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Posted by: Deepa Vasudevan on Thu, Jan 31st, 2013

The Current Account Deficit

The Current Account Deficit

India has a history of running trade deficits, and managing a surplus on invisibles (through worker remittances in the pre-reform period, and net exports of services post-reform). This combination has ensured that its Current Account Deficit (CAD) stayed within 1%-3% of GDP in the past, a level that is perceived to be sustainable by policy makers and overseas investors[1].

 

The last six quarters have shown a different and dangerous trend. In 2011-12, CAD at $ 78.2 billion or 4.2% of GDP, was the highest attained in the last thirty years. By Jul-Sept 2012, it had gone up to 5.4% of GDP (Pic 1). Based on these trends, CAD for 2012-13 is expected to be as much, or worse than last year.

 

Pic 1: Quarterly CAD- levels and % to GDP

 

Quarterly CAD- levels and % to GDP

Source: RBI

 

A country running a CAD is a debtor to the rest of the world: it "owes" foreign exchange equal to the value of the CAD. This foreign exchange has to be attracted from overseas investors, who bring in capital to invest in real assets (factories, airports, roads, buildings) or financial assets (equity, debt, treasury bills, bank deposits). These inflows are routed through the capital account, which complements the current account by financing its deficit.

 

The higher the CAD, the greater the dependence on foreign inflows of capital, and the higher the risk of a systemic crisis arising due to a reversal of capital flows.  The last time CAD crossed 3% in 1990-91, a BoP crisis took place. There are concerns that if left unchecked, the economy may be heading towards another crisis.

 

CAD can be reduced by increasing exports or decreasing imports. Since the export slowdown is largely attributed to poor global demand, the government has focused on reducing imports. In particular, policy action has been taken to reduce gold imports, which have crossed 10% of the total import bill in recent years, vindicating its role as a hedge against inflation and currency risks (See Table 1).

 

Table 1: Rising Gold Imports

 

Rising Gold Imports

Source: Ministry of Commerce, Govt of India

 

schemes that channelize retail gold holdings into institutions so that more gold could be released and circulated rather than being imported[2].The impact of these steps is yet to be seen, but recent reforms to facilitate investment (including the easing of monetary policy by RBI) have created a strong positive sentiment about the Indian growth story. This may ensure that we get the $70-$80 billion necessary to plug the CAD this fiscal, but three risks will remain until the deficit is reduced.

 

First, the composition of the capital account has shifted away from the more stable FDI and towards volatile components such as NRI deposits and portfolio inflows, as well as debt creating ECBs (Table 2). This has increased our external vulnerability:  in any crisis, the volatile flows dry up first.

 

Table 2: Major Items of Capital Account

 

Major Items of Capital Account

Source: RBI

 

Second, deteriorating CADs always lead to currency depreciation, which could re-ignite inflationary expectations through higher import prices. This could loop back to further worsen CAD, especially if exports growth is poor.  Finally, there is always a "tipping point" for CAD when the dependence on foreign inflows leads lenders to question the country’s ability to pay for its imports or repay external debt. At this level, most of the capital will pull out, leaving the country with a full blown currency .

 



[1] To read more about trends in CAD and its implications for BoP, please refer to CIEL Concept Note on "The Current Account Deficit", available at http://ciel.co.in/article_comment.php?a_id=1843

[2] See the Ministry of Finance Press Release dated January 21, 2013 for more details. Available online at http://finmin.nic.in/press_room/2013/GoldDep_ETF_unfreezed.pdf

Harish Tilokani on Sat, Feb 2nd, 2013 9:06:35 am

Govt is taking steps to curb gold imports in order to curtail CAD. But just as FII are encouraged to invest in India, Govt. could come out with plans to discourage consumption of gold. For eg. how much an Indian required gold?? 10gm. 50gm 100gm .... Why not to chek the Wealth Tax Returns of Wealthy People and tax them heavily on gold stock they have? Why not to make a rule of using the Property they buy, to build infrastructure and employment generation. This Big Fat moneyman just keep piling wealth only for their personal interest, keeping aside the interest of country.

