Monday, June 11, 2012

The Fiscal Deficit - Is it really that bad

We are hearing a lot about this term "Fiscal Deficit" and more likely it has been depicted as the Devil behind all this recent economic mayhem experienced in India.You talk to any International Investment banker / Analyst / Economist and he will refer to the fiscal deficit number as the major bottleneck with of the biggest reason for rerating India downwards by the investors of the world.
To deliberate on this let us try to understand the definition of this term in simpler words.
What is Fiscal Deficit?
Fiscal deficit is an economic phenomenon, where the Government's total expenditure surpasses the revenue generated. It is the difference between the government's total receipts (excluding borrowing) and total expenditure. Fiscal deficit gives the signal to the government about the total borrowing requirements from all sources whether internally (from Domestic Tax payers) or externally (from other nations or Institutions). This Deficit is mostly measured as a percentage to the Gross Domestic Production (commonly known as GDP) of that nation.  With this definition – it becomes clear that Deficit is indeed a worry – how long can someone survive with Deficits running year to year. But wait! This can turn out to be half baked conclusion.
I shall try to avoid being hugely technical – however a little understanding of this phenomenon will yield an obvious analysis.  Let us take the case of our nation - the Indian Government has adopted the strategy of posting Fiscal Deficits year on year. Meaning they should have borrowed that much money every year (from internal or outside sources). This borrowing should have accumulated to a sizable figure. In Economic dictionary this is known as "Public Debt". All fiscal deficit issues culminate into the Public Debt going up for the if the issue of Fiscal Deficit is a problem – its outcome (read Public Debt) should be more of a concern.....therefore deliberating on the question "Public Debt – whether a menace to the economy" rather than "Fiscal Deficit – whether a menace to the economy" might be more prudent.
Debt by nature is a burden for future years – so it has to be bad. But one cannot extend such a generalised statement. Debt incurred on account of capital expenditure/investment is hugely beneficial as its output will arrive in future years. Debt raised and spend by way of subsidies/grants to counter balance the ill-effects of Capitalism is also welcome – what I mean by ill-effects of Capitalism is cornering of wealth rich becoming richer and subsequent widening of gap between rich & poor.  So there comes a rider that Debt may not be that bad if spend for purposes as mentioned above.
Now let us understand the sources of Debt meaning nature of money raised.
Public Debt can be raised from internal sources (from the constituents of the economy) and also from the external sources (raised from foreign nations, institutions). Not that the later is bad – but former mode of raising money (internal sources) is far better and less worrisome. The internal (Domestic) Public Debt accumulated over the years is actually a burden on the Tax Payers/constituents of the economy meaning revenue of future years collected in Advance from the constituents of the economy. This future revenue so collected is spent by the Government back on the same very constituents from whom it is collected. So how can they be a burden! Fortunately in India – due to high saving rates – we have this benefit of continuous availability of domestic debt unlike the western nations which spend on tomorrow's earnings.
So finally we arrive at the conclusion that – Rise in Public Debt on account of spending for investments/infrastructure or countering the ill effects of capitalism by borrowing more from internal sources is a welcome step. We realise that Public Debt of such nature is actually not bad. It is rather the Good Cholesterol, which is required to keep the bad cholesterol (read depression / slowing down / stagnation) under check to keep the body (read Economy) healthy.
Another aspect to Public debt which we forget is whether this Debt should be seen in absolute numbers (the amount of money owed by the Government) or should it be measured as a percentage to GDP. Is it possible that Public Debt in absolute numbers may rise but as a percentage to GDP might fall over the years? And if yes –what does it signify? The answer to the first question is a big "Yes" (as shown in the chart below) and when this happens – it only signifies that the economy is moving in the right direction.
This can be well understood by way of an example. All enterprise/companies wish to grow. This growth requires capital/funds as one of the input. This capital can be borrowed if the company has exhausted its own equity. The company will not frustrate its growth for want of Equity as long as it is getting debt (leveraging). If it has equity it would still want to leverage more to capture the growth available. A stage will come when it stops leveraging. This situation signifies two things
1) the company is able to fund its expansion from its own equity and has become conservative, because it doesn't find any merit to expand more with borrowed money as pay-offs are not appropriate or
2) it has actually stopped growing and so doesn't require money anymore.
In both the situation the company is slowing or decelerating which is the opposite of growing. When leveraging is reducing or converging to "ZERO" – the growth curve starts flattening out.
The same holds true for an economy...Leveraging shows things are growing. But, there is a Caveat to this statement, excess of anything is bad as they say. One has to observe reasonableness in Leveraging and that is what we are trying to define. What is reasonable leveraging? Measuring debt to the repayment capacity is the best ratio and so measuring Public Debt to the Overall GDP should give an indication of its reasonableness.
We therefore try measuring Public Debt as a percentage of GDP. If this shows a declining trend then it fits into our criteria of Reasonableness. In India (table below) we find the Public Debt in absolute number increasing but simultaneously the GDP (read the denominator) is growing at a rate higher then Debt which throws a comfortable ratio of Debt over GDP indicating enough evidence to show the economy is not unwell. As the GDP grows (we happen to be the second best growing economy) – this percentage of Public Debt over GDP will fall further. So lets us not harp on the Fiscal Deficit or Say Public Debt playing spoil sport in India. If that be the reason – that what happens to Japan which has public Debt crossing 200% of its GDP....USA is almost 100% public debt to GDP much ahead to India in this ratio...and with more of QE's / bailouts by the Governments (including Euro-Zone countries) the figure for such countries is going to only worsen going forward.
The table below shows the Public Debt percentage to GDP over the last few years for Indian Economy...:-
Gross debt
Percent Change
Gross debt
Percent Change
Source – IMF – 2011 World Economic Outlook
We observe that the average Public Debt over GDP for India has been around 78% but what is important to note is the drop from these average levels post Yr 2005 onwards despite an increase in absolute number of Public Debt. Why then the economist world over are perturbed with this fiscal deficit number of India slipping? Why don't they talk about the Public Debt as a percentage to GDP reducing over the years? Why don't we infer that this is a positive sign of economy growing?All a matter of visibility.
Japan/ USA and other Euro Zone countries have alarming Public Debt measure as a percentage to their GDP and with so less GDP growth – it becomes all the more alarming. Still – on account of the strong visibility created by such countries, the world investors develop a "Feel Safe factor" overriding their decisions and they are more willing to subscribe to loan papers of such nations. This makes the task easier for such nations to ride more of leveraging and try fuel their slow economic growth (knowing fully-well that they are entering the danger zone of unreasonableness). Whereas, India despite a comfortable figure is being portrayed as bad investments and we find the run on Indian Currency.
Visibility of the economic condition, proper representation on all World Economic platforms is a call of the day – and our Politicians have utterly failed in this exercise. We have a massive market (size of Indian Market) coupled with conservative economy, and growing GDP – which should be a huge attraction to the investors' world over......
Then why Foreign Investors are shying away from investing.... Plain and simple – OUR POLITICIANS who represent us have put such a clumsy show; have conveyed to the world how confused we are in our policies that despite good indicators – the investor money is afraid of betting money on India. And to top it, our industry representatives have also started voicing that they feel more comfortable running businesses – not at home but outside.We have been more visible as a corrupt state rather than our growing economy.
We need to correct this portrayal of India. It is the visibility factor rather than Fiscal Deficit which is playing spoil sport.
By: Inani BP

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