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In Context
- As per the RBI’s quarterly statistics, the current account deficit (CAD) widened to 4.4 per cent of GDP in the second quarter of 2022-23, down from 2.2 per cent in the preceding quarter.
About the “Current Account”
- A nation’s Current Account maintains a record of the country’s transactions with other nations. It comprises the following components:
- trade of goods and services,
- net earnings on overseas investments and net transfer of payments over a period of time, such as remittances
- This account goes into a deficit when money sent outward exceeds that coming inward.
- Calculation:
- It is measured as a percentage of GDP.
- Trade gap = Exports – Imports.
- Current Account = Trade gap + Net current transfers + Net income abroad.
- It is measured as a percentage of GDP.
About Current Account Deficit (CAD)
- Meaning:
- When the value of the goods and services that a country imports exceeds the value of the products it exports, it is called the current account deficit.
- Twin deficits:
- CAD and the fiscal deficit together make up the twin deficits – the enemies of the stock market and investors.
- Different from the Balance of Trade:
- It is slightly different from the Balance of Trade, which measures only the gap in earnings and expenditure on exports and imports of goods and services.
- Whereas, the current account also factors in the payments from domestic capital deployed overseas.
- For example, rental income from an Indian owning a house in the UK would be computed in the Current Account, but not in the Balance of Trade.
- Significance:
- Country’s trade and transactions:
- If the current account – the country’s trade and transactions with other countries – shows surplus, that indicates money is flowing into the country, boosting the foreign exchange reserves and the value of rupee against the dollar.
- These are factors that will have ramifications on the economy and the stock markets as well as on returns on investments by people.
- Indicator of Economy:
- CAD may be a positive or negative indicator for an economy depending upon why it is running a deficit.
- Foreign capital is seen to have been used to finance investments in many economies.
- It may help a debtor nation in the short-term, but it may worry in the long-term as investors begin raising concerns over adequate return on their investments.
- CAD may be a positive or negative indicator for an economy depending upon why it is running a deficit.
- Country’s trade and transactions:
Characteristic features of India’s CAD
- India’s CADs have both desirable and undesirable components:
- A desirable deficit is a natural reflection of rising investment, portfolio choices and the demographics of the country.
- However, large and persistent CADs can be undesirable if they reflect bigger problems such as poor export competitiveness and are financed by unstable financing.
- The countercyclical nature of India’s CAD is a matter of concern:
- Research suggests that the country’s CAD rises when output falls rather than when demand rises, indicating the dominance of external shocks.
- For instance, if oil prices rise, and as oil is an input in the production process, it raises the cost of production and leads to a fall in economic growth.
- In this case, CADs rise with falling growth due to both the inelasticity of oil import demand as well as its major share in India’s total imports.
- Research suggests that the country’s CAD rises when output falls rather than when demand rises, indicating the dominance of external shocks.
- Risks associated with financing:
- Large and persistent CADs expose India to the risks associated with its financing.
- Economic theory suggests that if CADs can be financed by stable capital inflows, such as FDI inflows, they are desirable as they are less prone to capital flight.
- However, if deficits are financed by volatile capital flows such as portfolio flows, there may be a cause of concern.
- Portfolio flows are capricious and more susceptible to reversals in case of any global financial shock. Hence, the composition of financing is crucial.
- Current example:
- While FDI inflows were enough to finance the deficit in 2021-22, these inflows have been weak in the current fiscal year.
- FDI and portfolio inflows each only financed about 18 percent of CADs in the second quarter of 2022-23. So, there is a financing issue.
- Counter-balancing Remittances:
- Remittances and services exports have provided a counter-balance to rising merchandise trade deficits.
- While capital flows are pro-cyclical and react negatively to contractionary monetary policy by the Fed, remittances have exhibited remarkable stability.
Suggestions & way ahead
- Controlling negative spillovers from global changes:
- Over the medium term, policymakers need to arrest the negative spillovers from the slowdown in global trade on merchandise exports.
- Further rate hikes by the US Fed may lead to capital outflows leading to additional exchange rate market pressures.
- This could be challenging in the current situation as a weaker currency, coupled with a sticky import basket will lead to imported inflation.
- Making exports competitive:
- Policy measures thus must facilitate exports by focusing on structural reforms to improve trade competitiveness, alongside which the government must sign free trade agreements.
- Ensuring stable financing:
- India is currently facing the twin-deficit problem of high fiscal and CADs.
- While aggressive fiscal consolidation may be undesirable in the face of rising fears about a global slowdown, a comfortable external environment can be maintained by ensuring stable financing, along with using exchange rates as a shock absorber to weather the adverse global economic situation.
Daily Mains Question [Q] India’s Current Account Deficit (CAD) has both desirable and undesirable components. Examine. Discuss the need for stable capital flows to manage India’s CAD. |
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