Report for Macroeconomics by Group 5

Current Account Deficit An Indian Perspective

Indian Institute of Management, Kozhikode

Report by: GROUP 5: Aishwarya Kumar (063) Anirban Bhar (064) Anusha Acharya (071) Nimish Shah (110) Palak Bansal (097) Pratik Agarwal (101)

Table of Contents
Introduction ............................................................................................................................................ 3 India CAD Historical perspective (1991 present) .............................................................................. 7 Case Study 1 - US Current Account Deficit and the 2008 Financial Crisis.............................................12 Case Study 2 - Brazil: A unique transition from current account surplus to current account deficit...14 Appendix: ..............................................................................................................................................16 References ............................................................................................................................................17

Introduction
In economics, the Current Account is one of the two components of the balance of payments. The other component is the Capital Account. Current account is the sum of 1) Balance of Trade (net revenue on exports minus payments for imports), 2) Factor Income (earnings on foreign investments minus payments made to foreign investors) and 3) Cash Transfers The current account balance is considered a major measure of the nature of a country's foreign trade. It is called the current account as the goods and services are consumed in the current period. In the case of a current account surplus, a country's net foreign assets are increased by the corresponding amount, and in case of a Current Account Deficit (CAD), the reverse occurs. Government and private payments are both included while calculating the CAD. The balance of trade is the difference between a nation's exports of goods and services and its imports of goods and services. A nation is said to have a trade deficit if it imports more than it exports ignoring transfer payments and investments. Since the trade balance is generally the largest component of the current account, positive net exports are accompanied by a current account surplus. But, this is not always the case especially with secluded or somewhat closed economies which may have an income deficit larger than their trade surplus. The net factor income or income account consists of income payments as outflows and income receipts as inflows. Income includes the money received from investments made abroad (investments are recorded in the capital account but income from investments is recorded in the current account) and the money sent by individuals working abroad called remittances to their families back home. A country is paying more than it is taking in interest, dividends, etc. if the income account is negative. Meaning and Implications The current account equals the change in net foreign assets in the traditional accounting of balance of payments. A CAD implies that the net foreign assets have reduced.
CA = Changes in Net Foreign Assets

If an economy has a CAD, it is absorbing more than that it is producing. This implies other economies are lending their savings to and thus the foreign assets in the economy are getting reduced. If an economy is running a current account surplus it is absorbing less than that it is producing. Thus, it is saving. This saving is invested abroad and foreign assets are thus created. How the Current Account is calculated The current account is calculated by adding up the 4 components of current account: Goods, services, income and current transfers. Goods:- Exports are considered as credit and imports as debit. Services:- When a service is used by a foreigner in our nation and the local resident receives money from a foreigner, it is credited as an export. 3

Income:- When a citizen of the nation or a domestic company receives money from a foreign company.. Current Transfers:- When a foreign country provides currency to another country with nothing received as a return in the form of donations, aids, or official assistance etc. Thus,

Where CA is the current account, X and M the export and import of goods and services respectively, NY the net income from abroad, and NCT the net current transfers.

Link between budget deficit and current account deficit

It has often been contemplated if budget deficit (difference between what the government earns and what it spends) is in anyways related to current account deficit and if they are related, do they share a positive relationship or a negative one. This section tries to give a simplistic view of the same conundrum by simple mathematical equation and establish a logical relationship between the two. S = SP + SG where SP = Yd C = Y T C SG = T G SP = private saving; SG = government saving; Yd = disposable income; T = net tax. Then SP = (C + I + G + CA) T C = I + CA + (G - T) where G T = government budget deficit. So CA = SP I (G T)
The above equation CA = SP I (G T) shows that current account deficit is dependent on budget deficit as it has (G-T) as one of its components. (G-T) would indicate the difference between the government expenditure and its revenues (which are majorly in the form of taxes). A budget deficit would mean that (G-T) is a negative number and this would add to the extent of current account 4

