Download Statistical Analysis: Theoretical Background

These few pages explain the links between the following indicators:
(1) Budget deficit and its impact on (a) trade deficit (b) current account deficit
(c) interest rate (d) inflation rate (e) portfolio capital outflow and (f)
exchange rate.
(2) Subsidies and their impact on budget deficit.
Subsidies consist of handouts to people in cash and kind; to industries in
different forms and to agriculture in terms of lower price of fertilizer; higher
tariffs on import of agricultural goods.
(3) Higher subsidy requires the government to borrow more money from the
market.
Governments’ borrowing makes less money available for private sector
investment. Competition between the two sectors raises interest rate.
Higher interest rate payment and subsidy payment enlarges the budget
deficit and produces adverse effect on GDP and other indicators such as
trade deficit, current account deficit, capital outflow, exchange rate etc.
Statistical Analysis: Theoretical Background
Economic theory and the experience of the prolonged recession in the global
economy suggest that most indicators of the economic health of a country and its
GDP growth rate are greatly influenced by the state of the government’s budgetary
balance and by the level of prudence exercised in its fiscal management. A surplus
in the budget tends to improve the country’s trade and current account balances in
its balance of payment account; to increase the inflows of FDI and portfolio
capital; to strengthen the value of its currency against that of major currencies in
the international market; to prevent the rise in interest rate (discount rate and
commercial lending rates); and to facilitate the rise in the size of its GDP and in
GDP growth rate. On the other hand, a deficit in the government’s budgetary
balance fuelled by increase in payment of subsidies and rising interest payment on
public sector loans tends to produce deleterious effects on most of such indicators
as mentioned above of economic health of the country and to drive the portfolio
capital out of the country.
A deficit in a government’s budget tends to occur when the size of that
government’s budgetary expenditure exceeds that of its budgetary revenue. This
deficit is made up by a loan of an equivalent amount from the market or from the
central bank. The competition between public sector and private sector entities in
the loanable fund market drives up the rate of interest and produces a “crowding
out” effect on private sector led investment which in turn produces an adverse
effect on the country’s GDP growth rate. The rise in the rate of interest increases
the cost of production of all kinds of goods and services which include those
destined for the export market thereby lowering the country’s income from export.
But the rise in inflation resulting from the rise in cost of production of goods and
services in the home market makes unit prices of foreign goods cheaper in the
home market. This in turn increases both quantity and total cost of imports which
in turn tends to make the size of the payment for import higher than that of the
income earned from exports. These deficits in trade and current account balances
are therefore directly linked to the deficit incurred by the government in its budget.
Furthermore an alarming rise in the share of this deficit in the country’s GDP
lowers the global confidence in the country’s economic health.
In the services account in the country’s current account balance, income outflow,
now tends to exceed income inflow, thereby creating and or further enlarging the
current account deficit. The loss of confidence of foreign investors in the
economic strength of the country, makes the ”herd mentality” take hold in foreign
investors’ sentiment thereby driving foreign capital out of the country and
simultaneously depreciating the value of the domestic currency in the foreign
exchange market. If this rate of depreciation of the currency becomes quite severe,
it may fail to increase income from export well enough to pay for payments of
imported goods.
Meanwhile, the rise in the share of budget deficit and current account deficit in the
country’s GDP well above 4 percent significantly increases the likelihood of global
rating agencies according “Junk Status” to the country’s Sovereign Bonds. Once
this happens, interest rate on Sovereign Bonds continues to rise and economic
activities tend to rapidly decelerate. The rate of economic growth may become
negative and the country turns itself into a “Pariah State“.
Since subsidies are used to prop up inefficient agricultural sector and to some
industrial units as well as to fund other unproductive welfare schemes by
democratically elected governments to buy votes in election to stay in power, in
order to reduce the size of the budget deficit, the income of the government from
revenue collection has to rise and the level of expenditure has to fall.
However since the rural sector and agriculture account for the overwhelming
proportion of total subsidy payment in India in particular, subsidies by adversely
affecting the budgetary balance, are also adversely affecting all other indicators of
economic health of the country.
In the quantitative analysis, therefore, we are required to examine (i) the corelation between subsidy and major indicators of economic health of the country
such as budget deficit or surplus, movements in the discount rate, size of the GDP
and economic growth rate; (ii) co-relation between budgetary balance and (a)
balance in trade and current account; (b) movement of portfolio capital ; (c)
exchange rate movement; (d) movement in discount rate; (e) size of the GDP
growth in absolute amount and as percentages.
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Dependences to choose:
1. A surplus in the budget tends to improve the country’s trade and current
account balances in its balance of payment account.
2. A surplus in the budget tends to increase the inflows of FDI.
3. A surplus in the budget tends to increase the inflows of portfolio capital.
4. A surplus in the budget tends to strengthen the value of its currency against
that of major currencies in the international market.
5. A surplus in the budget tends to prevent the rise in interest rate.
6. A surplus in the budget tends to prevent the rise in discount rate.
7. A surplus in the budget tends to prevent the rise in commercial lending rates.
8. A surplus in the budget tends to facilitate the rise in the size of its GDP.
9. A surplus in the budget tends to facilitate the rise in GDP growth rate.
10. A deficit in the government’s budgetary balance fuelled by increase in
payment of subsidies and rising interest payment on public sector loans
tends to produce deleterious effects on most of such indicators as mentioned
above of economic health of the country and to drive the portfolio capital
out of the country.
A deficit in the government’s budgetary balance fuelled by increase in
payment of subsidies and rising interest payment on public sector loans tends to
produce deleterious effects on most of such indicators as mentioned above of
economic health of the country and to drive the portfolio capital out of the
country.
10a.
11.