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Enigma of Twin Deficits!

By – Ishan Kekre

The problem of twin deficits has pestered past Indian governments and was a problem of grave concern for the UPA-2 government. Without further ado, I would like to talk about what twin deficits really are? The twin deficit comprises of fiscal and current account deficit. The fiscal deficit is the total debt generated by the government to finance its expenses. It shows that the government has no other option other than borrowing. PIIGS countries are an example of how high fiscal deficits can lead a country to bankruptcy.

When the fiscal deficit is high, it implies government has to borrow heavily, meaning demand for loans will rise in the market leading to higher interest rates and higher cost of borrowing. Private firms shy away from loans and even pull out from existing projects as loans are costly. This has an adverse impact on employment and income. This phenomenon refers to as ‘crowding out’ of private investments. The FRBM act (2003) mandates every central government to restrict its fiscal deficit to 3% of its GDP.

On the other hand, current account deficit or C.A.D is the situation where imports are significantly greater than exports leading to a negative balance of trade. It is therefore also known as trade deficit and has a substantial impact on G.D.P of a country.

The linkage between the two deficits is critical. Under heavy fiscal deficit, the government borrows from credit market and then from foreign sources. Due to high demand and opportunity to make a profit, institutions from abroad supply funds. This lead to currency exchange by foreign firms leading to an increase in demand for the Indian rupee. Hence, rupee appreciates making exports expensive and imports cheaper. Hence, imports start exceeding exports leading to a higher trade deficit for the country. Thus, a high fiscal deficit can lead to a very high trade deficit for the country and together they are called the ‘Twin Deficits’!

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