Fiscal Defcit and Its Impact on Indian Economy

CAPSTONE PROJECT REPORT

SUBMITTED IN PARTIAL FULFILLMENT OF THE

REQUIREMENT FOR THE AWARD OF

MASTER OF MANAGEMENT STUDIES (MMS)

ON THE TOPIC

‘FISCAL DEFICIT AND ITS IMPACTON INDIAN

ECONOMY’

SUBMITTED TO

S.I.E.S COLLEGE OF MANAGEMENT STUDIES

NERUL, NAVI MUMBAI

BY

HARSH M SANKHALA

ROLL NO. 62

BATCH 2011-13 (MMS FINANCE)

Acknowledgment

I have taken efforts in this project. However, it would not have been possible without the kind

support and help of many individuals and organizations. I would like to extend my sincere

thanks to all of them.

I am highly indebted to Mrs. Madhavi Dhole for her guidance and constant supervision as

well as for providing necessary information regarding the project & also for his support in

completing the project.

I would like to express my gratitude towards Mr CR Radhakrishnan, (Dean Finance

SIES College of Management Studies Nerul for his kind co-operation and encouragement

which help me in completion of this project.

Harsh M Sankhala

Roll No 62

SIES college of Management Studies

1

Declaration

I hereby declare that this project report on, “Fiscal Deficit and Its Impact on Indian

Economy”, which is being submitted in partial fulfilment of the program Master of

Management Studies year 2011-13 is a result of the work carried out by me. I further declare

that I or any other person has not previously submitted this project report to any other

institution or university for any other degree or diploma.

Date:

2

CERTIFICATE

This is to certify that Mr. Harsh Mohanlal Sankhala studying in the second year of MASTER OF

MANAGEMENT STUDIES (MMS) at SIES College of Management Studies, Nerul, Navi

Mumbai, has completed the Capstone Project titled “Fiscal Deficit and Its Impact on Indian

Economy” as a part of the course requirements for MASTER OF MANAGEMENT STUDIES

(MMS) Program.

Date:

Signature of the Faculty Guide

Name: Prof Madhavi Dhole

3

ContentsExecutive Summary...............................................................................................................................6

Objective...............................................................................................................................................7

Methodology.........................................................................................................................................8

1. Introduction.......................................................................................................................................9

1.1.Trends in Deficit of Central Government in India......................................................................10

1.2.Trends in India’s Fiscal Policy.....................................................................................................11

2. Fiscal Deficit and Economic Growth................................................................................................14

2.1. Introduction..............................................................................................................................14

2.2. Gross Fiscal Deficit and Growth Rate of Gross Domestic product:-..........................................15

2.3. Empirical Analysis of Economic Growth and Fiscal Deficit:.......................................................20

2.4. Conclusion................................................................................................................................22

3. Inflation and Fiscal Deficit................................................................................................................23

3.1. Introduction..............................................................................................................................23

3.2. Analytical Framework...............................................................................................................26

3.3. Graphical Analysis.....................................................................................................................28

3.4. Quantitative Analysis................................................................................................................29

3.5. Conclusion................................................................................................................................32

4. Current Account Deficit and Fiscal Deficit........................................................................................33

4.1. Introduction..............................................................................................................................33

4.2. Theoretical Perspective............................................................................................................33

4.3. Quantitative Analysis................................................................................................................40

4.4. Conclusion................................................................................................................................42

References...........................................................................................................................................43

Appendix.............................................................................................................................................44

4

List of Tables and GraphsGraph 1.1. Deficits over the years 11

Graph 2.1. GDP and Gross Fiscal Deficit 15

Table 2.1 Different Theories 18

Figure 3.1. Inflation and Fiscal Deficit Cycle 26

Graph 3.1. WPI Inflation and Gross Fiscal Deficit 28

Graph 3.2. WPI Inflation and Mo 29

Figure 4.2. Empirical Tests of Twin Deficits Hypotheses 35

Table 4.1. Some Cross-Country Evidence of the Twin Deficits over

Different Time Spans 35

Graph 4.1. India’s Current Account Deficit and Fiscal Deficit as percentage 39

of GDP

5

Executive Summary

Fiscal deficit is one of the most important data from any economy which is seen by the

economist around the world. It is one data probably which had become a cause of concern for

the Indian economy wherein India was on the verge of being downgraded. The current study

tries to understand the impact fiscal deficit has on various important areas of the country.

Firstly the study tries to understand the impact fiscal deficit has on an economy using Indian

economy as a case. Secondly the study tries to understand the impact of fiscal deficit on

inflation. The fiscal response in India to deal with the impact from the global crisis during

2008-10 was driven by the need to arrest a major slowdown in economic growth. However,

there could be medium-term risks to the future inflation path, in the absence of timely fiscal

consolidation. As highlighted in the study, fiscal deficit is seen to influence the inflation

process through either growth of base money or higher aggregate demand. The recent global

financial crisis has led to graver imbalances in both the external and the internal deficits of

several countries including India. This study was undertaken with a view to examining the

causal linkages between the government budget deficit and the current account deficit for

India, within a multi-dimensional system with interest rates acting as the interlinking

variables. The causal chain of such linkages is important as different results lead to very

different policy recommendations regarding the target variable for controlling the twin

deficits

6

Objective

To relationship between Fiscal Deficit and Economic Growth.

To study the impact of Fiscal deficit on inflation

To study Fiscal and Current Account deficit

Limitations:

The study has considered only limited factors and other factors impacting (Inflation,

Growth and CAD) the test variables are not considered

The variables are not tested for unit root and stationarity.

7

Methodology

The present study uses a quantitative and graphical analysis to understand the effect of

various macroeconomic factors.

Data Source: Data source involves secondary data of various macro-economic factors and

also policy rates and actions available on various reporting platform like RBI Database on

Indian economy, CCIL, Ministry of statistic website.

Methodology:

Graphical Analysis: Through graphical analysis we would be able to understand the

trends and correlations existing between Fiscal Deficit and various parameters.

Graphical analysis helps in locating any variances in the said relationship between

variables and trying to understand the variance

Quantitative Analysis: Quantitative analysis includes correlation and multivariate

analysis. The multivariate analysis is validated by testing for cointegration using

Durbin Watson Test.

8

1. Introduction

What is Fiscal Deficit?

We've all heard about it and we've all read articles that worry about a large fiscal deficit,

whether in India or in the United States. But the question is what the problem with a big

fiscal deficit is? Indeed, what is it to begin with? Every year, the Government puts out a plan

for its income and expenditure for the coming year. This is, of course, the annual Union

Budget. A budget is said to have a fiscal deficit when the Government's expenditure exceeds

its income. When this happens, the Government needs additional funds. Now there are two

ways for the Government to arrange these funds. The first is, of course, to borrow. The

Government can borrow either from the citizens themselves or from other countries or

organisations like the World Bank or the IMF. The money borrowed by a nation's

Government is called public debt. As on any other debt, the Government promises to pay a

certain rate of interest. To pay this interest in the future, the Government has three options:

1. increase the amount of taxes collected by increasing the tax rates;

2. help stimulate economic growth so that tax collection automatically increases with it; or

3. print new currency notes to pay back the debt – also called debt monetization.

