CURRENT ACCOUNT DEFICIT (CAD) FROM A DIFFERENT PERSPECTIVE

CAD is one of the major issues that Indian economy is facing today. You must have read about it from different sources and it is a common topic that was taken up by many in the past. But I decided to take this topic to try to give you analytical perspective rather than the facts. I have divided this article into different sections. 1. 2. 3. 4. 5. 6. 7. About CAD Is CAD due to demand or due to supply side factors? What does CAD actually means? What are the reasons for high CAD in India? Is CAD good or bad? Why CAD is concern for India? Is situation in 2013 similar to that of in 1991?

What is CAD Current Account represents the export import of goods and services. (For imports we have to pay thus it is expenditure for us and exports represent income from sale of goods and services to the foreigners. Deficit = Expenditure > Income Surplus = Income > Expenditure) CAD is the difference between what we are paying to the foreigners and what we are earning from them. (i.e. our expenditure is more than our income as we are importing more than what we are exporting) Thus CAD is Payment > Income (outflow of Forex) or Imports > Exports (It indicates India is borrowing and a net debtor to rest of the world) CAD shows international competitiveness of a country (India is way behind)

CAD is there because of two main reasons: (or why Import > Export ?)
More demand for foreign goods Less Supply of Domestic goods

Is CAD in India due to excess Demand or Supply Shock?

In India Rest of the World
CAD is pro cyclical (i.e. due to excess demand) CAD rises when demand rises or consumption rises.

CAD is counter cyclical (i.e. due to supply shock) CAD rises when output falls and not because of a rise in demand

A countercyclical situation in Indias case shows that CAD occurs due to external supply shocks rather than excess demand factor. For e.g. Oil Supply Shock. This can be proved with this analysis: In recent years, the peak CAD saw both sharp rise in oil prices and falling growth (i.e. due to less supply). As against this, CAD was only 1.3% in 2007-08, a year of high consumption, investment and growth (High demand). Summary:- the CAD in India is due to supply side factors.

High CAD can be seen from two perspectives:

Difference between exports and Imports

Domestic Saving and Investment gap

In theory: When GDP Falls Indian situation When GDP falls

Imports falls

CAD is nothing but = Investment Savings i.e. Investment > Saving. If CAD increases it means either savings is falling or investment is rising. But Indian story here is again different In India CAD is increasing with falling investment because saving rate has been falling at an even faster rate 2008 2013 Total Fall Saving 37% 30% -7% Rate (of GDP) Investment 38% 35% -3% Rate (% fall in Saving Rate > % fall in Investment Rate) (Thus Indians need to save more to lower CAD)

no significant fall in Imports (imports remained stable)

Reasons for High CAD in India: (Why imports > exports)

1. Euro zone Crisis:
Austerity measures in Advance Economies and Recession in Euro zone Crisis lead to fall in Indian exports (as we mainly exports to these countries) and ultimately our growth fell. Measure Global recovery

2. Slowdown in Exports:
Due to weak global demand, Indian exports fell. (But the point to be noted here is that GDP growth rate in India was not affected by the crisis of 2007-08, but fall later on. The reason being that the recession spread from USA to those European countries which are the trading partners of India like Germany, UK, France etc., thus India exports fell. This shows that Indian exports are income sensitive i.e. depends on the global demand than price sensitive. In simpler words, India exports depends upon the income of foreign nations, If the income in foreign countries is higher than they will purchase more goods like jeweler, cloths from India and hence exports will increase, and prices of the goods has no effect on the export demand. Thus export is income sensitive and not price sensitive.) Measure Boost exports by giving incentives like tax and duty concession, EPZ, export credit etc.

3. Higher Imports:
Although exports slowed down, still imports did not decline as much The reason being oil and gold import Now let us see why oil and gold imports were inelastic (i.e. did not fall) Oil Imports Demand for oil import is high in India. Also high oil prices lead to increase in import bill as India imports more that 2/3 of its oil requirement (The oil prices fell in recent times but the depreciating rupee has nullified its effect) Gold Import India is the largest importer of Gold in the world and gold is second biggest item imported after oil in India. Gold is unproductive as it cannot be invested anywhere, so the

money invested in gold is block which could otherwise be used in investment on infrastructure or setting up of industries etc. Share of Oil and Gold import in total Indian imports is around 45% (2012-13). It lead to outflow of money from India. Measure to curb Oil and Gold imports. For this government has raised the duty on import of gold and subsidies are reduced for oil products and made petroleum prices market determined.

4. Weak Rupee:
Though measures were taken by the government to reduce import but depreciating rupee cancelled that effect. For e.g. suppose India imports 100 barrels of Oil from USA at $10 ($1 = Rs. 50). That means India need to pay Rs. 50,000 (100 x 10 x 50). Now the prices of oil in international market fell from $10 to $9 (But the rupee depreciated and now $1 = Rs. 60). So India needs to pay Rs. 54,000 (100 x 9 x 60) for the same quantity of oil. Thus a reduction in oil prices does not benefitted India. Measure: RBI intervention to remove speculation in forex market. Fiscal measures to stabilize exchange rate.

