The Explainer: Adverse Effects of Fiscal Deficit
In the third part of the Understanding the Budget Series, I had explained the idea of Fiscal
Deficit. In this post, I 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: Bond)
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 Rs55. 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 Rs52 per U.S. dollar.
This means that while earlier one U.S. dollar would have
fetched Rs55, now it would fetch only Rs52. This would hurt exports and encourage
imports. How?
As an an importer, in the past you
were paying Rs55 per U.S dollar of import while now you are paying only Rs52.
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 Rs55 for U.S.
dollar of export while now it is only Rs52!
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.
In the next installment of The Explainer, I will focus on Current Account Deficit.