Gross Fiscal Deficit:

The gross fiscal deficit (GFD) of government is the excess of its total expenditure, current

and capital, including loans net of recovery, over revenue receipts (including external grants)

and non-debt capital receipts.” The net fiscal deficit is the gross fiscal deficit reduced by net

lending by government (Dasgupta and De, 2011). The gross primary deficit is the GFD less

interest payments while the primary revenue deficit is the revenue deficit less interest

payments

Fiscal Deficit = Total Expenditure (that is Revenue Expenditure + Capital Expenditure) –

(Revenue Receipts + Recoveries of Loans + Other Capital Receipts (that is all Revenue and

Capital Receipts other than loans taken))

9

1.1.Trends in Deficit of Central Government in India

The following figure-1 traces the trends in deficits of central government over the past four

decades. The gross fiscal deficit as a percent of Gross Domestic Product (GDP) increased

from 3.04 percent of GDP in 1970-71 to the peak of 8.37 percent in 1986-87 and then

declined to 4.84 percent in 1996-97. It was around 7 percent of GDP during 1987-88 to 1990-

91. During the 1990s the average fiscal deficit as a percent of GDP was 5.67 percent.

However, after 2003-04 central governments contained the fiscal deficit from 4.48 percent of

GDP to its all time minimum of 2.54 percent in the year 2007-08. Then it increased to 6.48

percent in 2009-10 and declined to 5.89 percent. In it was 5.8% of GDP in 2011-12 and now

the ABE of 5.2% in 2012-13. Similarly primary deficit, which is fiscal deficit excluding

interest payment has increased from 1.74 percent in 1970-71 to a peak of 5.43 percent in

1986-87 and declined to 0.53 percent of GDP in 1996-97. Primary deficit was dissolved from

the year 2003-04 to the year 2007-08 except the year 2005-06. It was 2.78 percent during the

year 2011-12. After 1991-92, primary deficit has declined much due to the rising interest

payment and to some extent a decline in fiscal deficit. Revenue deficit was incurred in the

period 1971-72 and 1972-73. It was 0.57 percent in 1979-80, after that it increased to 3.26

percent in 1990-91. It reached maximum of 5.25 percent of GDP in 2009-10. The average of

revenue deficit as a percentage of GDP in 1980s, 1990s and 2000s has been 1.72 percent,

3.02 percent and 3.40 percent respectively. It was 4.46 percent of GDP during the period

2011-12

10

1970-71

1973-74

1976-77

1979-80

1982-83

1985-86

1988-89

1991-92

1994-95

1997-98

2000-01

2003-04

2006-07

2009-10

2012-13 0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

Revenue DeficitGross Primary DeficitGross Fiscal Deficit

Graph 1.1. Deficits over the years

1.2.Trends in India’s Fiscal Policy

Fiscal policy deals with the taxation and expenditure decisions of the government. Monetary

policy, deals with the supply of money in the economy and the rate of interest. Fiscal policy

is composed of several parts. These include, tax policy, expenditure policy, investment or

disinvestment strategies and debt or surplus management. Fiscal policy is an important

constituent of the overall economic framework of a country and is therefore intimately linked

with its general economic policy strategy. Fiscal policy also feeds into economic trends and

influences monetary policy

India Fiscal Policy Frame Work

The Indian Constitution provides the overarching framework for the country’s fiscal policy.

India has a federal form of government with taxing powers and spending responsibilities

being divided between the central and the state governments according to the Constitution.

11

The sharp deterioration of the fiscal situation in the 1980s resulted in the balance of payments

crisis of 1991. Following economic liberalisation in 1991, when the fiscal deficit and debt

situation again seemed to head towards unsustainable levels around 2000, a new fiscal

discipline framework was instituted. At the central level this framework was initiated in 2003

when the Parliament passed the Fiscal Responsibility and Budget Management Act

(FRBMA).

Evolution of Indian fiscal policy

India commenced on the path of planned development with the setting up of the Planning

Commission in 1950. That was also the year when the country adopted a federal Constitution

with strong unitary features giving the central government primacy in terms of planning for

economic development. The subsequent planning process laid emphasis on strengthening

public sector enterprises as a means to achieve economic growth and industrial development.

The resulting economic framework imposed administrative controls on various industries and

a system of licensing and quotas for private industries. Consequently, the main role of fiscal

policy was to transfer private savings to cater to the growing consumption and investment

needs of the public sector. Other goals included the reduction of income and wealth

inequalities through taxes and transfers, encouraging balanced regional development,

fostering small scale industries and sometimes influencing the trends in economic activities

towards desired goals.

The major developments in India’s fiscal policy from the early stages of planned

development in the 1950s, through the country’s balance of payments crisis of 1991, the

subsequent economic liberalisation and rapid growth phase, the response to the global

financial crisis of 2008 and the recent post-crisis moves to return to a path of fiscal

consolidation. India’s fiscal policy in the phase of planned development commencing from

the 1950s to economic liberalisation in 1991 was largely characterised by a strategy of using

the tax system to transfer private resources to the massive investments in the public sector

industries and also achieve greater income equality. The result was high maximum marginal

income tax rates and the consequent tendency of tax evasion. The public sector investments

and social expenditures were also not efficient. Given these apparent inadequacies, there were

limited attempts to reform the system in the 1980s. However, the path of debt-induced growth

that was pursued partly contributed to the balance of payments crisis of 1991.

12

Following the crisis of 1991, the government charted out a path of economic liberalisation.

Tax reforms focussed on lowering of rates and broadening of the tax base. There were

attempts to curb subsidies and disinvest the government holdings in the public sector

industries. While initially the fiscal deficit and public debt were brought under control, the

situation again started to deteriorate in the early 2000s. This induced the adoption of fiscal

responsibility legislations at the central and state levels. There were also reforms in the state

level tax system with the introduction of VAT. Consequently there were major improvements

in the public finances. This probably contributed to the benign macro-fiscal environment of

high growth, low deficits and moderate inflation that prevailed around 2008. The global

financial crisis brought an end to this phase as the government was forced to undertake sharp

counter-cyclical measures to prop up growth in view of the global downturn. Measures

included, excise duty cuts, fiscal support to selected export industries and ramping up public

expenditure.

The Indian economy weathered the global crisis rather well with growth going down to 5.8

percent in the second half of 2008-09 and then bouncing back to 8.5 percent in 2009-10. In

view of the recovery, a slow exit from the fiscal stimulus was attempted in a manner whereby

fiscal consolidation was achieved without hurting the recovery process. Recent policy

documents like the 12th Plan Approach Paper and the government‟s Fiscal Policy Strategy

Statement of 2011-12 appear to indicate that the fiscal consolidation mindset is fairly well

institutionalised in the country’s policy establishment (Planning Commission, 2011; Ministry

of Finance, 2011). This is partly reinforced by institutional structures like fiscal responsibility

legislations and the regular Finance Commissions that mandate the federal fiscal transfer

regime. In the future, it appears that the government would focus on tax reforms and better

targeting of social expenditures to achieve fiscal consolidation while maintaining the process

of inclusive growth.

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2. Fiscal Deficit and Economic Growth

2.1. IntroductionThe impact of fiscal deficit on economic growth is one of the highly debated issues in all

world economies. The target of achieving sustained growth and maintaining macroeconomic

stability is the dream among many developed, developing and underdeveloped economies.

