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Financial Scene - Troublesome twin deficits
October, 10th 2011

Two reports, one concerning the external economy and the other on government finances, have deep implications for the macroeconomy.

According to the Reserve Bank of India's recent balance of payments (BOP) data, the current account deficit (CAD) increased to 3.1 per cent of the GDP in the first quarter of the current fiscal (2011-12) from 2.6 per cent a year ago.

The trade deficit has widened to $35.54 billion from $31.38 billion last year despite an impressive export performance.

This is because imports too have grown offsetting the advantage.

Invisibles, comprising services, transfers and investment income, have grown to $21.73 billion from $19.76 billion. Once again, capital flows helped growing to $20.94 billion in the first quarter from $17.6 billion last year.

Foreign direct investment has gone up and that is desirable. Not so welcome from the external economy's point of view is the jump in debt creating flows, comprising, among others, external commercial borrowings by Indian companies. These are essentially of a short-term nature.

Widening CAD
The proportion of short-term external debt to total external debt may still be small, but its unbridled growth can strain monetary policy management and put pressure on the exchange rates. It is for these reasons that the RBI has frowned upon them.

In India's current state of development, trade deficit and CAD are inevitable. The key task is to contain CAD within a sustainable' limit. The Prime Minister's Economic Advisory Council (PMEAC), in its Economic Outlook (July, 2011), has said that given the current trends in the world economy and behaviour of international markets, CAD should be contained at below 2.5 per cent of the GDP.

This will mean a larger inflow of capital in absolute amount as the GDP keeps growing.

And now fiscal deficit

The government recently announced that it would be borrowing from the markets about Rs.53,000 crore more than what it had estimated in the budget.

The government has justified the extra borrowings on the ground that collections under various small savings schemes, over which the Central budget has a claim, have fallen.

The higher interest rates that banks offer on their deposits have led to lower small savings collections. By resorting to additional borrowings, the government claims, it is merely substituting one source of budget financing with another.

The category of small savings will provide less and bonds correspondingly more. Consequently, there will be no increase in the size of the fiscal deficit, budgeted at 4.6 per cent of the GDP.

Rising debt costs
This argument is only technically correct. There is no doubt at all that the costs of issuing new debt will increase. Besides, well before the recent government decision to borrow more, most analysts had expected the fiscal deficit to be around 5 per cent, well above the budgeted figure. Their reasoning is beyond reproach, as it is based on the time-tested correlation between economic growth and revenue buoyancy.

There are no two opinions that the economic performance in the second half of 2011-12 will be lower than in the first six months. Revenues will decelerate during the rest of the year as the slowdown in the economy makes its impact. Direct and indirect collections will be hit.

The reasons for the relative tax buoyancy are rooted in the relatively strong GDP growth of the past. Uncertainties in India's principal export markets will stymie export performance. Higher interest rates meant to counter inflation will impinge on corporate profitability and hence lead to lower corporate tax collections.

At the same time, expenditure will be hard to curtail. Global oil prices are firm, despite slowdown in the advanced economies. In India, the unexpected rupee depreciation will push up the cost of subsidies.

Interest payments
Interest payments, which account for about 20 per cent of total government expenditure, are likely to exceed the budget projections. Finally, the unfavourable equity market environment will lead to shelving of the public sector disinvestment programme. Hence, there may not be much to show under capital receipts.

In any case the gilts market reacted to the government's claims extra borrowings sans pain with scepticism. On Thursday, when the higher borrowing plan was announced, yields on the benchmark ten year 2021 Government of India stock rose from 8.34 per cent to 8.44 per cent.

The market's doubts were reinforced by the subsequently released official data which showed the Centre's fiscal deficit at Rs.2.74 lakh crore during April-August. This is 81 per cent higher than the deficit for the first five months of last year and moreover, it is almost two-thirds of the budgeted Rs.4.13 lakh crore for the current fiscal.

The danger of government borrowing crowding out' private sector borrowing through higher interest rates is real. Although at the present juncture the credit offtake is reportedly slowing down, it is likely that the additional government borrowings will push up interest rates.

The reasons for the present slackness in credit growth are several: high interest rates from past monetary policy actions acting a disincentive; uncertainty and indecision at the highest levels of policy making that discourages new investment.

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