Current Account Deficit & Its Impact on Economy

Current Account Deficit & Its Impact on Economy

What is Current Account Deficit?

Current Account Deficit (CAD), is a key indicator that reflects the economic strength of a nation. The CAD is the net of foreign exchange inflows and outflows.

CAD is one of the key indicators of an economy’s health and measures the difference between the value of the goods and services a country imports and the value of its exports.

A current account reflects the net results of a country’s recurring financial transactions with the rest of the world. Trade in goods and services, net income from foreign investments and direct money transfers are the usual components of CAD. Trade includes both export and import of physical goods and services. Income from foreign investments includes dividends and interest. Direct transfer is all money remitted to a home country by its citizens working abroad. If the net value (credit minus debit) of all these components is positive, then its current account is said to be in surplus. A negative value indicates that the country runs a deficit (CAD). Trade in goods and services is the biggest component in the current account.

Current account deficit (CAD) increased to USD 57.2 billion or 2.1 percent of GDP in FY19 as against 1.8 percent in the previous year according to RBI report . the CAD, which is the net of foreign exchange inflows and outflows, had stood at USD 48.7 billion in FY18.

  • India had a fiscal deficit of ₹3.66 tn in the first two months of this fiscal year, which is 52% of its full-year target
  • January-March CAD is lower due to lower merchandise trade deficit

(Source: Developments in India’s Balance of Payments during the Fourth Quarter (January-March) of 2018-19 & Sources of Variation in Foreign Exchange Reserves in India during 2018-19)

Components of CAD

The largest component of a current account deficit is the trade deficit. Trade Deficit occurs when the country imports more goods and services than it exports.

The second largest component is a deficit in net income wherein foreign investment income exceeds the savings of the country's residents. This foreign investment can help a country's economy grow. But if foreign investors worry they won't get a return in a reasonable amount of time, they will cut off funding. That causes widespread panic.

Net income is measured by the following four things.

  1. Payments made to foreigners in the form of dividends of domestic stocks.
  2. Interest payments on bonds.
  3. Wages paid to foreigners working in the country.
  4. Direct transfers, mostly money foreign residents send back to their home countries. It also includes government grants to foreigners. This component is the smallest, but the most hotly contested.

Consequences of CAD

In the short-run, a current account deficit is helpful to the debtor nation. Foreigners are willing to pump capital into it. That drives economic growth beyond what the country could manage on its own.

But in the long run, a current account deficit gradually weakens economic vitality. Foreign investors question whether economic growth will provide enough return on their investment. Demand weakens for the country's assets, including the country's government bonds.

As foreign investors withdraw funds, bond yields rise. The national currency loses value relative to other currencies. That lowers the value of the assets in the foreign investors' strengthening currency. It further depresses investor demand for the country's assets. This can lead to a tipping point where investors will dump the assets at any price.

The only saving grace is that the country's holdings of foreign assets are denominated in foreign currency. As the value of its currency declines, the value of the foreign assets rise. That further reduces the current account deficit.

In addition, a lower currency value increases exports as they become more competitively priced. The demand for imports falls once prices rise as inflation sets in. These trends stabilize any current account deficit.

Regardless of whether the current account deficit unwound via a disastrous currency crash or a slow, controlled decline, the consequences would be the same. That's a lower standard of living for the country's residents.

Source: (Current Account Deficit, Its Components and Causes)