The economic growth and stability of developing countries in recent times has brought the

issues of fiscal deficit into sharp focus. Continuing high levels of fiscal deficit, even if

adoption of fiscal Responsibility and Budget Management Act (FRBM), pose a serious

danger to macroeconomic stability in India. The excessive fiscal deficits seem to be the major

concern of academicians and policy makers in India. The annual growth rate of GDP is 6.5

percent in 2011-12, whereas gross fiscal deficit is 5.8 percentage of GDP in same period in

India. Now, the question of interest is whether this persistent fiscal deficit hampers economic

growth in India? How has increase in fiscal deficits impacted India’s economic growth over

the last four decades? In India, gross fiscal deficit is defined as the excess of the sum total of

revenue expenditure, capital outlay and net lending over revenue receipts and non-debt

capital receipts including the proceeds from disinvestment. The government has to incur

deficits to finance its revenue and expenditure mismatches and also to finance investments.

The problem arises when the deficit level becomes too high and chronic.

The ill-effects of high deficits are linked to the way they are financed and how it is

used. The fiscal deficits can be financed through domestic borrowing, foreign borrowing or

by printing money. Excess use of any particular mode of financing of the fiscal deficit has

adverse macroeconomic consequences, viz, seigniorage financing of fiscal deficit can create

inflationary pressures in the economy, bond financing of fiscal deficit can lead to rise in

interest rates and in turn can crowd out private investment and the external financing of fiscal

deficit can spill over to balance of payment crisis and appreciation of exchange rates and in

turn debt spiraling. Sometime large fiscal deficit can affect the country’s economic growth

adversely. A higher fiscal deficit implies high government borrowing and high debt servicing

which forces the government to cut back in spending on relevant sectors like health,

education and infrastructure. This reduces growth in human and physical capital, both of

which have a long-term impact on economic growth. Large public borrowing can also lead to

crowding out of private investment, inflation and exchange rate fluctuations. However, if

productive public investments increase and if public and private investments are

14

complementary, then the negative impact of high public borrowings on private investments

and economic growth may be offset. Fiscal deficit used for creating infrastructure and human

capital will have a different impact than if it is used for financing ill targeted subsidies and

wasteful recurrent expenditure. Therefore the fear about high fiscal deficit is justified if the

government incur deficit to finance its current expenditure rather than capital expenditure.

In this context, it is important to understand the consequences of rising fiscal deficit

on the economic growth of Indian economy. There have been concerns about the high fiscal

deficit. The literature, in particular the empirical part, on the relationship between fiscal

deficit and economic growth is scarce.

2.2. Gross Fiscal Deficit and Growth Rate of Gross Domestic product:-

As it is clear from the figure-2.1, India’s economic growth rate has been plotted against this

GFD to GDP ratio for the period 1970-71 to 2011-12. It is seen that the rate of growth is

lower when the GFD-GDP ratio of the Central government is high. This implies higher fiscal

deficit may be detrimental for the Indian economy.

1983

-84

1985

-86

1987

-88

1989

-90

1991

-92

1993

-94

1995

-96

1997

-98

1999

-00

2001

-02

2003

-04

2005

-06

2007

-08

2009

-10

2011

-12

0.00

2.00

4.00

6.00

8.00

10.00

12.00

Gross Fiscal DeficitGDP

Graph 2.1. GDP and Gross Fiscal Deficit

15

2.2.1.Theoretical Perspectives:

There is no agreement among economists either on analytical grounds or on the basis of

empirical results whether financing government expenditure by incurring a fiscal deficit is

good bad, or neutral in terms of its real effects, particularly on investment and growth.

Generally speaking, there are three schools of thought concerning the economic effects of

budget deficits:

Neoclassical, Keynesian and Ricardian. Among the mainstream analytical perspectives, the

neoclassical view considers fiscal deficits detrimental to investment and growth, while in the

Keynesian paradigm, it constitutes a key policy prescription. Theorists persuaded by

Ricardian equivalence assert that fiscal deficits do not really matter except for smoothening

the adjustment to expenditure or revenue shocks. While the neo-classical and Ricardian

schools focus on the long run, the Keynesian view emphasizes the short run effects

The Neo-Classical ViewThe component of revenue deficit in fiscal deficits implies a reduction in government saving

or an increase in government dis-saving. In the neoclassical perspective (see, e.g. Bernheim,

1989), this will have a detrimental effect on growth if the reduction in government saving is

not fully offset by a rise in private saving, thereby resulting in a fall in the overall saving rate.

This, apart from putting pressure on the interest rate, will adversely affect growth. The neo-

classical economists assume that markets clear so that full employment of resources is

attained. In this paradigm, fiscal deficits raise lifetime consumption by shifting taxes to the

future generations. If economic resources are fully employed, increased consumption

necessarily implies decreased savings in a closed economy. In an open economy, real interest

rates and investment may remain unaffected, but the fall in national saving is financed by

higher external borrowing accompanied by an appreciation of the domestic currency and fall

in exports.In both cases, net national saving falls and consumption rises accompanied by

some combination of fall in investment and exports. The neo-classical paradigm assumes that

the consumption of each individual is determined as the solution to an inter-temporal

optimisation problem where both borrowing and lending are permitted at the market rate of

interest. It also assumes that individuals have finite life spans where each consumer belongs

to a specific generation and the life spans of successive generations overlap. Citing recent

evidence in the US context, Gale and Orszag(2002), observe that a reasonable estimate is that

a reduction in the projected budget surplus (or increase in the projected budget deficit) of one

16

percent of GDP will raise long-term interest rates by 50 to 100 basis points. In their view,

fiscal discipline promotes long-term growth primarily because budget surpluses are a form of

national saving.

Keynesian View of Fiscal Deficits

The Keynesian view in the context of the existence of some unemployed resources,

envisages that an increase in autonomous government expenditure, whether investment or

consumption, financed by borrowing would cause output to expand through a multiplier

process. The raditional Keynesian framework does not distinguish between alternative uses of

the fiscal deficit as between government consumption or investment expenditure, nor does it

distinguish between alternative sources of financing the fiscal deficit through monetisation or

external or internal borrowing. In fact, there is no explicit budget constraint in the analysis.

Subsequent elaborations of the Keynesian paradigm envisage that the multiplier-based

expansion of output leads to a rise in the demand for money, and if money supply is fixed and

deficit is bond financed, interest rates would rise partially offsetting the multiplier effect.

However, the Keynesians argue that increased aggregate demand enhances the profitability of

private investment and leads to higher investment at any given rate of interest. The effect of a

rise in interest rate may thus be more than neutralised by the increased profitability of

investment. Keynesians argue that deficits may stimulate savings and investment even if

interest rate rises, primarily because of the employment of hitherto unutilised resources.

However, at full employment, deficits would lead to crowding out even in the Keynesian

paradigm. In the standard Keynesian analysis, if everyone thinks that a budget deficit makes

them wealthier, it would raise the output and employment, and thereby actually make people

wealthier. Unlike the loanable funds theory, the Keynesian paradigm rules out any direct

effect on interest rate of borrowing by the government.

