Risks Involved In Fiscal Imbalances Among Developing Economies
by IRM India Affiliate World's Leading Professional BodyFiscal
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 . https://careers.ihsmarkit.com/careers.php
2)
FISCAL
DECENTRALISATION IN DEVELOPING COUNTRIES
https://www.cmi.no/publications/file/5125-fiscal-decentralisation-in-developing-countries.pdf
3)
The Financial and Economic Crisis
and Developing Countries
https://journals.openedition.org/poldev/144
4)
Essays on Fiscal
Policy Effects in Developing Countries
https://tel.archives-ouvertes.fr/tel-00606175v1/document
5)
Fiscal Policy in
Developing Countries- https://crawford.anu.edu.au/acde/asarc/pdf/papers/2007/WP2007_01.pdf
6)
Fiscal Imbalances in
India: Recent Trends https://ijcrt.org/papers/IJCRT1705192.pdf
7)
“The Economics of
International Trade and Finance” http://people.duke.edu/~grieco/chapter2fulldoc.pdf
Submitted by:
Soumya Bhasin
Member – Student Risk Committee at the Institute of Risk Management – India Affiliate
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Created on Mar 24th 2021 04:50. Viewed 552 times.