Why a current account can be harmful to the economy

  • Unsustainable?If a current account deficit is financed through borrowing it is said to be more unsustainable. This is because borrowing is unsustainable in the long term and countries will be burdened with high-interest payments. E.g. Russia was unable to pay its foreign debt back in 1998. Other developing countries such as Brazil, African countries have experienced similar repayment problems. Latest example is of Pakistan who is facing similar problem. Countries with large interest payments have little left over to spend on investment.
  • Risk of capital flight. A very high balance of payments deficit may, at some point, cause a loss of confidence by foreign investors. Therefore, there is always a risk, that investors will remove their investments causing a big fall in the value of your currency (devaluation). This can lead to a decline in living standards and lower confidence for investment.
    • A factor behind the Asian crisis of 1997 was that countries had run up large current account deficits by attracting capital flows (hot money) to finance the deficit. But, when confidence fell, these hot money flows dried up, leading to a rapid devaluation and crisis of confidence. When confidence fell and the exchange rate fell, there was a degree of capital flight as foreign investors sought to return assets.
  • Foreign ownership of assets. If you run a current account deficit, it means you need to run a surplus on the financial/capital account. This means foreigners have an increasing claim on your assets, which they could desire to be returned at any time. For example, if you run a current account deficit, it could be financed by foreign multinationals investing in your country or the purchase of assets. There is a risk that your best assets could be bought by foreigners, reducing long-term income.
  • An indication of an unbalanced economy. A persistent current account deficit may imply that you are relying on consumer spending, and the economy is becoming unbalanced between different sectors and between short-term consumption and long-term investment.
  • For example, the UK has had a high share of GDP focused on consumer spending and relatively low levels of investment – especially in the manufacturing sector.  This focus on domestic consumption can have adverse effects in the long-term with less investment in productivity. The UK experience might be contrasted with Germany which has a current account surplus and generally considered to have better levels of investment in the economy.
  • An indication of an uncompetitive economy. A current account deficit may imply the economy is becoming uncompetitive and the exchange rate relatively overvalued.
  • For countries with floating exchange rate – e.g. Pound Sterling, this is not so serious because market forces will cause a depreciation to restore competitiveness.
  • However, a current account deficit can be a real problem for countries in the Euro – who cannot devalue to restore competitiveness. For example, 2000-2007, a divergence in inflation rates caused very large current account deficits in southern Eurozone economies. This lack of competitiveness and low level of export demand was a factor behind the weak domestic demand 2008-13 of Greece, Portugal, Spain during the Eurozone recession of 2008-13.
  • Risk of depreciation. A country running large current account deficit is always at risk of seeing the value of the currency fall. If there is insufficient capital flows to finance the deficit, the exchange rate will fall to reflect the imbalance of foreign flows of funds. A depreciation in the exchange rate will cause imported inflation for consumers and firms who rely on imports of raw materials. 

Source: (Problems of a current account deficit)


Why is CAD important?

CAD indicates that a country’s spending is higher than what it earns from the rest of the world. When a country runs a CAD for years at a time, it contributes to a steady outflow of foreign exchange and weakens its exchange rate. Take for instance, India’s persisting trade deficit ($16.3 billion in January 2018) has always kept its current account balance under pressure. The result has been a steadily depreciating rupee against other currencies. A widening trade deficit also indicates that a country’s domestic producers are finding it tough to compete effectively with their global counterparts, prompting consumers to depend on imported products.

Why should we care about CAD?

The US accounts for 15 per cent of India’s exports. Precious metals, jewellery and pharma products together contribute over 30 per cent of India’s exports to the US. Some of India’s largest job-creating sectors like TCS, Infosys, Cognizant etc are heavily reliant on exports. Therefore, any measure by the US to shrink its trade deficit with India could hit these sectors and worsen the jobs problem. It is not just in the case of goods that India has a lot to worry about. Trump’s move to curtail new H1-B visas for entry-level programmers and rethink visa extensions for those whose green card applications are under process have already jolted the Indian IT industry and the Indians residing in the US - the top destination accounting for over 55 per cent of its services exports.

Its impact on India apart, US aggression on curbing imports can unleash global trade wars that can unsettle the nicely recovering global economy. If Trump decides to target nations like China in a bid to curb the CAD, it could attract retaliation in the form of trade or financial counter-moves from China. Such measures can in turn accelerate the trend of de-globalisation. This wouldn’t be great news either for the Indian economy or its stock market.

The bottomline

The U.S. goods and services deficit with its global trading partners widened slightly in March 2019 as demand for foreign goods buoyed imports. President Donald Trump has already begun playing his campaign trump cards one at a time. The latest one in the name of Trade War, which has roiled global trade, is the decision to slap higher import tariffs on steel and aluminium. The US is busy upping its import tariffs on a range of goods to prune its trade deficit and thus, its Current Account Deficit (CAD), a key indicator that reflects the economic strength of a nation. Trump’s targets are the nations which run up huge trade deficits with the US. The US has the highest trade deficit of $552 billion (in 2017) rising to $ 621 billion in 2018 (Source: US Trade Deficit and How It Hurts the Economy).  It has trade deficit of $ 419 billion with China, followed by Mexico ($81 billion), Germany $ 68.2 billion) & Japan ($67.6 billion). With a deficit of around $ 24.2 billion, India isn’t off the hook. (Source: U.S.-India Bilateral Trade and Investment)

Trump’s Trade War decision is a step towards reducing the CAD Gap, but for every action, there is an equal and opposite reaction.

(Source: Article by Gurumurthy K published in Business Line 2th March 2018.)

 

 

 

 

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