Ricardian Equivalence Perspective

In the perspective of Ricardian, fiscal deficits are viewed as neutral in terms of their

impact on growth. The financing of budgets by deficits amounts only to postponement of

taxes. The deficit in any current period is exactly equal to the present value of future taxation

that is required to pay off the increment to debt resulting from the deficit. In other words,

government spending must be paid for, whether now or later, and the present value of

spending must be equal to the present value of tax and non-tax revenues. Fiscal deficits are a

17

useful device for smoothening the impact of revenue shocks or for meeting the requirements

of lumpy expenditures, the financing of which through taxes may be spread over a period of

time. However, such fiscal deficits do not have an impact on aggregate demand if household

spending decisions are based on the present value of their incomes that takes into account the

present value of their future tax liabilities. Alternatively, a decrease in current government

saving that is implied by the fiscal deficit may be accompanied by an offsetting increase in

private saving, leaving the national saving and, therefore, investment unchanged. Then, there

is no impact on the real interest rate. Ricardian equivalence requires the assumption that

individuals in the economy are foresighted, they have discount rates that are equal to

governments’ discount rates on spending and they have extremely long time horizons for

evaluating the present value of future taxes. In particular, such a time horizon may well

extend beyond their own lives in which case they save with a view to making altruistic

transfers to take care of the tax liabilities of their future generations

The economic universe of these alternative schools of thought also is characterised by

individuals who differ in their behavioural responses in critical respects. The Keynesian

world is inhabited by myopic, liquidity constrained individuals who behave under money

illusion, and have a high propensity to consume out of current disposable income. The

Ricardian equivalence people conceive of a universe of farsighted, fully informed, altruistic

individuals. The neo-classical world is inhabited by rational individuals who respond to real

changes in their wealth portfolios, and who are farsighted enough to plan consumption over

their life-cycle. Table 2.1 summarises the main differences in these alternative paradigms.

Table 2.1 Different Theories

Neo-Classical Ricardian Keynesian

Consumers Finite, life-time

horizon

Infinite time

perspective through

altruistic transfers

Myopic,

liquidity

constrained

Effects of a deficit

based tax cut on

private saving

Private saving

would fall

Private saving

remains unaffected

Aggregate

demand

increases

Employment of

resources

Full employment Full employment Resources

not fully

18

employed

Effect on interest

rate

Interest rate

increases

No effect Interest rate

increases

Contention Fiscal deficits

detrimental

Fiscal deficits

Irrelevant

Fiscal deficits

Beneficial

In reality, an economy may be populated by all the three types of consumers. Depending on

which group is relatively larger, one or the other theory may be found to be more relevant in

different contexts

The ‘Tax and Spend’ Hypothesis

A fourth hypothesis formalised by supply side economists, is sometimes called the “tax and

spend” hypothesis. An exposition of the hypothesis is given in Vedder, Gallaway, and Frenze

(1987). In their view, raising taxes with a view to cutting down deficits would not work

because it would only encourage the politicians to spend more. The result would be that while

the deficit would remain the same, in the long run the size of the private sector would be cut

down. In their view, a tax cut, which puts pressure for contraction of government spending

leaving deficits and national savings unchanged, and which leads to an increase in private

consumption, should be considered more desirable. The main problem is that when

government expenditure does not fall, it has to run a deficit, which raises interest payments

and causes total government expenditure including interest payments to rise as a share of

GDP.

19

2.3. Empirical Analysis of Economic Growth and Fiscal Deficit:

From the graph above it was observed that the behavior of GDP and Gross Fiscal Deficit

followed a pattern except for the certain places and it is observed that as Gross Fiscal Deficit

increases the GDP decreases for most of the period which neo classical view supports. But

we can see that during certain period like 2008 -11 we observe a direct positive relationship

indicating that the economy was consumption driven and that to mostly propelled by

government funds. To develop the equation we would be using the multiple regressions to

develop an equation of GDP and Gross Fiscal Deficit. The independent variable here is Gross

Fiscal Deficit and the dependent variable is GDP. Also it can be observed from the graph that

there is a bit lag shown by GDP to Gross Fiscal Deficit in the early and late 90’s. The data

used is % change in GDP from 1980 to 2012 and Gross Fiscal Deficit as percentage of GDP.

Variable Type Details

GDP Dependent As % change over past year

Gross Fiscal Deficit Independent As % of GDP

Correlation Matrix

GDP Fiscal Deficit

GDP 1.000

Fiscal Deficit -.501 1.000

Regression Analysis

r² 0.251 n 30

r -0.501 k 1 Std.

Error 1.894 Dep. Var. GDP

ANOVA

table

Source SS df MS F p-value

Regression 33.7207 1 33.7207 9.40 .0048

20

Residual 100.4920 28 3.5890 Total 134.2127 29

Regression output confidence interval

variables coefficients std. error t

(df=30)

p-value 95% lower 95% upper

Intercept 10.9190 1.5237 7.166 8.46E-08 7.7980 14.0401 Gross Fiscal Deficit -0.7830 0.2555 -3.065 .0048 -1.3063 -0.2597

Durbin-Watson = 1.84

Testing for Co- integration:

To check for spurious regression due to trend following we will check the regression for co-

integration using Cointegrating Regression Durbin-Watson (CRDW) Test.

H0: GDP and Fiscal Deficit are Cointegrated

Ha: GDP and Fiscal Deficit are not Cointegrated

Dcal = 1.84

Dtable: 1.16 ( for 0.01 level of significance)

Since Dcal > Dtable

We accept null Hypothesis and GDP and Fiscal deficit are cointegrated

Hence we conclude that Economic growth shown by GDP and Fiscal Deficit shows a long

run relationship.

21

2.4. Conclusion R2 of 0.251 is small and indicates not so predicting relations between GDP and Gross

Fiscal Deficit

A negative r value indicates that Gross Fiscal Deficit has been detrimental to the

economic growth of the country

Graphical analysis indicates economic growth show a lag to Gross Fiscal Deficit

Cointegrating Regression Durbin-Watson (CRDW) Test validates the regression and

concludes that GDP and Gross Fiscal Deficit are Cointegrating to show a long term

relationship.

In the recent years it has shown a positive relation indicating the growth by propelled

by government spending (Fiscal Stimulus) during 2008-2011.

22

3. Inflation and Fiscal Deficit

3.1. Introduction

Fiscal stimulus emerged as the key universal instrument of hope in almost every

country around the world, when the financial crisis in the advanced economies snowballed

into a synchronised global recession. Borrowing as much at as low a cost as possible to

stimulate the sinking economies necessitated unprecedented coordination between the fiscal

and monetary authorities. It is the fiscal stance that had to be accommodated without any

resistance by the monetary authorities so as to minimise the adverse effects of the crisis on

output and employment, while also saving the financial system from a complete breakdown.

Given the deflation concerns in most countries -rather than the fear of inflation - monetary

authorities had no reasons to resist. The universal resort to fiscal stimulus, however, has now

led to significant increase in deficit and debt levels of countries, which has operated as a

permanent drag for some time, affecting the overall macroeconomic outlook, including

inflation. OECD projections indicate that OECD level fiscal deficit may reach 60 year high of

about 8% of GDP in 2010, and public debt may exceed 100% of GDP in 2011, which will be

30 percentage points higher than the comparable pre-crisis levels in 2007.

