IBS HYDERABAD

ACADEMIC YEAR – 2019-21

MACRO ECONOMICS AND BUSINESS ENVIRONMENT

SEMESTER 2
A REPORT ON TWIN DEFECIT HYPOTHESIS IN INDIA

S.no. Name Enrollment No. Seat No.

1. Debashish Banerjee 19BSPHH01C0317 71
2. Sravya Talupula 19BSPHH01C1220 72
3. Priyank Chandraker 19BSPHH01C0844 73
4. Praveen Kumar Hulsure 19BSPHH01C0827 74
5. Akashdeep Singh Bhatia 19BSPHH01C0095 75
6. Arya Lal 19BSPHH01C0210 76
7. Subham Ghosh 19BSPHH01C1243 77
8. Shanjalika Chaudhary 19BSPHH01C094 78
9. Pritanshu Acharya 19BSPHH01C 0835 79
10. Nitisha Rajput 19BSPHH01C0740 80
 ACKNOWLEDGEMENT

Words are indeed inadequate to convey my profound gratitude to all those who
have been instrumental in the preparation of our project report.
We would like to thank our professor Dr.Vigneswara Swamy for giving us the
opportunity to undertake this project.
 TABLE OF CONTENTS

1.INTRODUCTION………………………………………………………………………
2.REVIEW OF LITERATURE……………………………………………………..
3.DATA COLLECTION AND INTERPRETATION…………………………………………
4.DISCUSSION………………………………………………….
5.SUMMARY…………………………………………………………………………….
6.REFERNCES………………………………………………………………………….
1. Introduction

In macroeconomics, the twin deficits hypothesis or the twin deficits phenomenon is

the proposition that there is a strong causal link between a nation's government budget
balance and its current account balance.
Standard macroeconomic theory points to how a budget deficit can be a contributing
factor to a current account deficit. This link can be seen from considering the national
accounting model of the economy:
Y = C+ I + G + (X - M)
where Y represents national income or GDP, C is consumption, I is investment, G is
government spending and X–M stands for net exports. This represents GDP because
all the production in an economy (the left hand side of the equation) is used as
consumption (C), investment (I), government spending (G), and goods that are exported
in excess of imports (NX).
Fiscal Deficit is the deficit that gives the difference between the total revenue and the
total expenditure of the government. It tells us about what are the total borrowings that
are needed by the government. As we calculate the total revenue, we do not include the
total borrowings in it.
The excess of the total expenditure including the loans and non-debt receipts gives the
gross fiscal deficit. The net fiscal deficit is obtained by reducing the net lending of the
central government from the gross fiscal deficit.
Net Fiscal Deficit = Gross Fiscal Deficit – Net Lending of the Central Government.
The main reasons why fiscal deficit takes places is either because of the revenue deficit
or if there is a major hike in the capital expenditure by the government. Capital
expenditure is usually done to create long term assets like factories, buildings and other
developmental activities.
This deficit is financed by the government by either borrowing from the reserve bank of
India or by issuing different instruments like treasury bills and bonds in the capital
markets.
The current account deficit is a measurement of a country's trade where the value of
the goods and services it imports exceeds the value of the products it exports.
The current account represents a country's foreign transactions and, like the
capital account, is a component of a country's balance of payments (BOP).
A country can reduce its existing debt by increasing the value of its exports relative to
the value of imports. It can place restrictions on imports, such as tariffs or quotas, or it
can emphasize policies that promote export, such as import substitution,
industrialization, or policies that improve domestic companies' global competitiveness.
The country can also use monetary policy to improve the domestic currency’s
valuation relative to other currencies through devaluation, which reduces the country’s
export costs.

While an existing deficit can imply that a country is spending beyond its means, having
a current account deficit is not inherently disadvantageous. If a country uses external
debt to finance investments that have higher returns than the interest rate on the debt,
the country can remain solvent while running a current account deficit. If a country is
unlikely to cover current debt levels with future revenue streams, however, it may
become insolvent.

A current account deficit represents negative net sales abroad. Developed countries,
such as the United States, often run deficits while emerging economies often run
current account surpluses. Impoverished countries tend to run current account debt

2. REVIEW OF LITERATURE

Increasing fiscal deficit is the results of recession or a sustained amount of slow growth.

During downswing revenue falls from indirect and direct taxes at identical time, the govt.
is required to pay additional for welfare edges like the state edges means-tested
financial gain support, and different welfare activities. The automatic stabilizers lead to a
locality of commercial enterprise deficit. The governments of most developed countries
area unit ready to permit the automated stabilizers to figure through as a result of, once
their economy recovers, the circular element of a fiscal deficit can diminish, so in
associate economic boom, the govt.
A large (and rising) fiscal deficit may additionally be the deliberate impact of a
government selecting to use expansionary economic policy to spice up combination
demand, output and employment at a time once non-public sector demand (C I X) is
stagnant or falling.

