the government spends. For the financial year 2007-2008 (i.e. the period between April 1,2007 and March 31, 2008) the fiscal deficit stood at Rs 1,26,912 crore. This shot up to Rs 5,21,980 crore for the financial year 2011-2012. In a time frame of five years the fiscal deficit has shot up by nearly 312%. During the same period the income earned by the government has gone up by only 36% to Rs 7,96,740 crore.
The fiscal deficit targeted for the current financial year 2012-2013(i.e. between April 1, 2012 and March 31,2013) is a little lower at Rs 5,13,590 crore. Let us try and understand why lowering the fiscal deficit from the amount proposed by the government would be very difficult.
Interest and debt repayment
The increasing fiscal deficits over the years have been financed through raising debt. Now debt does not come free of cost. Interest needs to be paid on it. Also the debt raised needs to be repaid. In the year 2012-2013, the government will spend Rs 3,19,759 crore to pay interest on the debt that it has taken to finance the fiscal deficits. Rs 1,24,302 crore will be spent to payback the debt that was raised in the previous years and matures during the course of the year 2012-2013. Hence a total of Rs 4,44,061 crore or a whopping 86.5% of the fiscal deficit will be spent in paying interest on and paying off previously issued debt. This is something that the government cannot really do away with. It has to pay interest and repay the debt previously taken on.
The other big entry on the expenditure side of the budget is the subsidy on food, fertilizer and petroleum. This is an expenditure which the finance minister typically ends up underestimating at the time he presents the budget.
In his budget speech last year Pranab Mukherjee had set the fiscal deficit target for the financial year 2011-2012, at 4.6% of GDP. He missed his target by a huge margin when the real number came in at 5.9% of GDP. The major reason for this was the fact that Mukherjee had underestimated the level of subsidies that the government would have to bear. He had estimated the subsidies at Rs 1,43,750 crore but they ended up costing the government 50.5% more at Rs 2,16,297 crore.
Generally all the three subsidies of food, fertilizer and petroleum are underestimated, but the estimates on the oil subsidies are way off the mark. For the year 2011-2012, oil subsidies were assumed to be at Rs 23,640crore. They came in at Rs 68,481 crore. This has been the case in the past as well. In 2010-2011 (i.e. the period between April 1, 2010 and March 31, 2011) he had estimated the oil subsidies to be at Rs 3108 crore. They finally came in 20 times higher at Rs 62,301 crore. Same was the case in the year 2009-2010 (i.e. the period between April 1, 2009 and March 31, 2010). The estimate was Rs 3109 crore. The real bill came in nearly eight times higher at Rs 25,257 crore (direct subsidies + oil bonds issued to the oil companies).
The twin deficit hypothesis
The hypothesis basically states that as the fiscal deficit of the country goes up its trade deficit (i.e. the difference between its exports and imports) also goes up. Hence when a government of a country spends more than what it earns, the country also ends up importing more than exporting.
So what are the reasons behind this theory? One particular reason is the fact that governments typically end up with greater fiscal deficits when they cut taxes but at the same time do not match the cut in taxes with an increase in expenditure. This leaves people with a greater amount of money in their hands. Some portion of this money is used towards buying goods and services, which might be imported from abroad. This leads to greater imports and thus a higher trade deficit.
The government of India has been cutting taxes since 2007, but the cut in taxes hasn’t been matched up a cut in expenditure. This has meant increasing incomes of the Indian taxpayer maybe to some extent responsible for an increase in Indian imports. But that could have hardly been responsible for the trade deficit of $185billion that India ran in 2011-2012. In simple English this meant that the Indian imports were $185billion more than Indian exports.
It’s basically about oil and gold
The major reason for India’s huge trade deficit is the fact that we import a major part of our oil needs. And we continue to be obsessed with gold. Very little of both the commodities is found within the country and hence has to be imported. So we end up importing more than exporting. The trend continues in the current financial year as well. The imports for the month of April 2012 were at $37.9billion, nearly 54.7% more than the exports which stood at $24.5billion.
With imports being greater than exports there is a greater demand for dollars, which are used to pay for imports. This means importers sell rupees and buy dollars. When this happens the amount of rupees floating in the foreign exchange market goes up, leading to its losing value against the dollar. This to some extent explains the current rupee dollar rate of $1 = Rs 54.5. The Reserve Bank of India does intervene at times to stem the fall of the rupee. This it does by selling dollars and buying rupee. But the thing is that the RBI does not have an unlimited supply of dollars and hence cannot keep intervening indefinitely.