In India, the fiscal response to the global crisis was swift and significant, even though India

clearly avoided a financial crisis at home and also continued to be one of the fastest growing

economies in the world in a phase of deep global recession. Despite the absence of any need

to bailout the financial system, it is the necessity to partly offset the impact of deceleration in

private consumption and investment demand on economic growth, which warranted adoption

of an expansionary fiscal stance. One important consequence of this, though, was the

significant deviation from the fiscal consolidation path, and the resultant increase in the fiscal

deficit levels over four consecutive years (2008-12). The immediate impact of the higher

levels of fiscal deficit on inflation was almost negligible, since:

(a) the expansionary fiscal stance was only a partial offset for the deceleration in private

consumption and investment demand, as the output gap largely remained negative, indicating

no risk to inflation in the near-term, and

23

(b) despite large increase in the borrowing programme of the Government to finance the

deficit, there was no corresponding large expansion in money growth, since demand for

credit from the private sector remained depressed. Thus, neither aggregate demand nor

monetary expansion associated with larger fiscal deficits posed any immediate concern on the

inflation front.

The usual rigidity of deficit to correct from high levels to more sustainable levels in the near-

term, however, entails potential risks for the future inflation path of India, which become

visible when the demand for credit from the private sector reverts to normal levels and if the

revival in capital flows turns into a surge again over a sustained period. The major risk to

future inflation would arise from how the extra debt servicing could be financed while

returning to sustainable levels through planned consolidation. Revenue buoyancy associated

with the recovery in economic activities to a durable high growth path would only contribute

one part; the major important part, however, has to come either from a combination of higher

taxes, withdrawal of tax concessions and moderation in public expenditure, which could

weaken growth impulses and the pace of recovery, or from higher inflation tax, suggesting

higher money growth and associated pressure on future inflation. Conceptually, the risk to

inflation from high fiscal deficit arises when fiscal stimulus is used to prop up consumption

demand, rather than to create income yielding assets through appropriate investment, which

could have serviced the repayment obligations arising from larger debt. As highlighted by

Cochrane (2009) in the context of the US, “...If the debt corresponds to good quality assets,

that are easy...If the new debt was spent or given away, we’re in more trouble. If the debt will

be paid off by higher future tax rates, the economy can be set up for a decade or more of

high-tax and low-growth stagnation. If the Fed’s kitty and the Treasury’s taxing power or

spending-reduction ability are gone, then we are set up for inflation.” It may be worth

recognising that all over the world, at some stage, the risk of active anti-inflationary policy

conflicting with inflexible fiscal exit cannot be ruled out. As highlighted by Davig and

Leeper (2009) in this context for the US, “...as inflation rises due to the fiscal stimulus, the

Federal Reserve combats inflation by switching to an active stance, but fiscal policy

continues to be active....In this scenario, output, consumption and inflation are chronically

higher, while debt explodes and real interest rates decline dramatically and persistently”.

The future risk to inflation in India, from fiscal stimulus, thus could arise from the downward

inflexibility of the deficit levels, and with revival in demand for credit from the private sector

and stronger recovery taking economic growth closer to the potential, high fiscal deficits

24

could be manifested in the form of pressures on both aggregate demand and money supply.

Surges in capital flows could complicate the situation further. This Study recognises the

possible policy challenge arising from higher money growth on account of persistent large

fiscal deficits, revival in private credit demand and surges in capital flows, on the one hand,

and higher policy interest rate chasing higher inflation on the other. Possible crowding-out

effects associated with the fiscal imbalances may also lead to a situation where high inflation

and high nominal interest rates co-exist. Since much of these possibilities could be

empirically validated over time depending on what outcome actually may materialise in the

future, this Study only recognises the potential risk to future inflation path, and accordingly

aims at studying the relationship between fiscal deficit and inflation in India Macroeconomic

variables are generally interrelated in a complex manner. Therefore, a deeper understanding

of inflation dynamics would involve analysing its relationship with macroeconomic variables

such as deficit, money supply, public debt, external balance, exchange rate, GDP and interest

rates. In the literature, particularly in the developing country context, simple models are,

however, often used to analyse the inflationary impact of fiscal deficit. This largely reflects

the role of fiscal dominance, which has often been a phenomenon in many developing

countries. Thus, fiscal-based theories of inflation are more common in the literature of

developing countries. On the other hand, for developed countries, fiscal policy is often

considered to be unimportant for inflation determination, at least on theoretical grounds, as

the desire to obtain seigniorage revenue plays no obvious role in the choice of monetary

policy (Woodford, 2001). In the Indian context also, there are several studies analysing the

nexus between government deficits, money supply and inflation. The findings of these studies

generally point to a self perpetuating process of deficit-induced inflation and inflation-

induced deficit, besides the overall indication that government deficits represent an important

determinant of inflation. The above results have been on the expected lines given that till the

complete phasing out of the ad hoc treasury bills in 1996-97, a sizable portion of the

government deficit which could not be financed through market subscription was monetised.

However, extending the period of analysis further beyond the automatic monetisation phase,

Ashra et al. (2004) found no-long relationship between fiscal deficit and net RBI credit to the

Government and the latter with broad money supply. Thus, they concluded that there is no

more any rationale in targeting fiscal deficit as a tool for stabilisation. On the other hand,

Khundrakpam and Goyal (2009), found that government deficit continues to be a key factor

causing incremental reserve money creation and overall expansion in money supply, which

leads to inflation.

25

Figure 3.1. Inflation and Fiscal Deficit Cycle

3.2. Analytical FrameworkInflation, according to monetarists, is always and everywhere a monetary phenomenon.

However, it is viewed that fiscally dominant governments running persistent deficits would

sooner or later finance those deficits through creation of money, which will have inflationary

consequences. The rapid monetary growth may often be driven by underlying fiscal

imbalances, implying that rapid inflation is almost always a fiscal phenomenon. Historical

evidences have shown that governments’ often resorted to seigniorage (or inflation tax)

during times of fiscal stress, which has inflationary consequences. Thus, contemporary

macroeconomic literature, while trying to explain inflationary phenomenon has also focussed

on the fiscal behaviour, particularly in the developing country context. This is because

fiscally dominant regimes are often seen as a developing country phenomenon, due to less

efficient tax systems and political instability, which leads to short-term crisis management at

26

Fiscal Deficit

Finance through Montizing

Increases Liquidity in Economy

Leads to Demand Side Inflation

Financed through Borrowing

Results in Crowding out of Private investments

Leads to Supply Side Inflation

the cost of medium to long-term sustainability. As noted by Cochrane (2009), “...Fiscal

stimulus can be great politics, at least in the short-run.” Furthermore, more limited access to

external borrowing tends to lower the relative cost of seigniorage in these countries,

increasing their dependence on the inflation tax while delaying macroeconomic stabilisation.

The relationship between government deficit and inflation, however, is more often analysed

from a long-term perspective. This is because borrowing allows governments to allocate

seigniorage inter-temporally, implying that fiscal deficits and resort to inflation tax need not

necessarily be contemporaneously correlated. The short-run dynamics between inflation and

deficit is also complicated by the possible feedback effect of inflation on the fiscal balance. In

the short-run, the government might also switch to alternative sources of financing in relation

to seigniorage, weakening thereby the correlation between inflation, deficit and seigniorage.

