Managing India’s budget deficit

December 17, 2013

(Any opinions expressed here are those of the author and not of Thomson Reuters)

The budget deficit has been a concern for India, but Finance Minister P. Chidambaram has assured that the government will not deviate from the target of 3 percent deficit in 2017. In the very first year, however, it has become almost obvious that the target will be missed.

Budget deficit is not the privilege of government alone as even corporates and households borrow like the government to fund deficits. However, they ensure that the money is used in a manner that it is repaid in time. With the government it is different — it can borrow more in order to repay old loans and it can do so with impunity because banks are a captive market for the government securities. That results in mounting public debt which stood at 56.5 trillion rupees at the end of March 2013. Of this, 40 percent is held by banks.

When companies borrow they invest the money in assets which are productive and yield a return. Companies’ deficits generate growth and productive employment. Budget deficit of the government to the extent it funds productive expenditure is no different, but there are no assets against 60 percent of public debt. The money is spent on current uses and the government borrows without any consideration for repayment.

That creates two major problems. First, the huge borrowing by the government results in overcrowding of the market and consequently in increasing interest rates. The available finances get distributed in favour of the government to finance less productive expenditures and against private sector which could have invested in more productive assets. The budget deficit consequently suppresses growth.

Second, since the bulk of government expenditure from borrowing is on non-productive uses budget deficit adds to demand without adding to supply. The result is inflation. That is what worries the Reserve Bank which persistently reminds the government to restrain budget deficits.

What should be the maximum budget deficit that is not harmful to the economy?  That question was posed by European Union in its formative years and there is now a consensus that the deficit should not exceed 3 percent of the GDP. Over the years, some EU governments indulged in higher deficits and found themselves on the verge of sovereign default.

Budget deficit is keenly watched because it lowers growth and heightens inflation. The deficit can be on the revenue account and on the capital account, but it is the former which really creates all the problems. To ensure that the budget deficit is productive and non-inflationary, it is the revenue deficit that should be the primary target.

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