Demystifying India’s twin deficits

By October 17, 2014 Trading No Comments
trade deficit

We must have encountered the words “twin deficits” not less than a million times in the recent past. But have we ever thought about the composition and origin of these words. Let’s spend some time to delve into the details of twin deficits – current account and fiscal deficit.

Demystifying deficits in share trading market

Demystifying deficits in share trading market

Current Account

  • Export& Imports of goods – “a net of Trade deficit”
  • Invisible comprising import and exports of services –  especially software (a surplus)
  • Income from investments – India witnesses net outflow of ~ $5 billion per quarter
  • Remittances – India receives a net of ~ $ 15 billion per quarter in remittances from abroad

The current account is defined as a sum of the above components and is considered as an important indicator about an economy’s health. A positive current account balance indicates that the nation is a net lender to the rest of the world, while a negative current account balance indicates that it is a net borrower from the rest of the world. A current account surplus increases a nation’s net foreign assets by the amount of the surplus, and a current account deficit decreases it by that amount. The current account and the capital account are the two main components of a nation’s balance of payments.

Why do we have such a high deficit on Current account

India always  had a deficit on its current account as we have a high trade deficit since our imports outweigh exports, largely as a result of humongous crude oil and gold imports. What led to such an exponential rise in CAD, creating such a hue and cry from FY12 onwards?Surely crude oil remains the biggest component, a little over 30 percent of our imports; it was largely the increase in quantum of gold imports (refer the illustration below in $ billion) coupled with a gigantic price rise of gold during FY12 and FY13 which created massive imbalances in CAD.

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This phenomenon was largely a result of culmination of factors like high inflation which induced gold buying as a proxy for inflation, distressed performance of other financial assets as a spillover of uncertainty in global markets and handsome returns in gold as a function of global rise of gold prices. Some other areas that could be attributed to these imbalances are rise in coal imports and reduced exports of iron ore. However, the government has been successful in addressing the rising deficit concerns by putting a number of restrictions on gold imports in FY14.

India's Twin deficits

How do we finance the trade deficit

Now the question that arises is how does India even out large trade deficits. The answer is mostly through the Invisible surpluses comprising service exports and income transfers like remittances from abroad which have played crucial role in financing India’s large trade deficits. The rest is financed by the capital inflows that India receives from year-on-year.

Fiscal deficit

Let’s look at this terminology from the perspective of a family budget. A family whose expenditure exceeds that of its income can only survive on borrowing from outside. This is the acute problem with India’s financial accounts as the government spends more than the total revenues it garners which is termed as fiscal deficit. India, being a developing economy, has to put some extra resources for poor in the form of subsidies and welfare programs which leads to a deficit in its budget. The problem got compounded when the government revenues could not catch up with expenses on account of the slowdown in our economy post global crisis and inefficient government policies.

Let’s understand the revenues and expenses components of government’s budget and the sources from where the government gets it revenues.

India's Twin deficit
The noticeable thing is that our government relies heavily on capital receipt to finance our budget deficit which is mostly in the form of market borrowings. So effectively our government finances are under the stress because of the high budget deficit and thereby its dependency on high market borrowing.

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