How deleveraging affects economy

During deleveraging the income falls more than reduction in debt due to the austerity measures.

In the first article in the series of understanding how the economic machinery works, we introduced transactions, credit, interest rates and inflation (the article can be read here). In the second article, we dealt with the importance of credit and introduced deleveraging (the article can be read here).  In this part (third), we will delve into the impact of deleveraging and introduce fiscal deficit and quantitative easing. The concluding part would weave all the different parts of the economic machinery together to help the readers take a view on the current economic scenario in India.

Impact of deleveraging

In the previous articles we saw that deleveraging happens when the rate of increase in debt outpaces the rate of growth of income. Incomes fall, people and organizations cut spending or austerity measures are taken up, such as projects halt, pay cuts for employees, bonuses come down and unemployment increases.

Asset prices drop, credit disappears, stock market falls, the banks try to reduce debt – restructuring of debt, writing off defaults, deposits into banks fall and default rate goes up.

Then the government tries to redistribute wealth by increasing its spending for generating employment. The spending of the government more often is larger than the income in such scenarios. This creates fiscal deficits.

During deleveraging the income falls more than reduction in debt due to the austerity measures. This is deflationary and painful. It may even lead to an extreme case of recession, also known as depression. This is a classic case that has repeated many times in history. For example, even Hitler came to power because of the social disharmony created by depression.

In such scenarios, many economies resort to printing more money. The central bank buys financial assets from the government, who in turn engages in spending to generate employment and lift demand. This is called quantitative easing.

Printing money has an impact on the exchange rate as the supply of currency being printed increases in the market.

The central bank must play very safe and must strike a balance such that the income growth is larger than the rate of growth of debt. Once deleveraging begins, going back to the boom periods usually takes 7-10 years. Hence, it is called “the lost decade”.

Source: http://planningcommission.nic.in/data/datatable/1612/table_23.pdf

The debt to GDP ratio of India stood at around 68 percent in 2013. While this ratio is much lower than in countries like US and many European nations, the interest payments and principal repayments make India very vulnerable. The fiscal deficit of India has been on the rise since 2008 and reached alarming levels in 2011-12.

This also had an impact on the exchange rate. The Indian rupee started to depreciate again the dollar as the fiscal deficit widened, the GDP growth rate started to come down, and inflation was at an all time high. The flight to a safer currency (US Dollar) meant that the Indian currency depreciated. This caused great deal of concern to importers as their imports, which are often priced in US Dollars, became more expensive in terms of Indian rupees.

In fact, The Indian economy has an underground economy, with an alleged 2006 report by the Swiss Bankers Association suggesting India topped the worldwide list for black money with almost $1,456 billion stashed in Swiss banks. We are not only a rich country, but we can actually take on more debt if we had that money in India and really wipe the tears off every citizen and more.

The above is a pretty complex but easy to understand story of how the economic machine works. We as citizens often get lost because we look at things at the microcosmic level and hence react emotionally. But if we were to see the big picture then we can play really smart in more ways than one.

In the next piece we shall delve deeper into the state of the Indian economy currently and the uphill task the next occupants of the North Block face.

Khemchand H Sakaldeepi is a researcher in the Centre for Investment at Indian School of Business, Hyderabad, and Nupur Pavan Bang is head analytics, Insurance Information Bureau of India, Hyderabad.