The double whammy
As mentioned earlier the major part of the trade deficit is because of the fact that we need to import oil. Oil prices have been high for the last few years, though recently they have fallen. Oil is sold in dollars. Hence when India needs to buy oil it needs to pay in dollars. But with the rupee constantly losing value against the dollar, it means that Indian companies have to more per barrel of oil in rupees.
The government of India does not pass on a major part of the increase in the price of oil to the end consumer and hence subsidizes the prices of diesel, LPG, kerosene etc. This means that the oil companies have to sell these products at a loss to the consumer. The government in turn compensates these companies for the loss. This leads to the expenditure of the government going up and hence it incurs a higher fiscal deficit.
Hence in India’s case a greater trade deficit also leads to a greater fiscal deficit. So the causality in India’s case is both ways. A high fiscal deficit leads to a higher trade deficit. And a high trader deficit leads to a higher fiscal deficit. And this in turn also leads to what economists call a weaker rupee, which pushes up the cost of oil in rupee terms, leading to a higher fiscal deficit.
Oil prices have come down a little recently. But this is unlikely to benefit India because the rupee is constantly losing value against the dollar. Hence most likely Indian companies will continue to pay the same price for oil in rupee terms as they had.
High interest rates
As mentioned earlier the government finances its fiscal deficit by borrowing money. It borrows money from the same pool of savings that the private sector does. This in effect leads to what economists call “crowding out”. When the government borrows more and more, the pool of savings left for the private sector to borrow constantly narrows. This leads to higher interest rates. A higher interest rate also means that a lot of opportunities that the private sector might want to invest in do not remain viable because the cost of borrowing has gone up.
In fact the high interest rate scenario that has prevailed in India since 2008 is to some extent responsible to the private capital spending coming down from 17% of the gross domestic product to the current 12%. This in turn has been to some extent responsible for lower economic growth. But it works both ways. Higher interest rates have led to corporates cutting down on their capital spending, leading to low economic growth. And low economic growth has in turn has led to lower capital spending by corporate.
How do we take care of this?
The starting point of getting out of this rut is cutting the fiscal deficit. As mentioned earlier, the payment of interest on debt and repayment of debt together account for nearly 86.5% of the fiscal deficit. This is something that cannot be done away with. The other major expenditure of the government are subsidies. This is where something can be done.
If the government decides to stop subsidizing the various oil products and ask consumers to pay the “right” price, the fiscal deficit can be brought down to some extent. If these products are priced correctly, their consumption is likely to come down as well in the near future, given that their prices will go up. Lower consumption is likely to lead to lower imports and thus a lower trade deficit. This to some extent also takes care of the other problem that we have.
When imports are more than exports what it means is that the country is paying more dollars for the imports than it is earning from the exports. This difference obviously comes from the foreign exchange reserves that India has accumulated over the years. But that clearly isn’t healthy given our imports are more than 50% of our exports and there is a limited supply of foreign exchange reserves.
A lower trade deficit takes care of that problem to some extent. A lower trade deficit would also mean that the fall of the rupee against the dollar may stop. This in turn would mean a lower price for the oil we import in rupee terms and that in turn help overall economic growth. A lower fiscal deficit will lead to lower government borrowing and hence lesser “crowding out” and so lower interest rates, which might get corporates and individuals interested in borrowing again.
To conclude:
On the flip side an increase in the price of oil products will immediately lead to higher inflation. One of the few things in economics that most economists agree on and do not offer a counterpoint to is the fact that a higher price of oil leads to higher inflation, in the short term. The question is whether the UPA government is willing to take that risk?
The other major point is that the only way out of this economic “rut” is to start by cutting subsidies. A cut in subsidies will bring down the fiscal deficit, which in turn will bring down both the interest rates as well as the trade deficit. The trade deficit coming down will lead to the rupee stabilizing against the dollar.
But the government will have start with cutting down subsidies. Will that happen? We all saw the hungama that happened when Dinesh Trivedi, the erstwhile Railway Minister, tried to increase rail fares after almost ten years. Will the allies in the Congress led UPA allow it to increase prices of various oil products? Will the Congress cut down on food subsidies budgeted at Rs 75,000 crore for the current financial year, which have been a favourite with Sonia Gandihi? And the biggest point remains that 2014 elections are largely being seen as the launch of Rahul Gandhi as the Prime Ministerial candidate for the UPA. Under these conditions what are the chances that the government will slash subsidies?
I remain pessimistic.

(A version of this article appeared in Daily News and Analysis on May 19,2012. http://www.dnaindia.com/money/column_of-deficits-falling-rupee-good-economics-and-mindless-austerity_1690732)
(Vivek Kaul is a writer and can be reached at [email protected])