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The twin deficits myth
Harish Damodaran
The link between fiscal and current account deficits is grounded more in belief than evidence.
October 3, 2012:
Economists in India have a strange fascination for dyads.
In the post-Independence period and well into the nineties, the two major constraints seen as yoking the economy into
a permanent Hindu rate of growth were foreign exchange and food.
Scarce forex, by imposing limits on import of crucial machinery, equipment and other intermediate inputs, frustrated
Indias early industrialisation efforts. So did food the primary wage-good, whose lower production and high relative
costs rendered employment of labour by industry unviable beyond a point.
But as the country, from the mid-nineties onwards, went on to accumulate a sizeable chest of forex reserves and
public foodgrain stocks, concerns over the 2Fs receded to the background.
In the last couple of years, our economists notably in the Reserve Bank of India (RBI) have discovered a new
diptych that goes by the name of twin deficits. These refer to the Governments fiscal deficit and the countrys
current account deficit (CAD) in its external balance of payments transactions.
Shaky basics
The 2F obsession was at least rooted in ground realities. The twin deficits formulation, by contrast, has little useful
to offer in the Indian context.
Even from a theoretical perspective, it is built on precarious foundations, deriving from the basic macroeconomic
identity that holds investments in an economy (I) to be the sum of savings generated internally (S) and that supplied
from outside. The latter is equal to the forex capital inflows financing the excess of imports over exports, i.e. the CAD.
Simply put, I=S+CAD. The accompanying table shows it applying to the Indian economy, with investment or gross
domestic capital formation working out to be the sum of gross domestic savings and the CAD, all expressed as
percentages of GDP.
The problem comes when one attempts to impute causality into the above identity, which is what the twin deficits
formulation essentially does. How? By assuming the CAD to be the result of lower savings that are, in turn, the by-
product of high government deficits. We shall come to the last point later. Right now, it is the contention about
savings determining both investment as well as CAD levels in the economy that needs examination.
From the table, the link between savings and CAD appears rather weak. Indias savings rate was low during 2001-02
to 2003-04. Yet, these were years when it actually ran current account surpluses. Moreover, as the savings rate rose
from 2003-04 to 2007-08, it was accompanied by a widening CAD.
It is only after 2007-08 that some correlation between falling savings rate and rising CAD emerges. Since it can be
said that for a given level of investment, any decline in savings would have to be matched by a higher CAD, one could
claim causality to that extent.
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But even here, what lends complexity is the fact that the period after 2007-08 has also witnessed a drop in investment
rates.
The latter can plausibly be attributed to lower savings on account of rising government deficits and reduced surpluses
available with companies. But extending it further to say that the investment rate would have dropped even more but
for the CADs widening the latter basically compensating for the fall in savings is stretching logic too far.
Nothing domestic to it
In an insightful article (Business Line, August 8), Ashima Goyal of the Indira Gandhi Institute of Development
Research, has argued that CAD increases in India are influenced more by external shock factors than domestic
savings or investment rates.
There is basis to this view. In 2008-09, the CAD soared by a full percentage point of GDP only because export
markets suddenly collapsed following the global meltdown, even while imports did not fall correspondingly due to the
inelastic nature of demand in India for high value items like oil and gold.
The same thing happened in 2011-12. The Euro-Zone crisis, combined with tensions over Irans nuclear programme
and a surge in global liquidity resulting from the US Feds monetary stimulus measures (quantitative easing),
impacted the country from both sides. Not only did exports slow down from the second half, but the renewed rally in
international oil and other commodity prices also pushed up the import bill.
The typical pattern in all these shocks, thus, is one of the CAD widening in the short run, from imports shooting up or
staying high and exports taking a plunge. The rupees consequent weakening would rein in imports first by also
engineering a recession whereas the beneficial effects on exports manifest much later.
Either way, there is hardly any evidence of increased CADs being an outcome of decreased savings. If at all, it works in
the reverse a widening CAD and rupee depreciation induced by external shocks causing falling growth in output,
incomes, savings, investments and government revenues.
This is precisely what we are seeing today and saw in 2008-09 as well.
Belief without reason
Even more tenuous is the perceived link between CADs and fiscal deficits. The latter rather, the revenue deficit is
the difference between the Governments earnings from taxes and other current receipts and its spending on salaries,
subsidies and other non-capital expenditure heads.
The above gap represents the Governments dis-savings or over-consumption. That, according to the twin deficits
theory, spills over into generalised excess domestic demand, leading to higher imports and a widening of the CAD.
But the evidence once again from the chart, plotting the CAD and the combined revenue deficits of the Centre and
the States since 1990-91 suggests otherwise.
The revenue deficit peaked at 6.8 per cent of GDP in 2001-02, when the country recorded a current account surplus
of 0.7 per cent. The revenue deficit kept falling thereafter to reach a low of 0.2 per cent in 2007-08, by which time the
CAD had risen to 1.3 per cent.
Subsequently, both the revenue deficit and CAD have gone up. But rather than the latter being caused by the former,
the order may well be the reverse: High CAD and weak rupee affecting growth and, thereby, government revenues.
Despite the inherent fallacy in the formulation, it is remarkable how twin deficits is something every policymaker
and economist here today spouts as the gospel truth.
Take the RBIs latest Annual Report, which repeatedly warns of the risks emanating from the twin deficits, while
claiming the CAD to have widened due to impact of large government spending on aggregate demand. And like all
gospel truths, this one, too, requires no evidence!
It is nobodys case that CADs are good or governments (for that matter, even households and firms) must live beyond
their means. But building dubious theories around them does no good to the pristine discipline of economics.
(This article was published on October 3, 2012)