A popular method of analysing the inflationary potential of fiscal deficit in India is through

its direct impact on reserve money, which via the money multiplier leads to increase in

money supply that in turn leads to inflation (Khundrakpam and Goyal, 2009). In this Study,

we analyse the inflationary potential of fiscal deficit by hypothesising that either: (i) there can

be a direct impact on inflation through increase in aggregate demand; or (ii) through money

creation or seigniorage; or (iii) a combination of both. The causality is described in the

following flow chart. In essence, though, one has to recognise that the increase in demand

financed by fiscal deficit would automatically lead to higher money supply through higher

demand for money. In a Liquidity Adjustment Facility (LAF) framework, increase in money

demand associated with higher government demand has to be accommodated, in order to

keep the short-term interest rates in the system, in particular the overnight call rate, within the

LAF (repo - reverse repo) corridor of interest rates. In a LAF based operating procedure of

monetary policy, thus, money supply is demand driven, and hence endogenous. To the extent

that fiscal deficit leads to expansion in money supply, associated inflation risk must be seen

as a fiscal, rather than monetary, phenomenon.

27

Fiscal Deficit Inflation

Seigniorage

Inflation TaxMoney Creation

Demand Pressure

In this study, fiscal deficit (D) is defined as the net borrowing requirement of the Central

Government. Thus, it is derived as total expenditure (revenue plus capital) of the central

government less the revenue receipts (tax and non-tax, including grants) less non-debt capital

receipts (such as disinvestment proceeds). In the literature, primary deficit, which is fiscal

deficit less interest payments, is also often considered for analysing the inflationary impact of

government deficit, in order to remove any possible endogeneity bias resulting from reverse

impact of inflation on nominal interest rate. However, given the interest rate regime in India,

we do not expect any such significant endogeneity.

3.3. Graphical Analysis

The graph below shows the relative trends of WPI and Gross Fiscal Deficit from 1983

to 2012.

1983-84

1986-87

1989-90

1992-93

1995-96

1998-99

2001-02

2004-05

2007-08

2010-11 0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

WPIGross Fiscal Deficit

Graph 3.1. WPI Inflation and Gross Fiscal Deficit

Inferences:

Going by the trend both Inflation and Fiscal Deficit follow a positive relationship i.e.

with increase in fiscal deficit inflation also increases

It can be observed that during the mid 2000s there is drop in fiscal deficit but inflation

shows a upward trend indicating other forces impacting inflation

28

Overall high fiscal deficit has been never good for the inflation in the Indian context

1983-84

1985-86

1987-88

1989-90

1991-92

1993-94

1995-96

1997-98

1999-00

2001-02

2003-04

2005-06

2007-08

2009-10

2011-12 0

5

10

15

20

25

30

35

Reserve Money (M0)WPI

Graph 3.2. WPI Inflation and Mo

Inferences:

Inflation and money supply doesn’t show a constant trend

Inflation shows lag to Reserve money at some places

The general trend is that both follow a positively related pattern

3.4. Quantitative AnalysisFrom the graph above it was observed that the behavior of WPI and Gross Fiscal Deficit

followed a pattern it is observed that as Gross Fiscal Deficit increases the inflation also

increases for most of the period. To develop the equation we would be using the multiple

regressions where we would regress WPI inflation rate on Gross Fiscal Deficit, base money

divided by GDP deflator (M0/GDP Deflator) and a lag variable of inflation. The independent

variable here is Gross Fiscal Deficit, M0 and lag inflation variable the dependent variable is

WPI inflation. Finally the result would also be tested for cointegration to confirm a long run

stable relationship


29

WPI Dependent As % change over past year


Base Money by GDP Deflator Independent Ratio of M0 and GDP Deflator

WPI (t-1) Independent Lag variable

Regression Analysis

R² 0.206

Adjusted

R²

0.111 n 29

R 0.454 k 3

Std. Error 2.511 Dep. Var. WPI

ANOVA

table


Regression 40.9528 3 13.6509 2.16 .1174

Residual 157.6707 25 6.3068

Total 198.6235 28


variables coefficient

s

std.

error

t

(df=25)

p-

value

95%

lower

95%

upper

Intercept 4.3840 3.2117 1.365 .1844 -2.2306 10.9986

Gross Fiscal

Deficit

0.0620 0.3807 0.163 .8720 -0.7220 0.8459

Mo/GDPDE -0.0801 0.1380 -0.580 .5670 -0.3644 0.2042

WPI (t-1) 0.4050 0.1835 2.207 .0367 0.0271 0.7829


30




H0: WPI, Fiscal Deficit and Base money are Cointegrated

Ha:WPI, Fiscal Deficit and Base money are not Cointegrated

Dcal = 2.05


Since Dcal > Dtable

We accept null Hypothesis and WPI, Fiscal deficit and M0 are cointegrated

Hence we conclude that WPI, Fiscal deficit and M0 shows a long run relationship.

31

3.5. Conclusion The empirical evidence suggest fiscal deficit do impact the inflation but the values of

regression and r2 suggest the impact is limited The reason for limited impact can also be the nature of the economy and the usage of

the fiscal deficit money It was observed that Fiscal deficit due to spending on non capital or investment

purpose generally leads to inflation as can be currently seen in Indian economy Money supply a measure for how fiscal deficit is financed also has impact on the

inflation. Even though the variables are Cointegrating indicating a long run relationship but it is

largely due to lag of inflation

32

4. Current Account Deficit and Fiscal Deficit

4.1. IntroductionIndian economy is one of the few economies in the world to have both fiscal and current

account deficits. Hence it is also termed as a twin deficit economy. The few economies which

are a member of this club are US, UK, Greece, Ireland etc. In other words, this membership is

nothing to be proud of as all these economies have faced severe recession in 2007. Twin-

deficit may not have been the sole reason for recession in these economies but did magnify

the impact of the crisis. academic economists and policymakers alike, from various angles.

For example, the possible link between fiscal deficits and current account deficits has spurred

many studies analyzing the“twin deficit” hypothesis, particularly for the case of the United

States. For countries where current account imbalances are especially large, a relevant

question has been to what extent fiscal adjustment can contribute to resolving external

imbalances.

4.2. Theoretical PerspectiveThe national account identity provides the basis of the relationship between budget deficit

and current account deficit as explained below.

The theoretical literature explaining the twin deficits has advanced from mainly two

broad strands, the first based on the Keynesian or the Mundell-Fleming framework and the

second based on the Ricardian framework. According to the conventional (or Keynesian)

proposition, an increase in budget deficits increases domestic absorption, which leads to

import expansion and worsens the trade deficit. Also, budget deficits imply greater spending

on domestic as well as foreign goods, the former pulling exports down and the latter pushing

imports up, especially in an economy with supply bottlenecks. In a Mundell-Fleming

framework of analysis (Fleming, 1962; Mundell,1963), budget deficits cause upward pressure

on interest rates that in turn trigger capital inflows and appreciation of the exchange rate,

which implies imports get cheaper and exports dearer leading to deterioration in the trade

deficit under a flexible exchange rate system(also referred to as the Feldstein chain; Feldstein,

1986). Under a fixed exchange rate regime, the budget deficit stimulus would generate higher

real income or prices and this would worsen the current account balance. In other words,

running a budget deficit ultimately widens the current account deficit under both fixed and

flexible exchange rate regimes although the transmission mechanisms may differ. On the

33

contrary, the second strand of literature, which is based on the Ricardian Equivalence

hypothesis (REH), familiarised in the seminal work of Barro (1974), proposes that foreseeing

higher tax liabilities (because of current fiscal expansions), people would save more and

consume less. As a result, an inter-temporal shift between taxes and budget deficits does not

impact the real interest rate, the quantity of saving and investment, or the current account

balance. Empirical analyses of the inter-linkages of the government budget and current

account deficits centre around testing of the hypotheses of the existence of causal

relationships between the two and the direction of causality, particularly when the two

deficits are found to show co-movement over time. Testing the Keynesian or the Mundell-

Fleming proposition would amount to testing whether a positive relationship exists between

the current account and budget deficits, and second, whether there exists a unidirectional

causal relation that runs from the budget deficit to the current account deficit. Testing for the

REH, on the other hand, would imply rejection of any causal relation between the two.