deficit. We can safely conclude that a strong positive correlation exists between current account deficit and budget deficit. Reducing Current Account Deficits Reducing CAD usually involves increasing exports and decreasing imports. This may be done directly through import restrictions, quotas, or duties or by promoting exports (by subsidies, exemptions etc.). Another way is by changing the exchange rate to make exports cheaper for foreign buyers which will have an effect of increasing the balance of payments. Nowadays, another phenomenon has emerged in the form of currency wars which is basically a protectionist policy. Countries devalue their currencies to increase competitiveness when it comes to exports. Is CAD always bad? A CAD is not always a problem. Deficits reflect economic trends which may be desirable or undesirable for a country at a particular point in time. Whether a deficit is good or bad depends on the factors giving rise to that deficit. According to the Pitchford thesis, a CAD does not matter if it results from the private sector participants involved in mutually beneficial trade. This view is also called the "consenting adults" view of the current account. A CAD implies that foreign capital has to be repaid consisting of many individual transactions. Pitchford asserts that since each of these transactions were individually considered financially sound when they were made, the CAD should also be sound. This theory is true for the Australian economy, which has had a consistent CAD but has experienced economic growth for the past 18 years (19912009). The CAD may reflect an excess of imports over exports. Then, it may indicate competitiveness problems. Or the CAD also implies an excess of investment over savings. This would indicate a highly productive and growing economy. The deficit may imply low savings rather than high investment. This may be due to reckless fiscal policy or excessive consumption. Or it could reflect perfectly sensible intertemporal trade or the consenting adults approach. Without knowing which of these effects is at work, it makes little sense to talk of a deficit being good or bad. Transition from a measure to a crisis Another way to look at the current account is in terms of the timing of trade. Just as a country may import one good and export another under intratemporal trade, a country may import goods of today (running a current account deficit) and export goods of tomorrow (running a current account surplus in the future). Intertemporal theories of the current account suggest that running a current account deficit or a surplus may have a consumption-smoothing effect. For example, if a country is struck by a shock such as a natural disaster, the countrys productive capacity is reduced. In such an event, instead of absorbing the shock immediately, the country run a current account deficit and spread the burden of

consumption. These theories also suggest that countries that are prone to running large shocks should run current account surpluses as a precaution. Another factor which should be considered is the duration for which a country runs a CAD. When a country runs a CAD, it is in essence increasing its liabilities to the rest of the world which need to be paid back. However, it depends on how the country spends the borrowed foreign funds. If there is no long-term gain, then there would be a risk of the countrys ability to pay back and its solvency might be threatened. Thus, whether a country should borrow more and run a CAD depends on the extent of its foreign liabilities or external debt and also, on whether the borrowing will be used for an investment which yields higher returns than the interest rate the country has to pay on its foreign liabilities. Even if a country is solvent (i.e. its current liabilities can be covered by future revenues)its CAD may become unsustainable if it is unable to secure financing. Some countries (for example, Australia and New Zealand) have been able to maintain CADs of about 5 % of GDP for decades while others ( such as Mexico in 1995, Thailand in 1997) experienced severe CADs during the financial crisis. In such cases where there is a huge reversal in CAD, private consumption, investment, and government expenditure must be reduced abruptly when financing from abroad is not available and, indeed, a country is forced to run large surpluses to repay in short order what it borrowed in the past. Due to this, large and consistent deficits should be paid attention, lest a country experience a sudden withdrawal of financing. Such a huge change in CAD may be caused due to various reasons such as overvalued real exchange rates inadequate foreign exchange reserves excessively fast domestic credit growth unfavourable terms of trade shocks low growth in partner countries higher interest rates in industrial countries Companies may have more short-term liabilities than short-term assets and more mediumand long-term assets relative to their liabilities. Besides these there are other reasons such as lack of foreign direct investment (relatively stable) as compared to volatile foreign institutional investment. A country with weak financial sectors can also be at risk as banks may borrow a lot of foreign money and make risky loans.

India CAD Historical perspective (1991 present)

Prior to the liberalization and economic reforms of 1991, India financed its current account deficit using official flows and debt flows. Entry of foreign capital was restricted. Following the BOP crisis of 1991, the Indian government opened up the economy to FDI and FII and the currency shifted to market determined rates. Presently at a current account deficit of 4.5% FY13 Q3, Indias current account deficit has shot to an alarming new high, and has approached 1991 levels. However, the question to ask here is, are we really in a similar situation?

