Recently the government raised concern about the possibility of twin deficit problem emerging in Indian economy. A twin deficit problem occurs when there is a simultaneous increase in both the fiscal deficit and the current account deficit due to factors that cause these deficits to widen as a side effect of one or the other. An excess of government expenditure over government income is termed as fiscal deficit. An excess of country’s value of imports over value of exports is termed as current account deficit.
Increase in government expenditure and/or decrease in its revenue collection in comparison to their budgeted estimates may cause an increase in fiscal deficit. Typically, a government may have to sell bonds to cover up this shortfall. This may lead to increase in interest rates leading to increase in capital inflows. This would pull up the exchange rate making exports costlier in foreign markets and the imports more attractive, leading to higher trade deficit.
In India the twin deficit problem is partially the other way round
In India the situation is much more complex. Due to geo political tensions and the consequent sanctions imposed on the attacking nation, the commodity prices escalated worldwide. This adversely affected the balance of trade of the countries which are net importers of commodities and India was no exception. This caused current account deficit to widen. India’s current account deficit for the financial year 2022 was at a three-year high of $38.7 billion, and the major cause was increase in the merchandise trade deficit which nearly doubled to $189.5 billion from $102.2 billion in the previous year.
In particular, elevated global prices of crude and edible oil contributed heavily to the increase in retail inflation in India. High commodity prices pushed up the input costs for the manufacturers. In the domestic economy the food prices increased in tandem with increase in global price levels and this further aggravated due to the onset of summer heat wave. As if this double whammy was not enough, the increased burden of subsidy and reduction in the tax collections caused flaring up of the fiscal deficit.
Inflation became a major concern for the government as well as the Central Bank
The Central Bank is obligated to manage inflation within the target range of plus minus 4 per cent and so when inflation crossed the upper threshold limit of 6 per cent, the monetary policy committee resolved to increase the policy rates and took a proactive stance towards bringing inflation back into the target range. Increase in policy interest rates causes increase in the lending rates to individuals and corporates which hurts both the effective demand and supply forces to operate in the planned way. There is a fear of stagflation or slow down in the economic activity in such a scenario and that is why in the Monthly Economic Review the government has raised the concern about the possibility of the twin deficit problem emerging in India.
In order to complement the central bank’s efforts to tame inflation, the government reduced excise duty on diesel and petrol in order to curb the end-user prices. This caused the revenue stream squeeze from this source. On the other hand, the burden of subsidies kept increasing. In particular the food subsidy is likely to increase to Rs. 2.87 trillion as compared to the budget estimate of Rs. 2.07 trillion as the PM Garib Kalyan Anna Yojana has been extended to September 2022.
In addition, the government announced doubling of the fertilizer subsidy in order to protect the farmers against the steep rise in the fertilizer prices. As a result, the fertilizers subsidy bill for the Financial Year 2023 is expected to increase to Rs. 2.5 trillion as against the Budget estimate of Rs. 1.05 trillion all due to an increase in the fertilizer prices. Further the subsidy burden on the LPG cylinder also increased as the government tried to douse forces that fuel inflationary expectations.
Geo-political tensions shall continue to be a challenge
Ukraine and Russia, the two warring nations as on date, together account for about 20 to 30 per cent share in the global wheat market. Obviously, the Russia-Ukraine conflict created a wheat shortage in the global market resulting in international wheat prices rising from 250.5 GBP per ton in end February to 322 GBP per ton in end May 2022. The non-food inflation has been mainly fueled by sharp volatility and uptick in global crude oil prices.
To add to the woes of the Indian economy, there was a surge in the average price of Brent crude which increased from USD 105.8 per barrel in April 2022 to USD 112.4 barrel in May 2022 on account of increase in its demand from China as Covid-19 norms eased out over there and due to reduction in demand for the oil imports from the warring nation. Since India imports about 80 per cent of its crude oil needs, such increase in global crude oil prices only added to the overall import bill and contributed to the widening of its trade deficit.
Yet Stagflation is a distant possibility
As per the MER of May 20212, there seem to be some escape routes available and the economy may avoid getting trapped into stagflation sort of scenario. The following are some of the positive factors that may help sustain economic growth:
- The launch of the production linked incentive scheme is a very thoughtful way to do supply side management for easing out inflationary pressures. In traditional economics the prices would tend to decrease if the supply curve shifts to the right other things remaining the same. The Production Linked Incentive Scheme (PLIS) has been successfully launched in 14 sectors.
- The development of renewable sources of energy while diversifying import dependence on crude oil will soften the imports bill burden, and
- There are signs of strengthening of financial metrics and an uptick in credit demand.
Besides, the capex budget for 2022-23 will throughout provide a strong stimulus to growth except that have to be rationalized as government revenues have reportedly taken a hit due to reduction in excise duties on diesel and petrol leading to an increase in the gross fiscal deficit beyond the estimated levels.