5. Slowdown in Invisible Surplus

Before explaining this point let me explain to you the components of Current Account The Current Account transactions are classifies as

Import and Export of Merchandise Goods (Remember it is also called as trade) Merchandise goods are those physical goods, which can be seen, touched like gold, oil, soap, deo, shoes etc.

Import and Export of Invisibles Invisibles are those items which cannot be seen or are intangible. It includes: 1 Services (like Hotels, Telecom, IT Software etc.) 2 Transfer Incomes which means money is received from foreign country (like Bill Gates is your uncle and he send you $100 million as a gift or a tourist comes to India and spend foreign currency in India on site seeing, shopping etc.)

So Current Account transaction = import and export of Merchandise Goods (Trade) + import and export of Invisibles

India has always seen a trade deficit (i.e. import of merchandise goods > export of Merchandise goods, thus we need to pay to outsider). And there is invisible surplus (i.e. Export of Invisibles > Import of Invisibles, thus our income is more) This trade deficit is somewhat offset by the income from invisible surplus. (i.e. Surplus from invisibles is used to cover up the trade deficit) In 2012-13, Trade Deficit = - $196 Billion Invisible Suplus = + $108 Billion So CAD = - $88 Billion As shown above the income from invisible surplus use to offset the loss from trade deficit. But in recent years the invisible surplus has declined thus resulting in higher CAD.

6. Micro Factors:
Flawed policies of government have lead to a situation where once India was an exporter of a commodity or had enough production of commodities to meet our domestic demand, but now we are importing those commodities. For e.g. Iron Ore: India has been exporting Iron ore but due to environment considerations, export of Iron ore has decreased and now India is importing steel scraps. Coal: India has abundant coal reserves. But due to COALGATE Scam there has been problem in allocation of coal mines and this production of coal has decreased. Now India is importing coal.

Effects/Consequences of High CAD:

There can be both positive and negative effects of CAD

Positive effect:
In short term, a CAD could help in rise of investment from abroad which usually have a positive effect on the local economy. If this money is used wisely, it could help in increase the production for that economy in the future. Increased production would led to increase in exports and will ultimately reduce the CAD.

Negative Effects of high CAD

1. Reduction in Demand for Assets of a country In the long run, a persistent CAD can affect economic viability. A country needs to pay continuously for its excess Imports, which is not sustainable in the long run and the probability for a default increases. This, ultimately, will lead to fall of demand for countrys assets, which also include government bonds. (Following is a technical explanation and can be ignore by people from non economic background)

High CAD in the Long Run

It will lower the Demand for Counry's Assets

Price of the Government Bonds will Fall and yield would increase

Rupee will depreciate

It will lower the value of asset in forreign investor currency

Investor will dump the assests at any price

CAD can affect the viability of an economy. Demand would weaken for the countrys asset, including government bonds. As the price of the bond falls, yield will rise. This will lead to depreciation (of fall) in the value of currency vis--vis other foreign currencies. This will further lower the demand for countrys asset and could lead to a point where investors will dump the asset at any price.

2. Rupee Depreciation CAD = Imports > Exports Since international trade happens in US Dollars and India need to pay for its imports in $, so the demand for $ would go up, which will lead to depreciation of rupee (or fall in value of rupee). If domestic currency loses value, the foreign investors lose interest in the economy of that country on fear that it may not get return on in investment. (For e.g. Suppose Barak Obama invest $ 100 in India (1$ = Rs.50). He buys assets worth Rs.5000 (100x50). He gets 10% return on it. So the amount he will receive will be Rs.5500. But in USA rupee is not accepted to he has to convert this rupee in to Dollard. But at the time Indian Rupee depreciates from $1=Rs.50 t0 $1=Rs.60. Thus Obama will actually receive $ 91.66 (5500/60), which is less than his original investment of $100. He has actually lost money thus he will not invest in the country)

3. Funding of CAD from short term foreign inflow: There are three ways to fund CAD.

i) India can pay from its domestic savings (which has fallen in recent years and is not enough to pay for imports, so this option is out)

It can use its forex reserves (which is limited and kept for emergency purpose like BOP crisis, so this option is also out)

It can borrow from foreign companies or countries i.e. foreign inflows (which is what India is doing now). Foreign borrowings are of two types Short Term (like FII or Portfolio Investment and ECB) and Long Term (like FDI)

India has been able to fund its CAD from foreign inflows and it does not require using its domestic savings. But India has mainly dependent on short term foreign inflows like FII or portfolio investments to fund its CAD. But over dependence in foreign money would make India vulnerable to external shock India will face a risk in case foreign companies take out their money out from India. (This can be seen from the recent announcement of USA Federal Reserve to tamper its $85 billion per month bond buying Quantitative Easing (QE) Measures. As a result of this, FIIs took their money out from Indian markets on expectation of future implication of this announcement. Indian Rupee fall from around $1=Rs.50 to its record valur of $1=Rs.68). India has been borrowing from foreign market to fud its CAD. This has increased our external debt. In 2012-13 the external debt was around $390 billion (21.2% of GDP). Thus our short term debt has increased, which makes our economy vulnerable to external shocks.