A number of factors are responsible for the huge current account deficit faced by India and we shall talk about them in a systematic fashion. First let us establish the basic BOP equations; GDP = C+I+G+(X M) GNDY = C+I+G + (X-M) + NY + NCT CAB = NCT+NY + (X-M) -------------------------------------------(1) GNDY-C-G = S (S-I) = CAB------------------------------------------------------------(2) CAB + NKT NPNNA = NFI-----------------------------------------------(3) NKT NPNNA = Capital Account Balance---------------------(4) Now, C+I+G+X = C+S+T+M X-M = (S-I) + (T-G)--------------------------------------------------(6) (S-I) = Private savings (T-G) = Public savings Where C = Consumption, G = Govt. expenditure, I = Investment NY = Net income from abroad NCT = Net current transfers GNDY = Gross National Domestic Income CAB = Current Account Balance NKT =

Net capital transfers NPNNA = Net purchases of non-produced, non-financial assets NFI = net foreign investment or net lending/net borrowing with the rest of the world X-M = Trade deficit

Hence, current account represents the transactions involving exchange of goods, services, income, and current transfers between India and the rest of the world. In a closed economy, the items on the current account are entirely funded through domestic sources (domestic savings). In an open economy, however, a part of the items on the current account are financed by foreign debt. Capital account represents FDI (Foreign direct investments), FII (portfolio investments) and other investments. A capital account surplus denotes that capital is flowing into the country in terms of increase in borrowings or by the sale of assets. A capital account deficit on the other hand denotes that capital is flowing outside the country as our claim on foreign assets increases and as we lend money abroad.
CAB = NKA + RT (Where NKA = Net capital and financial account RT = Reserves) Reasons for CAD India 1. Booming imports over exports India has a trade deficit, which has been widening. Between FY 2001 2010 export growth was 16% p.a. whereas imports grew at a CAGR of 21%. The export growth has been driven by IT and IT enabled services (outsourcing industry), petroleum and related products, whereas the imports have been driven by gold and silver, crude oil and electronics goods. India has lost export competitiveness due to a fall in manufacturing activities. Indias current GDP composition shows that it has shifted from an agricultural to a services economy. Traditional export items like textiles and readymade garments, and leather and other manufactured goods have been growing at decreasing rates. Regulations that restrict small scale industries, reservations etc. harsh labour laws unfavourable indirect taxes poor infrastructure (road, logistics, storage, supply chain bottlenecks) Delays in transportation (port congestion, road transport) India needs to build up its manufacturing base and regain its export competitiveness.

2. Rising Fiscal Deficit (S-I) + (T-G) = X-M Since the Indian government has been going through a persistent fiscal deficit, T-G <0. If private savings arent enough to compensate for the budget deficit, there will be a current account deficit. It is therefore worrying in Indias scenario as we have high budget deficit that is increasing. We arent able to sustain our targets on the same and every year we end up surpassing the budgeted targets for budget deficit. This causes an upward pressure on 8

the current account deficit numbers that in turns leads to a double negative effect on the economy as a whole- from both current and budget deficit. And a high current account deficit means that a country isnt able to sustain its day to day expenses from the revenue it earns. This portrays a very sad and a worrying picture for any country. 3. Rising demand for gold, increasing oil prices coupled with depreciation of currency With rising oil prices, the import of oil has caused an increase in the CAD. Indias rising demand for gold is also another reason for the CAD. However, restrictions in the import of gold like increased customs and have reduced the overall demand /prices for gold. 4. Excessive and unfavourable movement of exchange rates 5. Aggregate demand (C+I) exceeds Domestic Output Indias growth is mainly consumption driven and not manufacturing driven (export driven). As a result, despite the global economic turmoil, Indias growth wont be affected. The downside to this is that this consumption is dependent on variables such as exchange rate. An appreciation of the Indian currency due to foreign capital inflows would boost imports, and hence consumption, but a depreciation of the rupee would adversely affect consumption. Financing CAD - Indian Scenario: (a) Capital Account Surplus Historically, India has had a current account deficit. Large deficits in the current account have been financed by surpluses in the capital account. India uses up its large capital inflows to finance its large current account deficit. Over the last three years, Indias CAD has deteriorated steadily owing to the global financial crisis, Euro crisis and weak global economy. The disadvantage of being dependent on capital inflows to cover up the current account deficit is that these capital flows may be unsustainable and volatile in the long run. As India moves towards an increasingly open economy, sudden shocks/capital outflows as it happened in the 2008 financial crisis could destabilize the economy and lead to a BOP crisis. (b) Foreign Remittances Foreign remittances also play a major role in financing the trade deficit in Indias CAB. NRIs sent in US$ 54 Billion in 2010, making India the largest receiver of remittances in the world. During the financial crisis of 2009, remittances remained stable while capital account saw huge swings. The important thing is to see if the foreign remittances are used to support consumption or investment.