However, these are obviously not the only two possible outcomes between the two deficits. A

high correlation between the two deficits is also consistent with two other competing

hypotheses. The third view is about testing for unidirectional causality that runs from current

account deficits to budget deficits. This outcome is said to occur when the deterioration in the

current account leads to a slower pace of economic growth and hence increases the budget

deficit through a loss in revenues or pressures on the government to increase spending on

sectors affected by falling exports. The reverse causation may be particularly true for a small

open developing economy highly dependent on foreign capital and one whose budgetary

position is affected by large capital inflows or through debt accumulations that eventually

lead to a budget deficit. The experience of Latin American countries and to some extent East

Asian countries illustrates this point (Reisen, 1998). This reverse causality running from the

current account to the budget deficit is termed “current account targeting” by Summers

(1988), who pointed out that external adjustment may be sought by governments through the

fiscal policy. Crises induced government bailouts as well as fall in tax revenues due to a

decline in business in the export sector, tend to support the causality from the current account

to budget deficits. The final pattern of causal relation between the two deficits to be tested

relates to whether the two variables are mutually dependent or if there is a bi-directional (or

two-way) causality between government budget and current account deficit; while the budget

deficit may cause the current account deficit, the existence of significant feedback may cause

causality between the two variables to run in both directions. Thus empirical tests of a range

of hypotheses regarding the inter-linkages of the two (balances/) deficits are based on the

34

theoretical perspectives with the Keynesian (Mundell-Fleming) model and the REH on two

ends of the spectrum as Figure 4.2 makes clear

Figure 4.2. Empirical Tests of Twin Deficits Hypotheses

Conflicting Evidence across Countries

Table 4.1

Some Cross-Country Evidence of the Twin Deficits over Different Time Spans

Country/ Time Frame Evidence on Twin Deficits Country Groups

US, Canada, Japan,

Mexico Germany, UK

Annual, 1960 to 1984 Budget deficit increases current account,

deficit, except in the case of Japan.

OECD countries 1960-2003 Little evidence for the twin deficit

hypothesis or for a contemporaneous effect

of budget deficits on the current account,

while country-specific productivity shocks

appear to play a key role.

18 industrial and 71

developing countries

Annual, 1971 to -1995 Government budget balances positively

affect current account balances.

US Q1947 to 1987

Quarterly, 1973 anQ1

to 2004

Temporary increases in spending worsen

current account. No discernible causal

relationship between the two deficits.

An expansionary fiscal policy shock or

Q1increase in government budget deficit

improves the current account and

depreciates the exchange rate.

94(30 OECD 64

developing inclu-1

1973 to 2008 countriesFiscal deficits have a significantly

negative andrelationship with current-

35

ding India) account balances across all country

samples. Overall, a countries percentage

point increase in the fiscal deficit is

associated with a 0.15 to 0.21percentage

point increase in the current-account deficit.

5 North

European

countries

4 Asian

and US

Quarterly, 1980

Annual & to 2007

The results for Sweden are consistent with

the twin deficits hypothesis, which

indicates unidirectional causality from BD

Tigers CAD. Reverse unidirectional

causality runs CAD to BD for Denmark and

is mediated either by the exchange rate or

by both the exchange and interest rates.

Results for Norway indicate a

predominantly bi-directional causality.

Results for both Korea and Taiwan are

consistent with the causal link of twin

deficits hypothesis, implying that BD leads

to CAD. There is also evidence of the

indirect causal link for Taiwan to be

reversed from CAD to BD through the

exchange rate and interest rate. A two-way

causality is detected between the twin

deficits in Singapore, while the causal link

for Hong Kong runs from CAD to BD. The

Keynesian proposition holds for the US.

Asean 4 1976Q1 to 2000 Q4 Long-run relationships are between budget

and current account deficits. Keynesian

reasoning fits well for Thailand since there

is a unidirectional relationship running

from budget deficit to current account

deficit. For Indonesia the reverse causation

(current account targeting) is detected,

36

while the empirical results indicate that a

bidirectional pattern of causality exists for

Malaysia and the Philippines. Indirect

causal relationship runs from budget deficit

to higher interest rates, and higher interest

rates lead to the appreciation of the

exchange rate, which then leads to the

widening of the current account deficit.

Middle East and

North Africa

1997-2003 Twin deficit seems to hold for Oman. No

discernible effects running from budget

balance to trade balance is observed for

Egypt, Turkey, and Yemen. Reverse

causation holds for Syria and Yemen.

Current Account and Fiscal Balance in National Accounts

The national account identity provides the basis of the relationship between budget deficit

and current account deficit. The model starts with the national income identity for an open

economy that can be represented as:

Y = C + I + G + X – M (1)

where Y= gross domestic product (GDP), C = consumption, I = investment, G = government

expenditure, X = export and M = import. Defining current account (CA) as the difference

between export (X) and import (M), and rearranging the variables equation 1 becomes:

CA = Y – (C + I + G) (2)

where (C + I + G) are the spending of domestic residents (domestic absorption). In a closed

economy savings (S) equals investment (I) and given that Y – C = S, we have:

S = I + CA (3)

Equation 3 states that an open economy can source domestically and internationally for the

necessary funds for investments to enhance its income. In other words, external borrowings

37

allow for investments at levels beyond those that could be financed through domestic savings.

From the policy perspective, this relationship implies that policies supporting investments

have a negative impact on the current account, while policies that reduce consumption

(private on public) have a positive impact on current account.

National savings can be further decomposed into private (Sp) and government savings (Sg)

Sp = Y – T – C (4)

and

Sg = T – G (5)

where T is the government revenue. Using equations 4 and 5 and substituting into equation 3

yield:

Sp = I + CA + (G-T) (6)

or

CA = SP – I – (G – T) (7)

Equation 7 states that a rise in the government (budget) deficit will increase the current

account deficit if and only if, the rise in government deficit decreases total national savings.

Supposing that current tax revenues are held constant and (Sp – I) remains the same, an

increase in temporary government spending will cause government deficit to rise (G – T) and

will affect the current account positively. In this way the government deficit resulting from

increased purchase reduces the nation’s current account surplus, which in other words

suggests the worsening of external balances.

