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Fiscal deficit: Grim consequences... - Views on News from Equitymaster

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  • Dec 12, 2006

    Fiscal deficit: Grim consequences...

    While India's GDP has been growing at a strong 8% per annum rate, there are several factors that can derail this growth process in the long run. Bad governance, poor physical and social infrastructure, fiscal deficit, you name it! Out of these, while a lot has been discussed and debated on poor governance and sorry state of infrastructure, the consequences with respect to the high fiscal deficit of central and state governments and the burden that these impose on the overall financial and monetary system, can be really grim.

    While it is not necessary that fiscal deficit should always be a matter of concern especially for developing economies like India, if unchecked, the same can lead to grim consequences. In this write-up, we shall examine the problems associated with a high level of fiscal deficit and the likely impact of the same on the economy.

    What is fiscal deficit?
    In simple terms, fiscal deficit is defined as the difference between government's expenditure and its total receipts. In other words, because the government fails to match its expenses with what it earns, it has to resort to 'deficit financing' by borrowing in various ways.

    One important argument against fiscal deficit is that it results in the crowding out effect i.e., the government 'crowds out' private investment leading to a possible hike in interest rates. To put things in perspective, if the government garners a higher share of the borrowings from the market, the private sector will consequently have a lesser share. This will lead to a rise in interest rates and a higher cost of capital for private investors. On the inflation front, a high fiscal deficit enhances the inflation of an economy. The reason is that government's borrowings to meet its expenditure lead to a rise in the money stock in the economy without a consequent growth in capital productivity. This is said to have an inflationary effect as few goods are chased by more money. This is especially so, if the borrowings of the government are utilised for the financing of the deficit rather than for accelerating the output.

    Therefore, the crux of the matter really is the composition of the government expenditure. Are the government borrowings utilised more for productive purposes? The answer is 'no'. As can be evinced from the table below, a larger chunk of the government expenditure is being diverted towards non-plan expenditure such as interest payments and subsidies. This means that the government is effectively borrowing to pay off debts and the interest on the existing debt, further compounding the fiscal deficit problem.

    Expenditure: Is it productive?
      FY01 FY02 FY03 FY04 FY05 FY06
    Total expenditure (Rs bn) 3,256 3,623 4,132 4,712 4,977 5,087
    (% of GDP) 15.4% 15.9% 16.9% 17.1% 15.9% 14.4%
    Plan expenditure (% of GDP) 3.9% 4.4% 4.6% 4.4% 4.2% 4.1%
    Non-plan exp (% of GDP) 11.5% 11.4% 12.3% 12.6% 11.7% 10.3%
    Source: CMIE

    To conclude...
    As mentioned earlier, a fiscal deficit is not a bad sign, if the government is utilizing the borrowings for productive purposes. Given the fact that India faces huge constraints on the infrastructure side, the focus has to be on development of roads, airports, highways, and curbing power shortages. This is more so if the current level of GDP growth has to be sustained. While the strong forex reserves position and GDP growth rate has ensured that India does not re-visit the 1991 crisis again, the government needs to understand that prudent utilisation of resources will go a long way in charting and sustaining India's economic health in the future.



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