4. Rating Downgrade The persistent high CAD increases the risk of non-payment, which can lead to downgrade of rating of India. This will make it hard for India to attract foreign investment (Recently credit rating agency S&P and Finch has warned India of its rating downgrade expectation. If rating is downgraded, Indian bonds will come into the category of junk bonds. This no one will invest in Indian bonds).

5. Reduction in Forex Reserves As told in the above point 3, there are 3 ways to fund CAD. Second option is to use Forex Reserves, but this could lead to reduction in our precious foreign reserves of our country. India has a Forex Reserves of around $290 Billion, which can cover imports for 7 months only. Thus if India uses its Forex Reserves, It will lead to another 1991 like crisis.

Why CAD is a concern for India:

There are 3 main concerns about CAD

1. The Quantum of CAD

2. Quality of CAD

3. Financing of CAD

RBI estimates sustainable level of CAD for India is 2.5% of GDP. Persistent high CAD raises the concern about our ability to meet our external payment obligations and this reduce the confidence of the foreign investors Economic logic suggests that CAD should improve in a slowing economy. The study in other countries have proved that fact. But Thats not been the case with India because of following reasons: i) Oil Imports are inelastic ii) Domestic production is not good enough to replace imported products. iii) Slow export demand export fell.

Quality depends in composition of imports.

the

India has been able to finance its CAD because of Push and Pull factors Push Factors are extra money invested in India due to monetary stimulus given by Advance Economy Pull Factors includes attracting Capital by liberating FDI norms, expanding limits for foreign investment in debt and removing restriction on External Commercial Borrowings (ECB) But the CAD is met from short term FII and Portfolio investments which are volatile in nature and this has put our economy on a risk. This can also lead to depreciation of rupee. In 2012-13 22% of CAD was funded by FDI inflow and rest 78% was financed by FII and Debt inflow which is not good.

If India was importing capital goods (like Plant and machinery, Land and Building, etc.), we may be able to handle higher CAD because investment in capital goods leads to future production On the other hand, import of Gold, which is used as a hedge against inflation is a non productive investment, thus not beneficial for India. The quantity of CAD has increased but the quality hass deteriorated.

The India of 2013 is not the india of 1991?

Some people have compared the current situation with the BOP crisis of 1991. In this section I will compare the economic situation in 1991 with that of in 2013 and see whether the above assumption is right or not. 1991 Situation in world was different in 1991. Western countries were strong and looking outward and trying to deepen the process of Globalization In 1991, foreign capital was limited in India (Actually foreign capital was banned in India) Then, India only had forex reserve that can meet imports payment for just 15 days (Reserves were around $ 3 Billion) In 1991, ratio of Indias short term debt to forex reserve was around 146% (This ratio signifies that forex reserves were insufficient to meet the repayment demand) Both Exchange Rates and Interest Rates were fixed by Reserve Bank of India Crisis was so deep that India mortgaged its gold reserves to Bank of England In 1991, India faced problem of availability of capital as foreign capital was not allowed to enter India 2013 Today, major economies are looking much more integrated than before, but their economies are trying to fix their own domestic economy. Now a substantial part of Foreign capital is invested in India and for a long term Now India has forex reserves that can cover up imports for up to 7 months (Now Reserves are around $ 290 Billion) Ratio of Short term debt to forex reserve in 2012 was 31% (it was once around 5% in 2003)

Today both the rates are market determined. Recently RBI has bought gold from IMF (This shows the strength of our economy) Indian economy is liberalized, now there is no dearth of investors investing in India

On the eve of 1991 economic crisis, invisibles Today Software exports and other invisible (service + Transfer Payments) surplus were inflows in 2012-13 were enough to cover more negligible and were in deficit (i.e. negative) in than half of the trade deficit in the same year. 1989-90. Thus they could not be used to cover trade deficits. Inflation was in double digit There was political instability Saving and Investment rates were very low Inflation is at 7-8% level Government is stable now Now there is much higher rate of saving and investment.

From above analysis it can be concluded that situation in 2013 are much in control as compared to the situation in 1991. Indian economy has matured itself to cope with different crisis. -x-x-x-

This article is submitted by: Akshay Dhadda