Keynesian economists have long favored the utilization of targeted and timely
commercial enterprise stimuli like labor-intensive construction and different
infrastructure investment comes, designed at kick-starting associate economy affected
by chronic lack of demand and financial gain.

There is associate intense dialogue concerning the impact of commercial enterprise

stimulant policies - at the guts of the conflict is that the seemingly size of the commercial
enterprise number effect arising (for example) from an increase in government payment,
or a series of tax cuts.

For some countries, commercial enterprise deficits appear associate virtually permanent
feature, seldom is that the government able to notice enough tax income to hide the
annual payment budgets.

India's current account (CA) balance deficit grew to $68 billion in 2018-19 from $49
billion the previous year, according to the International Monetary Fund (IMF), which said
the deficit was justified by development needs. The External Sector Report of the IMF
released by Chief Economist Gita Gopinath also found that India's Net International
Investment Position had slightly improved with the deficit coming down from $438 billion
in 2017-18 to $431 billion in 2018-19.

India's overall international reserves, though stood at $411.9 billion at the end of March
this year, down from March last year by $12.5 billion, it said. The report said that the
reserve level is adequate for "precautionary purposes relative to various criteria”.
“India’s low per capita income, favorable growth prospects, demographic trends, and
development needs justify running CA deficits," it said. Speaking to reporters at the
launch of the report in Washington, Gopinath explained: "Not all external imbalances
are a cause for concern as there are good reasons for countries to run current account
deficits or current account surpluses at certain points in time.
"For example, it's natural for young fast-growing economies to run current account
deficits as they borrow from ageing economies with weaker growth prospects". The IMF
report, however, cautioned that "external vulnerabilities remain, as highlighted by bouts
of turbulence in 2018".
"India's economic risks stem from volatility in global financial conditions and an oil price
surge, as well as a retreat from cross-border integration", the report said. "Progress has
been made on FDI (foreign direct investment) liberalization, whereas portfolio flows
remain controlled. India's trade barriers remain significant."
The IMF said that India has to attract more stable sources of financing to reduce
vulnerabilities.

The report said that the "yearly capital inflows are relatively small, but given the modest
scale of FDI, flows of portfolio and other investments are critical to finance the CA. As
evidenced by the episodes of external pressures, portfolio debt flows have been volatile,
and the exchange rate has been sensitive to these flows and changes in global risk
aversion".

To attract FDI, it suggested improving the business climate, easing domestic supply
bottlenecks, and liberalizing trade and investment. These would help "improve the CA
financing mix, and contain external vulnerabilities", it added. The IMF said that India
should take steps to rein in fiscal deficits and these should be accompanied by faster
cleanup of bank and corporate balance sheets and strengthening the governance of
public banks in order to increase credit availability. "Gradual liberalization of portfolio
flows should be considered, while monitoring risks of portfolio flows' reversals", it said.
"Exchange rate flexibility should remain the main shock absorber, with intervention
limited to addressing disorderly market conditions".

The current account represents country's trade balance, net income and direct
payments. The trade balance is a country's imports of goods and exports of goods and
services. The current account also measures the capital transferred internationally.

A current account represents the balance when the residents of the country have
enough to fund all purchases in the country. Residents include the people of the
country, businesses, and government and the funds include income and savings.
Purchases include all the consumer spending and government infrastructure spending.

The countries’ goal is exporting more goods and services than they import. That’s also
called trade surplus which means a country have more earnings than it spends. A deficit
occurs when a government of the country, businesses, and individuals export fewer
goods and services than they import or imports more goods and export less. They take
in less capital from foreigners than they send out.

The current account is part of a country's Balance of Payments. The other two parts of
Balance of Payments are the capital accounts and the financial accounts.

The Four Current Account Components

The current account is divided into four components: trade, net income, direct transfers
of capital, and asset income.

1. TRADE: Trade refers to sale and purchase of goods and services. Trade is the
largest component of the current account. Deficit in trade alone is enough to create a
current account deficit.
2. NET INCOME: This is income received by the country’s residents after deducting
income paid to foreigners. The country’s residents receive income from two sources that
are income from foreign assets owned by a nation's residents and businesses which
includes interest and dividends earned on investments held overseas and the second
source is income earned by a country's residents who work overseas.

If the income earned through these sources is more than the foreign official earns from
our own country then net income is positive and if it is less, then it contributes to a
deficit.

