The UPA government is now talking about austerity measures. That’s a joke and needs to be treated as one. Let’s look at the ground situation to understand why:

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India’s fiscal deficit - or the excess money government spends over its income — has risen 312% in the last five years to Rs521,980 crore on March 31, 2012 from Rs126,912 crore on March 31, 2008. During the same period, government’s income has risen just 36% to Rs796,740 crore.

Raising debt to repay debtHow is this excess expenditure or fiscal deficit being financed? Through debt, or by issuing government bonds.

Now debt does not come free, government needs to pay interest on it. And, over time, the principal also needs to be repaid.In this financial year alone, the government will pay Rs319,759 crore just as interest on debt taken earlier. And it will pay another Rs124,302 crore for previously issued bonds that mature in this fiscal.

That’s a total Rs444,061 crore. Meaning a whopping 86.5% of the fiscal deficit mentioned above is about paying interest on debt raised and returning previously issued debt. The subsidy cancerThe other big expenditure for the government is subsidy on food, fertilisers and petroleum. Typically, the finance minister underestimates this at the time of presenting the Union Budget. In his budget speech last fiscal, Pranab Mukherjee had set a fiscal deficit target at 4.6% of GDP.

He missed it by a huge margin — the actual number was 5.9%. The culprit? Subsidies, or the difference between cost price and sales price, such as those for diesel. He had estimated subsidies at Rs143,750 crore but they ended up costing the government 50.5% more or Rs216,297 crore.The twin defecit hypothesisThe hypothesis basically states that as the fiscal deficit of the country goes up its trade deficit (i.e. the difference between exports and imports) also goes up. Hence, when a government of a country spends more than what it earns, the country also ends up importing more than exporting.

The government also ends up with a bigger fiscal deficit when it cuts taxes to encourage spending but don’t. At times, you see some impact in terms of imports rising. But not so much that the trade deficit of $185 billion that India ran in 2011-2012.

The trade deficit continues to be high this financial year as well. For example, India’s imports in April were $37.9 billion, or 54.7% more than its exports, which stood at $24.5 billion.

In India, the trade deficit story is basically about oil and gold - two commodities that the country does not produce much but imports a hell of a lot.

Now, when we import more, we need more dollars to buy stuff. To buy dollars, importers have to pay in rupees. But when you demand more dollars, it becomes costlier, which weakens the rupee. That is, you need to pay more rupees to get the same number of dollars. The Reserve Bank of India does intervene at times to stem the fall of the rupee by supplying dollars into the foreign exchange market. But the RBI does not have an unlimited supply of dollars so can’t intervene continuously.The double whammyAs mentioned earlier, a major part of the trade deficit is because of our need to import crude oil. Since oil is sold in dollars, and the rupee is constantly losing value against the dollar, it means a double whammy - the price of oil goes up because Indian companies have to pay more per barrel of oil in rupee terms.

Now, the government of India does not pass on a major part of the increase in the price of oil to the end consumer and thus ‘subsidises’ diesel, LPG and kerosene (petrol is partially free). So oil companies sell at a loss, and the government compensates these companies for the loss. This increases government expenditure, which, in turn, increases the fiscal deficit. The vicious circleThus, in India’s case, a greater trade deficit also leads to a greater fiscal deficit. So the causality in India’s case is both ways. A high fiscal deficit leads to higher trade deficit. And high trade deficit leads to higher fiscal deficit. And this, in turn, also leads to a weaker rupee, which, in turn, pushes up the cost of oil in rupee terms — leading to a higher fiscal deficit. Interest rates rub saltWhen government becomes the largest borrower in the country, its ‘crowds out’ others because the pool of savings left for the private sector to borrow depletes.     Since demand for money in a growing economy is large, it leads to higher interest rates. Businessmen baulk at high rates because it narrows their profit margins and so they don’t invest. And when companies cut capital spending, it results in low economic growth. Conversely, when economic growth is low, capital spending also remains low. That vicious circle! How does one solve this?Cutting fiscal deficit remains the critical imperative. That alone will set off a virtuous cycle. It will happen when the government bells the subsidy cat by raising the prices of petrol, diesel, kerosene and LPG.That’s the most crucial decision the government needs to take today. If these products are costlier, consumption will reduce, leading to lower imports and lower trade deficit.

Mere lip service by saying cutting expenditure elsewhere is of no consequence. Hopefully, it will not end cutting Plan expenditure, which is required to generate jobs and assets in the country.Second is attack the trade deficit. When imports exceed exports, the country pays the difference by diping into its foreign exchange reserves. But that isn’t healthy given our imports are more than 50% of our exports and there is a limited supply of foreign exchange reserves.

Once the trade deficit is lowered, the rupee will regain strength against the dollar. This, in turn, reduces our oil bill, increases foreign investor money flows and engenders overall economic growth. A lower fiscal deficit will also mean lower government borrowings and hence lower crowding out and so lower interest rates. Ah, a virtuous circle.Why there's little hope, thoughThe flip side to increasing the price of oil products is higher inflation since prices of transported goods will rise. The zillion-dollar question is, does the UPA government have the courage to take the bull by the horns?

When Dinesh Trivedi tried to increase rail fares after almost ten years, he lost his job. Will the Congress cut down on food subsidies, budgeted at Rs75,000 crore for the current financial year, which is a favourite subject of Sonia Gandhi? With 2014 likely to be the official launch of Rahul Gandhi as a prime ministerial candidate, can the government afford to antagonise the poor who constitute a massive votebank - and who need the subsidies the most? Fat chance.

Vivek Kaul is a writer and can be reached at vivek.kaul@gmail.com