General Studies IIIEconomy

Current Account Deficit


Recently, an American financial services company Morgan Stanley has predicted that the Current Account Deficit will widen to a 10-year high of 3% of GDP in FY23.

What is Current Account Deficit?

The current account measures the flow of goods, services and investments into and out of the country. The country runs into a deficit if the value of goods and services we import exceeds the value of those we export. The current account includes net income, including interest and dividends, and transfers, like foreign aid.

A nation’s current account maintains a record of the country’s transactions with other nations, it comprises of following components:

  • Trade of goods,
  • Services, and
  • Net earnings on overseas investments and net transfer of payments over a period of time, such as remittances

A country with rising CAD shows that it has become uncompetitive, and investors may not be willing to invest there. In India, the Current Account Deficit could be reduced by boosting exports and curbing non-essential imports such as gold, mobiles, and electronics.

A current account deficit is not always a problem. The Pitchford thesis states that a current account deficit does not matter if it is driven by the private sector. It is also known as the “consenting adults” view of the current account, as it holds that deficits are not a problem if they result from private sector agents engaging in mutually beneficial trade.

What is the formula to calculate Current Account Deficit (CAD)?

The formula to calculate CAD is:

Current Account = Trade gap + Net current transfers + Net income abroad
(Trade gap = Exports – Imports)

Findings of Morgan Stanley 

  • In the wake of continued geopolitical tensions, the surge in oil prices is likely to be sustained, which would lead to deterioration in the current account deficit from a higher oil import bill.
  • The Balance of Payments (BoP) to be in deficit of approximately 0.5-1% of GDP (Gross Domestic Product) because capital flows are likely to be lower than the current account deficit.
  • The extent of vulnerability to funding risks will be cushioned by the large forex reserves, which stand at USD 681 billion.
  • The company expects the April 2022 policy to mark the process of policy normalization with a reverse repo rate hike. However, if the RBI were to delay its normalization process, the risk of disruptive policy rate hikes would rise.
  • There is less room for fiscal policy stimulus to support growth given high deficit and debt levels – it is seen that there is a possibility of a modest fuel tax cut and reliance on the national rural employment program as an automatic stabilizer.

Problems of current account deficit

Problems of Current account deficit  Evaluation  
  • Foreigners have greater claim on domestic assets
  • Large deficit could be unsustainable – if financed by borrowing from aboard.
  • It may indicate unbalanced economy – focused on short-term consumption rather than longer term investment in export sector
  • Large deficit could cause depreciation in exchange rate and cost-push inflation
  • For countries in fixed exchange rate-it may indicate they have become uncompetitive-due to higher inflation and if exports over-priced reduce domestic demand
  • Domestic country may benefit from this eg. Chinese investment in Africa
  • Current account deficit can also be financed by long-term investment, which improves productive capacity.
  • A current account deficit can enable the economy to have higher standards of living.
  • A moderate depreciation would help restore competitiveness
  • For countries in floating exchange rat-market forces should adjust to correct level in long-term

Is Current Account Deficit always a negative indicator?

  • Current Account Deficit 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. Current Account Deficit 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.

A current account deficit is not necessarily harmful:

  • A current account deficit could occur during a period of inward investment (surplus on financial account).
  • This inward investment can create jobs and investment. E.g. the US ran a current account deficit for a long time as it borrowed to invest in its economy. This enabled higher growth and so it was able to pay its debts back and countries had confidence in lending the US money.
  • With a floating exchange rate, a large current account deficit should cause a devaluation which will help automatically reduce the level of the deficit.
  • A current account deficit may just indicate a strong economy, which is growing rapidly. For example, the rise in deficit on UK primary incomes (2015-16) is a reflection that investment in the UK was giving a good return to foreign investors.

Further Evaluation:

  • It depends on the size of the current account deficit as a % of GDP. For example, a deficit of over 5% would be cause for greater concern.
  • It depends on how one is financing the current account deficit. If a country is borrowing from abroad to finance consumption, this is damaging in the long-term. If it is financing the current account deficit through attracting long-term capital investment, this could have positive benefits.
  • It depends on the country in question. For example, the US probably has less reason to be concerned about a current account deficit. The US can attract a lot of capital flows to buy dollar securities. However, a developing economy like India may be more vulnerable to a current account deficit. This is because investors may be quicker to fear an economic downturn and remove their capital.

Dealing with Current Account Deficit?

  • CAD exists due to a host of factors including existing exchange rate, consumer spending level, capital inflow, inflation level, and prevailing interest rate.
  • For the Current Account Deficit in India, crude oil and gold imports are the primary reasons behind high CAD.
  • The Current Account Deficit could be reduced by boosting exports and curbing non-essential imports such as gold, mobiles, and electronics.
  • Currency hedging and bringing easier rules for manufacturing entities to raise foreign funds could also help.
  • The government and RBI could also look to review debt investment limits for FPIs, among other measures.

What is Balance of Payments?

  • About:
    • BoP of a country can be defined as a systematic statement of all economic transactions of a country with the rest of the world during a specific period, usually one year.
  • Purposes of Calculation of BoP:
    • Reveals the financial and economic status of a country.
    • Can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.
    • Helps the Government to decide on fiscal and trade policies.
    • Provides important information to analyze and understand the economic dealings of a country with other countries.
  • Components of BoP:
    • For preparing BoP accounts, economic transactions between a country and the rest of the world are grouped under – Current account, Capital account and Errors and Omissions. It also shows changes in Foreign Exchange Reserves.
    • Current Account: It shows export and import of visibles (also called merchandise or goods – represent trade balance) and invisibles (also called non-merchandise).
      • Invisibles include services, transfers and income.
    • Capital Account: It shows a capital expenditure and income for a country.
      • It gives a summary of the net flow of both private and public investment into an economy.
      • External Commercial Borrowing (ECB)Foreign Direct InvestmentForeign Portfolio Investment, etc form a part of capital account.
    • Errors and Omissions: Sometimes the balance of payments does not balance. This imbalance is shown in the BoP as errors and omissions. It reflects the country’s inability to record all international transactions accurately.
    • Changes in Foreign Exchange Reserves: Movements in the reserves comprises changes in the foreign currency assets held by the Reserve Bank of India (RBI) and also in Special Drawing Rights (SDR)balances.
    • Overall the BoP account can be a surplus or a deficit. If there is a deficit then it can be bridged by taking money from the Foreign Exchange (Forex) Account.
      • If the reserves in the forex account are falling short then this scenario is referred to as BoP

Source:The Hindu

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