3. DIRECT TRANSFERS: It includes three types of direct transfer first is remittances

from workers to their home country, second is a direct foreign aid provided by the
government, third direct transfer is foreign direct investments that is when a country's
residents or businesses invest in ventures outside the country. To count as FDI, it has
to be more than 10% of the foreign company's capital.

4. ASSET INCOME: It is composed of increases or decreases in assets like bank

deposits, central bank and government reserves, securities, and real estate. If the value
of assets of one country is more than the other its current account is positive and vice
versa.

3. DATA COLLECTION AND INTERPRETATION

1. Era of Pre – Liberalization, 1980-81 to 1990-91

Year Gross Fiscal Deficit (%) Revenue Deficit (%)

1980-81 5.55 1.36

1981-82 4.93 0.22

1982-83 5.4 0.67

 1983-84 5.69 1.11

1984-85 6.79 1.65

1985-86 7.55 2.03

1986-87 8.13 2.4

1987-88 7.34 2.48

1988-89 7.08 2.41

1989-90 7.1 2.37

1990-91 7.61 3.17

2. Post - Liberalisation,1990-91 till FRBM Act, 2002-03

Deficit of Central Government as Percentage of GDP (1990-91 to 2002-03)

Year Gross Fiscal Deficit Revenue Deficit

1990-91 7.61 3.17

1991-92 5.39 2.41

1992-93 5.19 2.4

 1993-94 6.76 3.67

1994-95 5.52 2.97

1995-96 4.91 2.42

1996-97 4.7 2.3

1997-98 5.66 2.95

1998-99 6.29 3.71

1999-00 5.18 3.34

2000-01 5.46 3.91

2001-02 5.98 4.25

2002-03 5.72 4.25

3. Post Fiscal Responsibility and Budget Management (FRBM) Act,

2003 to 2018-2019
Deficit of Central Government as Percentage of GDP (2002-03 to 2018-19)

Year Gross Fiscal Deficit Revenue Deficit

2002-03 5.72 4.25

2003-04 4.34 3.46

2004-05 3.88 2.42

2005-06 3.96 2.5

2006-07 3.32 1.87

2007-08 2.54 1.05

2008-09 5.99 4.5

2009-10 6.46 5.23

2010-11 4.79 3.24

2011-12 5.84 4.46

2012-13 4.91 3.65

2013-14 4.43 3.15

2014-15 4.09 2.89

2015-16 3.94 2.8

2016-17 3.5 2.1

2017-18 3.2 1.9

2018-19 3.4 2.3

 Deficit of Central Government as Percentage of GDP (2002 - 03 to
2018 - 19)
7

3 Gross Fiscal Deficit

Revenue Deficit
2

At the time of recession when there is high unemployment and low income at
macroeconomic level, fiscal deficit is very effective in ending this trend. To
make the situation better, the government spends more than its revenue so
that income and employment level in the economy will improve.
As it is known that fiscal deficit means government expenditure exceeding
government revenue, the government has to borrow, it will borrow from the
public by issuing bonds. It is well known fact that people use their saving to
buy government bonds, private firms are hindered from borrowing from the
public. The effect if this is that the private investment and the revival of which is
the main objective of running a fiscal deficit during recession. So, it turns out to
be counterproductive.
The effect is also seen as the inflation in the economy, when the extra demand
created by government spending is more than the productive capacity of the
economy.
 CURRENT ACCOUNT DEFICIT

Financial years Current Current payments/ CAD/

Receipts/ GDP GDP GDP
2005-06 23.3 94.8 -1.2
2006-07 25.6 96 -1
2007-08 25.4 95 -1.3
2008-09 29.1 92.6 -2.3
2009-10 25.3 89.9 -2.8
2010-11 26.1 90.2 -2.8
2011-12 28.7 87 -4.2
2012-13 28.9 85.7 -4.8
2013-14 29.4 94.3 -1.7
2014-15 27 95.1 -1.4
Source Reserve Bank of India: Economic Survey