DESU SRIDHAR on Fri, Feb 1st, 2013 8:02:27 pm

FIRSTLY, I WOULD LIKE TO THANK CIEL FOR GIVING OPPORTUNITY TO SHARE MY OPINION ON CIEL PLATFORM. THE DEPENDENCE ON IMPORTS AND FOREIGN CAPITAL ARE THE BIGGER RISKS FOR THE COUNTRY AHEAD ALSO. I FEEL ITS NOT CORRECT TO DEPEND ON THE FOREIGN CAPITAL BECAUSE ITS JUST SELLING OF FIXED ASSETS FOR VARIABLE EXPENSES...... LET US GO ORGANIC... EVERYTHING CAN BE SOLVED.... COUNTRY SHOULD CALL YOUNGSTERS MEETS FOR INNOVATIVE IDEAS TO REDUCE THESE DEFICITS.

Deepa Vasudevan on Fri, Feb 1st, 2013 5:09:49 pm

Dear Mr.Nanjundaiya, Pegging the exchange rate has its own problems- even if it is only for a year. It will work in practise only if during that year, enough reforms are put in place to ensure export competitiveness. And giving a time frame will give speculative forces a time frame to act. There is also a huge global outcry against competitive devaluation- now that the yen has been allowed to depreciate. So this is a controversial path- with its own set of problems!

Deepa Vasudevan on Fri, Feb 1st, 2013 3:19:06 pm

Dear Arun, Your point about export promotion being a critical part of CAD reduction is completely valid. India could be a great export power house if it got its infrastructure and export incentives in order. In the long run, that is the most sustainable way to control CAD. As you may have read, taxing gold imports has only led to increased smuggling!

Ramesh Kumar Nanjundaiya on Fri, Feb 1st, 2013 10:33:47 am

Let's face it, all the economic methods and models for the Indian growth story, armchair thinkers and critics, RBI's CRR reduction, Central Government's wishy washy policies has not helped the Indian economy since the last 24 months for one reson or the other. Take a strong step. Peg the Indian Rupee for one year to the US$. The main reason is the fact that the India's foreign exchange reserves have dropped from a peak of $320bn in September 2011 to $290bn now, a drop of $30 billion. It is a sizeable drop indeed and which should alert the policy makers. It seems that people are selling rupee to buy $. The country's exporting firms are keeping their foreign earnings abroad as they expect the rupee to fall further. In addition to this, all the foreign investors are converting their rupee assets into dollars to take it out, a clear case of rupee devaluation. To arrest this situation, one easy method is for banks in India to protect their customers rupee deposits by increasing the rate of interest they pay on deposits. Remember, foreign monies coming into India has also reduced (since the last 12 months) due to the ongoing global financial crisis. There is currently an overall selling pressure on the rupee. In such a scenario, its will be worthwhile to consider a small devaluation in the rupees and peg it (for 1 year only) as Rs. 60/- to US$1/-. Things might improve.

Sulaiman Meghjani on Fri, Feb 1st, 2013 6:08:46 am

Energy bill is the biggest import bill We are paying. We should bring a clear cut policy on renewables , go towards BIOCNG, Bio butanol, Biodiesel ,Solar Small wind - Efficiency rewards for Indusrty , electric vehicles( They are costly in West But India has talent to develop low cost vehicles - Electric) and similar incentives with Private public partnership, which can make India totally free from debts.

Arun on Thu, Jan 31st, 2013 10:26:32 pm

Hello M'm, please don't mind, you have here given a very small glimpse that contain gold FDI only but CAD is a very wide range and both micro and macro lines too. This CAD problem is because of mismanagement and sick politics. You know very well that why you invest your money in other country, and why you use other countries goods. The aim is clear, comparatively best and money benefit, these two parameters are enough to take proper steps to increase inflow. And the best idea is export, we can export but we have no export specialized industry and program even we have supply deficit in our own country. This CAD is a result of short sightedness.

DIJO GEORGE on Thu, Jan 31st, 2013 6:30:13 pm

I think Slowing growth, elevated headline inflation and twin deficits weigh upon sentiments.. The macroeconomic scenario remains clouded given the deteriorating growth-inflation dynamics; the likelihood of fiscal slippages relative to Government of India's Budget Estimates; and concerns regarding the funding of the current account deficit in 2012-13

SRINIVASAN V NAIDU on Thu, Jan 31st, 2013 6:21:01 pm

Bravo. Welldone. If I were to be journalist, I would have written the same on 02Mar. 2012(post budget). Not bad to alarm the "SYSTEM". We are happy to read such open blunt comments. Are you (Hon. FM) listening Sir? THANK YOU ONCE AGAIN. 31Jan2013.

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