Current Account Deficit – UPSC Economics Guide

Definition

What is current account deficit i.e. CAD? Current Account Deficit measures the flow of goods, services, and investments into and out of the country. We run into a deficit if the value of goods and services we import exceeds the value of those we export. Before understanding CAD in detail, let’s understand what are the Current Account Transactions. Current Account Transactions are the transactions which require foreign currency to execute. For example, payments connected with foreign trade, i.e. import and export, which is the biggest component of Current Account. Interest on loans given to other countries or taken from other countries is also part of Current Account Transactions. Net income from investments in other countries, remittances for living expenses of parent, spouse and children residing abroad, also comes under Current Account Transactions as it involves foreign currency. And even expenses in connection with foreign travel, foreign education and medical care of parents, spouse and children, comes under Current Account Transactions.

Example

Let’s understand how this Current Account Deficit is calculated with an example. So suppose total value of goods and services coming into the country include for example, imports at $1,000 million. Expenses in connection with foreign travel, education, health, done by citizens, is suppose $200 million. Interests and dividends paid to other countries is suppose $150 million. And other outflows is suppose $100 million. So total value of goods and services coming into the country is $1450 million, i.e. $1.45 billion.

Now let’s take the example where we calculate the total value of goods and services going out of the country. So exports suppose is $900 million, income from foreigners traveling to the country, education, health etc is suppose $150 million. Interest and dividends earned on the investments done in other countries is suppose $200 million. And other inflows, which may include remittances, is suppose $150 million. So total value of goods and services going out of the country is $1400 million, i.e. $1.4 billion.

So in this case, Current Account Deficit = Total Value of Goods and Services coming into the country – Total Value of Goods and Services going out of the country = $50 million.

So we can say that Current Account Deficit occurs when the value of goods and services coming into the country exceeds the value of goods and services going out of the country.

CAD vs Trade Deficit

Trade Deficit is an economic measure of a negative balance of trade in which countries imports exceeds its exports. A Trade Deficit represents an outflow of domestic currency to foreign markets. Trade deficit actually is a subset of Current Account Deficit. Trade Deficit only measures the difference in exports and imports, and does not consider other transfers or interest or dividends. So in the example above, Trade Deficit is simply imports minus exports, which is $100 million.

Thus Trade Deficit = Imports – Exports =1000 – 900 = $100 million, and Current Account Deficit is $50 million.

Financing of CAD

Current Account Deficit can be financed by capital account or financial account. Government buys and sells foreign currency, so it may give loan to other countries or may take small short term loan from other countries. This may change the value of Current Account, and this type of financing is done by the Financial Account of the Government.

Another more popular and more important way of financing Current Account Deficit is through Capital Account transactions. Now these are the major capital account transactions:

• FDI – Long term money
• FII – Investments in Equity and Debt
• Remittances as Investments – Example in Real Estate

The graph above how India’s current account deficit to GDP ratio has been in last 25 years. We see there have been a marked improvement since 2012. But then it again started increasing. Major reason affecting Current Account Deficit is decreasing oil prices. This helps Indian currency to strengthen which further reduces India’s import bill. India is largely dependent on oil imports for its energy needs, and that is the biggest component of India’s total imports, and also the biggest component of Current Account Deficit. When oil prices start increasing again, and if India’s currency starts depreciating, it will increase the price of imports even more. Hence India’s Current Account Deficit will start increasing again. Global trade war started by United States is impacting India’s exports as well. And is also depreciating India’s currency, which is thus impacting India’s Current Account Deficit.

Also, when the US Fed increases its interest rate, one of the component of Current Account Deficit financing i.e. Foreign Indirect Investment is reducing in India. So all these factors are impacting India’s Current Account Deficit.

Conclusion

Even though a Current Account Deficit of 2.5% is not considered very high, but it can increase even more if the challenges continue. So challenge before the government currently is to device policies that will boost exports, and reduce unnecessary imports even more, such as gold. We want to know, is Current Account Deficit always bad? No. Big emerging economies and developed economies mostly have Current Account Deficit, and mostly small developing countries have Current Account surplus. Like in case of India, small Current Account Deficit may not be a bad as it shows it is highly dependent on India’s fuel imports, and fuel imports are increasing because India’s hunger for more energy is increasing as we are developing. We can thus say for a healthy balanced economy it is okay to have a moderate Current Account Deficit.