The chart shows the current account items of balance of payments. Current
payments were observed higher than current receipts. Currents receipts depict the
increasing trend and reached at 29.4 in 2013-14. Current payments were seen
higher in 2003-04, found at 112.6.
India's current account deficit narrows to 2.5% of Current GDP because of which fiscal
deficit widens
India’s external risks showed signs of waning with the current account deficit (CAD)
narrowing to 2.5% of gross domestic product (GDP) sequentially in the December quarter
(Q3), even as domestic risks increased with the fiscal deficit in the 11 months to February
touching 134% of the budgeted target, according to official data released on Friday.
India’s balance of payment eased mainly on account of falling oil prices, while lower-than-
expected tax collections and continuing government spending were responsible for the
widening fiscal deficit. However, while releasing the borrowing programme for the first
half (April-September) on Friday, economic affairs secretary Subhash Chandra Garg said
the government is sticking to its fiscal deficit target of 3.4% in 2018-19 and 2019-20.
The Reserve Bank of India’s monetary policy committee will release its monetary policy
statement on 4 April in which it is widely expected to cut interest rates for the second
consecutive time, given mounting growth concerns even as inflation remains well within
its ceiling. GDP growth for fiscal year (FY) 2018-19 is projected to be 7%, which is a drop
from 7.2% in FY18, the figure having moved up earlier on account of the revision in the
statistical series.
During the first half of 2019-20, the government will borrow 62.3% of its full-year borrowing
plan at $4.42 billion, at the rate of ₹17,000 crores per week. Though the net borrowing
programme for 2019-20 is similar to last year’s level at ₹4.48 trillion, gross borrowing is
at ₹7.1 trillion because of higher repayment obligations in the next fiscal year.
While the revised net direct tax collection target for 2018-19 is ₹14.84 trillion, the
government has been able to collect only ₹10.9 trillion till February, leaving a
whopping ₹3.94 trillion to be collected in March. As this is an election year, there may not
be much scope for expenditure cuts in the last month of the fiscal, though the total
expenditure is still 81.5% of the full-year target in the first 11 months, against 83% during
the same period a year ago.
However, the government has crossed the disinvestment target this fiscal with the state-
owned Power Finance Corp. Ltd finalizing a deal to acquire a majority stake in REC Ltd
for ₹14,500 crores. “As against a target of ₹80,000 crores for disinvestment for the current
year, the divestment receipts have touched ₹85,000 crores today," finance minister Arum
Jaitley said in a tweet on 23 March. The disinvestment target for FY20 is ₹90,000 crores.
Devendra Kumar Pant, chief economist at India Ratings and Research (Fitch Group), said
over-achievement of disinvestment will provide some buffer to the government. “However,
the slow pace of tax collection would keep pressure on the fiscal deficit. A higher GDP
number than the one used in the budget will help the government inch closer to FY19
fiscal deficit of 3.4% of GDP," he said. With oil prices receding from their peak, CAD
declined to 2.5% of GDP in December from 2.9% of GDP in the September quarter.
However, it increased to 2.6% of GDP during the April-December period from 1.8% during
the same period in the previous year.
India’s trade deficit increased to $145.3 billion in April-December 2018 from $118.4
billion in April-December 2017. While net FDI inflows in April-December 2018 increased
to $24.8 billion from $23.9 billion in April-December 2017, portfolio investment recorded
a net outflow of $11.9 billion in April-December 2018, against an inflow of $19.8 billion a
year ago. Madan Sabnavis, chief economist at Care Ratings, said the CAD is expected
to moderate further in Q4 with the trade deficit also coming down post the decline in
crude oil prices in global markets.

4.DISCUSSION

The above analysis shows how twin deficits have emerged as a risk for Indian
economy. Taking lessons from the recent crisis, we see the deficits could either be a
trigger or could just magnify the impact of the crisis. In India the twin deficits have been
persistent and were responsible for the 1991 crisis. The deficits have again widened
post the recent crisis leading to questions on the future trajectory of the Indian
economy. Within the twin deficits, high fiscal deficits remain a major concern for most
economists. However, as India is an emerging economy, current account deficits remain
a concern as well as we have seen in numerous developing economies’ crisis in the
past. Some economists say that worrying over these deficits is imprudent. India is a fast
growing emerging economy and deficits are expected in such economies. India has
high domestic savings which will help in financing the fiscal deficit. It has built large
forex reserves which will help in case current account deficit financing becomes a
problem. Others say with high growth rates expected in future, capital inflows are going
to continue and financing CAD is not a problem. However, going by the above case
studies of advanced economies we can never be sure. Earlier, this domain of crisis due
to deficits was seen as a domain of developing economies. But in 2007, advanced
economies themselves were victims. In this highly volatile and global economic set-up,
one can never take anything for granted. The deficits may not act as crisis triggers but
could easily create multiple problems for the economy. Hence, twin deficits remain a
major risk for Indian economy going ahead. For instance, in India’s case, high fiscal
deficit leads to problems of inflation management which could slow the growth going
forward. The inclusive growth agenda also implies government needs to aggressively
spend on education, healthcare and infrastructure. With persistent fiscal deficits, this
spending would be unlikely or may just push fiscal deficits higher. This would further
lead to problems associated with rising fiscal deficits – inflation, crowding out of private
sector, higher interest rates etc. The widening current account deficit will put pressure
on the government to get foreign savings to bridge the deficit. The large capital flows in
turn pose monetary management issues for the central bank. Overall, policymakers
need to remain vigilant and work towards reducing these twin deficits.

