• Effect of higher fiscal deficit on exchange rate and import/export

    In this write up we will try to explain the effect of higher fiscal deficit on currency exchange rate and import/export of a country. We will take the example ofIndiawhile explaining the same.

    High Fiscal deficit increases the government borrowing in the money market as the government borrows more to compensate the gap.

    Who are the creditors?

    The foreign banks and investors along with the domestic banks and financial institutions are the main credits who buy government bonds and treasury bills to fill the fiscal deficit.India, being a developing country with strong growth outlook (second fastest growing economy in the world), attracts lots of foreign money across the world.

    Impact of high borrowing- high USD inflow

    Due to high borrowing by the government and bond buying by the foreign investors generates high foreign currency inflow in the domestic market to support the fiscal expansion. It leads to high US dollar supply in the domestic money market as USD is used as the global standard currency for inter country investment and trading. It also increases the demand of local currency. Due to the high US dollar supply and increased demand of local currency, US dollar depreciates considerably and local currency (here Indian Rupee) appreciates.

    Impact of local currency appreciation

    Due to the appreciation of local currency rupee, the goods exported from the country to the world now cost more in US dollar term than they did before and the foreign goods imported in the country now cost less in Rupee terms than they did before. This phenomenon affects the importing and exporting company’s profitability.

    Impact on Import/Export

    Due to the local currency appreciation, export decreases and import increases because of the impact on profit margin of the import and export companies. So we can conclude that higher fiscal deficit indirectly decreases export and increases import in the long run. That’s why the main exporting countries keep fiscal deficit comparatively much lower than the main importing countries which keep fiscal deficit higher and borrow more money from outside.

    Example

    If we check the 2010 data, the two biggest exporting countries in the world China’s fiscal deficit is at 1.6% of GDP and Germany’s fiscal deficit is around 5% of GDP which is much lower than the other euro zone countries. Lower fiscal deficit helped them to increase their export.

    If we check the importing countries (where import is more than export), India’s fiscal deficit is at 4.68% of GDP and US’s fiscal deficit touched around 10% of GDP due to high government spending. High fiscal defect helped them to make import more favorable and cheap.

    That’s how fiscal deficit can also be used to control import and export as well in favorable manner.

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