Current account deficit occurs when a country’s total imports are greater than the country’s total exports. This situation makes a country a net debtor to the rest of the world
A deficit happens when a country’s government, businesses and individuals export less goods, services and capital from foreigners than they import. Broadly speaking, current account refers to trade in goods and services, as opposed to changes in capital assets (money, stocks, bonds, etc) resulting from trade. Exports of goods and services would be a plus in the current account; imports would be a minus.
What is a current account deficit?
Current account deficit (CAD) shows the difference between the nation’s exports and imports. A CAD occurs when a country’s government, businesses and individuals imports more goods, services—such as banking and insurance and capital than it exports. That’s because the current account measures trade, as well as international income, direct transfers of capital, and investment income made on asset. CAD is usually measured as a percentage of GDP (gross domestic product). GDP refers to the total market value of the goods and services manufactured within the country in a financial year. Current account to GDP in India is reported by the Ministry of Finance, Government of India.
When those within the country depend on foreigners for the capital to invest and spend, that creates a current account deficit. Depending on why the country is running the deficit, it could be a positive sign of growth, or it could be a negative sign that the country is a credit risk.
Components of deficit
Trade deficit: The first component of a current account deficit is usually a trade deficit. This means the country imports more goods and services than it exports. The trade deficit happens when a country’s total import of goods and services are greater than it total exports. An ongoing trade deficit weakens a country’s economy over the long term because it is financed with debt.
Net income: The second component is usually a deficit in the net income. If the income paid out by a country’s individuals, businesses and government to their foreign counterparts is more than they receive, it contributes to a deficit. Specifically, these are payments of interest and dividends to foreigners who own assets in the country, and wages paid to foreigners who work in the country. On the flip side, the opposite will cut the deficit:
Income earned on foreign assets owned by a country’s residents and businesses. This is usually receipts, such as interest and dividends, earned on investments.
Income earned by a country’s residents who work overseas.
Direct transfers: The third component of the deficit is direct transfers, which includes government grants to foreigners. It also includes any money sent back to their home countries by foreigners. Direct transfers refer to money transferred without exchanging any goods or services. For example: An Indian worker, who works abroad and sending money (remittance) to his family in India.
Specifically, deficit is increased by these direct transfers:
- Wages sent back to a foreigner’s home country.
- Government grants made to foreigners.
- Direct investments made abroad by a country’s residents.
- Bank loans to foreigners.
What causes deficit
Countries with current account deficits generally spend more, but are considered credit worthy. The businesses in these countries’ can’t borrow from their own residents, because they haven’t saved enough in their local banks. They would prefer to spend than save their income. Businesses in a country like this can’t expand unless they borrow from foreigners. That’s where the credit-worthiness comes into the picture.
Basically, the lender country also exports a lot of goods and possibly even some services to the borrower. Therefore, the lender country can manufacture more goods and give jobs to more of its people by lending to the spendthrift country. Both countries benefit.
Consequences of current account deficit
In the short-term, a current account deficit is mostly advantageous. Foreigners are willing to invest capital into a country to drive economic growth beyond what it could manage on its own. However, in the long term, a current account deficit can drain economic vitality. Demand could weaken for the country’s assets, including the country’s government bonds. As this happens, yields will rise and the national currency will gradually lose value relative to other currencies. This automatically lowers the value of the assets in the foreign investors' currency, which is now getting stronger. This further depresses the demand for the country's assets. This could lead to a tipping point, at which 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, thus further reducing the current account deficit. In addition, a lower currency value should increase exports, as the goods and services become more competitively priced. Similarly, demand for imports should lessen, as inflation on foreign goods and services sets in. These trends should 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 of a current account deficit would be the same -- a lower standard of living for the country's residents.
What is India’s current account situation?
India has a current account deficit; that is, its imports exceed exports. Current account deficit in India is reported by the Reserve Bank of India. India’s CAD for the second quarter ended September 2012 rose sharply to $22.3 billion from $18.9 billion in Q2 of a year ago higher pace of imports and moderating exports growth. Every year India imports crude oil and gold worth billions of dollar and that disturbs the whole balance. India’s current account deficit has increased due to weak exports, heavy gold and crude oil imports.
More foreigners invest in India compared to Indians investing abroad. Rajiv Gandhi Equity saving scheme was an initiative of the finance ministry, to make Indians reduce gold-purchase and use that money to invest in capital market. The CAD increased to 5.4% of gross domestic product for Q2 of FY2012-13 from 4.2% for Q2 FY11-12.
The rise in the current account deficit was mainly on account of a widening trade deficit and a slowdown in inward remittances from overseas Indians. The increasing CAD has become a major constraint on easing monetary policy. With the CAD turning out to be a record high of 5.4% of GDP in the second quarter of 2012-13, further caution is warranted while framing monetary and fiscal policies, according to Reserve Bank of India (RBI).
Implications of a large deficit
In January 2013, the finance ministry said that India’s record current account deficit is “worrying”. Deficit on the current account means a net outflow of foreign exchange. In India’s case, this means a dollar outgo. Such a deficit could drain the country’s forex reserves if inflows to make up the deficit do not materialise. Therefore, a country with a current account deficit has to attract capital flows, which could be in the form of, say, foreign direct investment, to meet the shortfall.
But when capital flows are insufficient to meet the deficit, the country’s currency starts to depreciate on concerns that it may find it difficult to meet its international commitment or fund its current purchases. A current account deficit in excess of 2.5% of GDP is seen as worrisome in case of India.
Source: Bureau of Economic Analysis