5. CONCLUSION

The study primarily analyses the internal budget balance and external account balance
nexus in a dynamic and globally integrated economy, namely, India, in a nonlinear
model setting for a period of 1970-1971 to 2015-2016. The study confirms the long-run
co-movements of two deficits and therefore refutes the Ricardian equivalence
proposition and validates the “twin-deficit” hypothesis. But instead of a linear
relationship like examined in the previous studies, the two variables are found to share
the asymmetric linkages both in the short run and the long run and fiscal deficit
increases leave a more pronounced effect on current account deficit than the decreases
do. The possible reason for such an asymmetric impact of fiscal policy stances on the
current account balance of a developing country like India may be due to existence of
liquidity constraints and downward inflexibility in consumption (Ratchet effect). The
other control variables used in the study such as real GDP growth and trade openness
are also found to have cointegration with the cad, but the relationship is symmetrical in
the long run, even though asymmetrical is in the short run. The study finally uses the
asymmetric cumulative dynamic multipliers to portray the route of asymmetries and
adjustments over the course of time. The dynamic multipliers also confirm the results
documented in the earlier part and therefore demonstrate their robustness.

The study, therefore, suggests the inappropriateness of presuming a linear association

between the variables under study and provides a more intensive examination of the
nexus among the variables under study. From the policy point of view, the asymmetric
results obtained in the study provide strong grounds to devise the policies adaptive to
changing realms in domestic and external sectors. Output growth, export promotion and
import substitution, increasing integration and fiscal austerity are seen as helpful in
achieving a desired (and growth conducive) external balance together with the
macroeconomic stability. The need for a prudent fiscal policy and avoidance of
profligacy is indicated based on the asymmetric results to ward off any unfavorable
impact of fiscal deficits on external account. To conduct a sound fiscal policy, the
government needs to cut down unproductive consumption expenditures, raise tax
revenues and pay an attention to distribution and trickle-down effects to avoid the
adversity of high inequality and liquidity constraints in the economy. Moreover, to
ameliorate the current account balance, policies aimed at increasing the real
competitiveness through control of domestic price fluctuations and improvement in the
quality of tradable goods and services (like productive investments and technological
advancements) should be adopted.

The most important for government is that it should look after their expenditure and
major emphasis should be given on careful planning.
The planning and the expenditure should be implemented so that benefits of such
projects are substantial.
The priority given by the government should deal with public goods and positive
externality.
The government must keep the deficit under control so that the growth of the economy
may continue without any pause.
If the deficits become unsustainable it can lead to
• Higher interest payments
• Loss of confidence
• Lower GDP growth rate
The government should manage the fiscal deficit and come out from the situation by
raising the taxes and cut government spending, but this may lead to lower economic
growth.

India’s current account deficit has widened in last few years mainly because of the rise in
gold and oil imports, and increase in investment income payments in conjunction with
the fall in investment income receipts, despite a large comfort provided by services sector
and private remittances. Given large demand in India, it is difficult to control import growth.
However, policy makers should focus on achieving the phenomenal export growth so that
a sustainable current account is maintained. With rising working-age and skilled
population, India could focus more on high-value product exports rather than low-value
manufactured items.
On the structural side, the widening CAD is contributed to a large extent by fall in the
household financial savings despite a fall in corporate investments, which raises
concerns.
Further investigation suggests that slowdown in household savings has been mainly led
by
acceleration in inflation. India has been financing its CAD through capital inflows and the
composition of capital inflows has changed during previous few years. In particular,
currently a large portion of CAD is financed through short-term volatile capital flows. The
rising short-term debt mainly due to high CAD is a risk to India’s external sector. Granger
non-causality test result suggests that capital inflows in the post-liberalization period are
driving CADs rather than the causality running from the opposite side. The empirical
results using unit root tests and Johansen cointegration test provide the evidence of
sustainability of India’s CAD in the long run. Results from econometric analysis revealed
that India’s current account is driven by fiscal deficit, term of trade, inflation, real deposit
rate and age dependency factor. The results suggest that one of the important factors
contributing to large CADs over the years from the structural side is fiscal deficit.
Therefore, it is important to correct fiscal deficits to keep current account balance at a
sustainable level.
REFERENCES:

https://www.cia.gov/library/publications/the-world-factbook/

https://www.ceicdata.com/en/indicator/india/consolidated-fiscal-balance--of-nominal-gdp