Thursday, July 9, 2009

Why Did The Fiscal Deficit Rise?

A scan of reactions to the budget on the net reveals a picture of what can be best described as a “cautiously optimistic yet defensive” budget. With the global markets experiencing such turmoil, maybe the  Finance minister would have been forced to defend his turf first and ensure that we maintain a GDP growth rate of at least 7% and inch closer to the targeted 9%. The increased government spending and increased stress due to sops like loan waivers the fiscal deficit figure has inflated to 6.8%.

There are enough articles on the net that would tell you that this figure of 6.8% is probably the highest in the world and is almost dangerous and we will cut ratings etc.

Then one might question that why did the government need to increase spending and how is government spending related to GDP and GDP growth rate?

A very brief session with the Boss yesterday gave me an idea that as I was unclear so might many of you be. So here is the explanation.


GDP can be explained in the following three ways. All three essentially amount to the same meaning in the end!!

1.       GDP is equal to the total expenditures for all final goods and services produced within the country in a stipulated period of time, usually one calendar or financial year.

2.       GDP is equal to the sum of the value added at every stage of production by all the industries within a country, plus taxes less subsidies on products, in a year.

3.       GDP is equal to the sum of the income generated by production in the country in the period—that is, compensation of employees, taxes on production and imports less subsidies, and gross operating surplus (or profits).

If you consider any of the three or all of them, you will appreciate the GDP figure for a country would indicate the economic health and vibrancy of the economy of that country. That would also mean that the GDP growth rate is an equally wonderful indicator of a countries “progress” on the economy front. The GDP growth rate would thus indicate the rate at which “wealth generation” is increasing in a country.

Let us consider the formula for GDP

GDP = C + I + G + (X – M)

Where                    C = Consumption (that would indirectly mean demand, will it not?)

                                I = Gross investment

                                G = Government spending

                                X = Exports

                                M = Imports

In this equation it is amply clear that the variables I, G, X and M are dependent on the overall demand in the market. In an increasingly free economy and in a world where economies are interlinked, depression of demand in one part of the world will definitely lead to a slowdown elsewhere. Have we not seen this happen recently?

So in the equation the only variable we can control is “G” or government spending. As the GDP growth rate of India is decreasing on account of the global meltdown, your government was left with no choice but to increase the “G” hoping that the GDP growth rate fall would be slowed, then arrested and ultimately return to a growth scenario.

But increased “G” means increased fiscal deficit as revenue are not increasing proportionally. So we can conclude that even though the jump from a figure of less than 3% to a figure of 6.8% is worrisome but was inevitable as the government has to spend more to weather the current storm.


Food for Thought: In case you get time, do visit the following link and you will see that we are 17th on a list of GDP growth rate of countries. Leave China, look at the other 15 with GDP growth rate better than India and try to find why countries like them have a GDP growth rate even up to 15% where we are struggling to meet 7%!! 

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