Figure 4.1, which traces the behaviour of India’s two deficits over the years, shows both

current account and fiscal deficits (CAD and FD as percentage of GDP) expanding during the

1980s, ultimately leading to the Balance of Payments crisis of 1991. Since the corrective

measures taken then, the CAD has remained in a comfortable zone, with occasional forays

into positive territory. However, as the global crisis erupted in 2008, India’s CAD jumped

from 1.3 per cent in 2007–08 to 2.3 per cent the next year and to 2.8 per cent by 2009–10.

The two deficits are clearly seen to run in opposite directions since the mid-1990s

38

Graph 4.1. India’s Current Account Deficit and Fiscal Deficit as percentage of

GDP over 1980–81 to 2010–11

the fiscal deficit had been trending higher since the mid-1990still 2004–05, when the

government started to significantly reduce its budget deficit by implementing the Fiscal

Responsibility and Budget Management (FRBM) Act, 2003. The current account deficit, on

the other hand, had been trending lower (the current account balance improving) since the

mid-1990s till 2004–05, when it was again driven up by escalating global oil prices, as oil

prices moved from US$29 per barrel to US$124 per barrel between Q2 of 2003–04 and Q2 of

2007–08. Though both the deficits are seen to have their own short-run spikes, they have

been on a particularly high trajectory during the past few years after the advent of the global

crisis. The crisis not only led to a deterioration in the current account balance as India’s

exports declined more than imports, it adversely affected the fiscal deficit as well because of

the necessity to provide effective fiscal stimulus during the peak crisis period. Given the

39

existence of several different theoretical postulates that relate the two deficits (/balances),

such occasionally concurrent and divergent behaviour of the two series needs to be examined

in detail to see if indeed a long-term relationship can empirically be established between the

two. If such a relationship does exist it is worth making an attempt to identify which other

variables mediate such a relation, with the help of empirical tools that allow for mapping of

the direction of causality flows between a set of interlinked variables. This in turn would

indicate which of the two deficits needs to be the primary target variable for policy making

purposes.

4.3. Quantitative AnalysisTo develop the equation we would be using the multiple regressions where we would regress

CAD on Gross Fiscal Deficit, Average Yearly Bond Yield and a lag variable of CAD. The

independent variable here is Gross Fiscal Deficit, Yield and lag CAD variable the dependent

variable is CAD. Finally the result would also be tested for cointegration to confirm a long

run stable relationship

Regression Analysis

R² 0.452

Adjusted R² 0.386 n 29

R 0.672 k 3

Std. Error 1.023 Dep. Var. CAD/GDF

40


CAD Dependent As % of GDP


Government Bond

Yield

Independent Percentage

WPI (t-1) Independent As % of GDP

ANOVA table


Regression 21.560

7

3 7.186

9

6.87 .0016

Residual 26.152

4

25 1.046

1

Total 47.713

1

28


variables coefficient

s

std.

error

t

(df=25)

p-

value

95%

lower

95%

upper

Intercept -0.5990 1.0920 -0.549 .5882 -2.8481 1.6501

Gross Fiscal

Deficit

-0.0396 0.1594 -0.248 .8058 -0.3678 0.2886

Bond Yield 0.0419 0.0928 0.451 .6557 -0.1492 0.2329

CAD/GDP (t-1) 0.7454 0.1892 3.941 .0006 0.3558 1.1349





H0: CAD, Fiscal Deficit and Interest rates are Cointegrated

Ha: CAD, Fiscal Deficit and Interest Rate are not Cointegrated

Dcal = 2.16


Since Dcal > Dtable

We accept null Hypothesis and CAD, Fiscal deficit and Interest rates are cointegrated

41

Hence we conclude that CAD, Fiscal deficit and Interest rate shows a long run relationship.

4.4. Conclusion

The main purpose of this empirical exercise was to examine the causal linkages between the

government budget deficit and current account deficit for India within a multi-dimensional

system, with the interest rates acting as the interlinking variables. The causal chain of such

linkages is important as different results lead to very different policy recommendations

regarding the target variable for controlling the twin deficits. Several studies make a clear

case for reduction in fiscal (or government budget) deficit to control the external deficit

Others indicate that the target variable for correcting the twin deficits may not be the fiscal

deficit because of the validity of the “current account targeting” hypothesis which, according

to which a country’s government budget deficit expands because of policies taken to counter

a growing external deficit. Our Results using regression and cointegration test suggest a long

run relationships between CAD Fiscal Deficit and interest rates.

42

References

Fiscal Deficit-Economic Growth Nexus in India: A Cointegration analysis - Ranjan

Kumar Mohanty

Fiscal Stimulus and Potential Inflationary Risks:An Empirical Assessment of Fiscal

Deficit and Inflation Relationship in India - Jeevan Kumar Khundrakpam, Sitikantha

Pattanaik

India’s Twin Deficits:Some Fresh Empirical Evidence - Suchisimta Bose and Sudipta

Jha

Fiscal Deficits and Government Debt in India: Implications for Growth and

Stabilisation -C. Rangarajan and D.K.Srivastava

Basic Econometrics – Damodar N. Gujarati

43

Appendix

YearGross Fiscal Deficit

Bond Yield WPI

CAD/GDF GDP

Mo/GDPDE

1983-84 5.86 8.58 7.50 -1.50 7.85 11.784451984-85 6.99 9.00 6.50 -1.20 3.96 6.9094711985-86 7.77 9.75 4.40 -2.10 4.16 2.9683751986-87 8.37 11.00 5.80 -1.90 4.31 6.5318671987-88 7.56 11.00 8.10 -1.80 3.53 5.1240921988-89 7.28 11.50 7.50 -2.70 10.16 9.2991231989-90 7.31 11.50 7.50 -2.30 6.13 9.377541990-91 7.84 11.50 10.30 -3.00 5.29 4.2088971991-92 5.55 11.84 13.70 -0.30 1.43 1.2436961992-93 5.34 13.00 10.10 -1.70 5.36 4.133861993-94 6.96 13.50 8.40 -0.40 5.68 8.812121994-95 5.68 12.50 12.60 -1.00 6.39 8.4020771995-96 5.05 14.00 8.00 -1.60 7.29 6.3447251996-97 4.84 13.82 4.60 -1.20 7.97 1.3841921997-98 5.82 12.82 4.40 -1.40 4.30 5.0725441998-99 6.47 12.35 5.90 -1.00 6.68 6.3549741999-00 5.36 11.89 3.30 -1.00 7.59 5.818762000-01 5.65 10.99 7.20 -0.60 4.30 4.4449412001-02 6.19 9.20 3.60 0.70 5.52 7.1461592002-03 5.91 7.49 3.40 1.20 3.99 4.6676562003-04 4.48 6.13 5.50 2.30 8.06 12.123842004-05 3.88 6.45 6.50 -0.40 6.97 6.3101242005-06 3.96 7.63 4.40 -1.20 9.48 11.379552006-07 3.32 8.10 6.60 -1.00 9.57 13.802392007-08 2.54 8.25 4.70 -1.30 9.32 18.140632008-09 5.99 7.87 8.10 -2.30 6.72 2.7460832009-10 6.48 8.11 3.80 -2.80 8.59 9.6071472010-11 4.87 8.39 9.60 -2.70 9.32 9.4086592011-12 5.89 8.79 8.94 -4.20 6.21 1.494032

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Fiscal Defcit and Its Impact on Indian Economy

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