Risks Involved In Fiscal Imbalances Among Developing Economies

by IRM India Affiliate World's Leading Professional Body

Fiscal Imbalance is the mismatch between revenue powers and expenditure responsibility of the government. When a government lives beyond its means, that is, the government spends more than what it receives as revenue – a fiscal deficit is formed. Running a fiscal deficit is neither uncommon nor necessarily always bad.


For a developing country like India or Brazil, it is quite common to incur a fiscal deficit to spur economic growth in times of recession or economic slowdown of the country. But with a high fiscal deficit comes with a higher interest rate along with the risk of defaulting the loan amount.


Moreover, before the 2007–09 financial crises, the major risk to the worldwide economy was thought to be the presence of huge current account surpluses and deficits. Thereafter, at the peak of the crisis, threats to the solvency of major financial institutions were the main target of attention. Now, with the waning of the crisis, the discussion is returning to the fiscal risks posed by the global current account imbalances.


Anyone might say if the imbalance is a problem, the balance would seem the right solution but paying back fiscal or budgetary deficit is far from easy. Just as the case with Argentina which now is synonymous with economic turmoil and has been frozen out of the international market. The country has caught itself in a vicious cycle of staggering debt, soaring inflation, and rising unemployment. Since independence from Spain in 1816, the country has defaulted on its debt nine times and inflation has often been within the double digits, whilst high as 5000%, resulting in several large currency devaluations.


Governments borrow from foreign investors mainly for funding their infrastructural projects. Investing in any developed economy say the US or Singapore is considered a safe investment because even if the country spends more, it will be able to pay back its loan by raising taxes or by printing more money but this is not the case with an emerging market. A developing economy finds it hard to borrow loans and even if they manage to get it, it is at the cost of a higher interest rate. The government in order to repay its debt either levies more tax in the future or increases the inflation rate or both. Along with this, a high fiscal deficit affects the confidence of foreign investors. Defaulting countries are treated with some suspicion in the international markets. Due to this, there is an inflow of hot money in the country which is used to balance the current account deficit.


Surges in fiscal imbalance increase, the chance of a financial crisis and such inflows worsen income inequality. This is exactly what happened in Asian Crisis, 1997. In the early 90s, Thailand’s economy got overheated with hot money and this created a credit bubble. As soon as the US increased the interest rates on their treasury bonds, investors pulled their money back from the ASEAN economies. Indonesia, South Korea, Thailand, and Malaysia saw their currency exchange rates, stock markets, and prices of other assets all plunge. Moreover, the GDPs of the affected countries fell by double digits. The world economy was on the brink of an economic meltdown.


In today’s times, even if we keep the pandemic out of the picture, many developing economies are still running in recession. Macroeconomic instability combined with uneven economic growth before 2020, raises some pertinent questions on the effectiveness of the fiscal and monetary policies of the country. Brazil, another developing country does not have engines to drive its economy forward. Its debt and deficit are among the highest in any emerging nation and at par with many developed economies. Several states are in different stages of insolvency. Rio de Janeiro, Rio Grande do Sul and State of Minas Gerais have declared a fiscal calamity. Also, persistent fiscal imbalances drive policymakers towards protectionism which takes a country further down the tunnel in the long run. Most of the well-regulated economies during Covid-19 were the ones who remained firmly committed to trade liberalization.


For those who do not have the faintest idea about foreign trade and protectionism, let’s look at two prominent South Asian economies - India, home to roughly 1.3 billion people is the fifth-largest economy in the world and ranks second when it comes to protectionism after Brazil. On the other hand, Singapore is a highly developed and successful free-market economy. Its population is four times less than that of India’s but Singapore’s economy has grown immensely since the 1960s. Its rise has been fueled by Industrialization and exports combined with big doses of government intervention. Something that should be taken into consideration is the fact that what India is trying to achieve for the last five years, Singapore has already crossed that milestone with four times less population. As long as protectionism continues in India, it can never become an advanced economy.


To conclude, a high fiscal imbalance causes overvaluation of the exchange rate along with an increase in borrowing cost for most of the developing economies. The risk of a financial crisis will always undermine the economic growth of the economy.


References –

1)    The risks of international imbalances: beyond current accounts .


3)    The Financial and Economic Crisis and Developing Countries

4)    Essays on Fiscal Policy Effects in Developing Countries

5)    Fiscal Policy in Developing Countries-

6)    Fiscal Imbalances in India: Recent Trends

7)    “The Economics of International Trade and Finance”


Submitted by:

Soumya Bhasin

Member – Student Risk Committee at the Institute of Risk Management – India Affiliate

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About IRM India Affiliate Freshman   World's Leading Professional Body

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Created on Mar 24th 2021 04:50. Viewed 578 times.


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