Is the CAD in India sustainable over the long term? Will this current account deficit lead to a BOP disaster? There have been growing fears amidst the market participants and the economists about the alarmingly high CAD levels in India. In the FY 2011-12, Indias CAD has reached 4.5% of GDP. This has led to the development of apprehensions concerning the sustainability of such high levels given the weak global economic scenario and various uncertainties that our country is going through. Economists and former RBI Governors opine that the sustainable level of CAD is around 2.5% and all efforts should be directed towards bringing the CAD to these levels. But the levels are not too high for India to cut imports drastically and provide high levels of export subsidies. These levels, though high, can be taken care of by effective policy measures. A strong self-correcting mechanism is at work. The big CAD has caused the rupee to fall sharply, from Rs 45 to Rs 56 to the dollar. Many alarmists used to complain that the RBI was keeping the rupee too strong. Well, without any effort from the RBI, their wish has come true. The rupee has weakened to a very competitive level, which itself should trim the CAD. Despite policy paralysis and a poor investment climate, India received large inflows of both FDI and foreign portfolio inflows in 2012. Despite bad publicity from the alleged mistreatment of Vodafone and Walmart, FDI inflows actually shot up 34.4% to $46.84 billion in 2011-12. FII inflows are typically far more volatile than FDI. However, despite the Eurozone crisis and recent slowdown in the US, FII inflows into India exceeded $10 billion in January-July 2012. Moreover, with the current policy measures, FDI and FII levels are set to increase due to opening of Retail, Insurance and Aviation sector. In short, though the CAD is currently at high levels, it hasnt reached to panic-stricken levels where desperate measures are required that might hamper growth and lower aggregate demand. In fact, growth-inducing policy measures would lead to increased confidence in the economy that would bring in more capital inflows. Also, with the INR deemed to have reached the true levels that reflect the state of Indias economy, further depreciation seems unlikely and with the advent of Jcurve effect, Indias CAD would become more favourable over a period of time.

Recommendations for sustainable improvement in CAD

1. Boost exports, build a strong manufacturing base Like the rest of the Asian countries, India needs to build a strong manufacturing base to boost its exports. This would lead to a shift in workers from the agricultural sector (which has surplus of workers) to the manufacturing sector. Not only will this generate employment opportunities, it will also There has to be diversification of Indias exports basket in terms of both, destinations as well as products. Indian exporters need to accelerate efforts to move up in the value chain at the global level. 2. Improve productivity /structural reforms There should be reforms to improve governance and reduce wastage in government programmes. Encourage private enterprise and innovation. All such measures will improve

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productivity. This is the best way to improve the balance of payments. A number of projects are stuck in bureaucratic mire environmental regulations, labour laws, unfavourable tax policies etc.
3. Encourage FDI/FII inflows Recent government policies like FDI in retail and aviation encourage capital flows and capital account surplus, which can cushion the current account deficits. Local land restrictions, labour, political and environmental restrictions are in a state of flux, and these uncertainties make it more difficult for foreign investors to invest in India. 4. Improve manufacturing by increase in number of SEZs, tax sops for manufacturing specially small scale industries. Encourage foreign investment in roads, infrastructure, logistics and supply chain. 5. Replicate Brazil model export growth through growth in agricultural products. India has the largest arable land in the world and is one of the largest producers of agricultural commodities and grains. However, net exports have remained small and the variety hasnt changed over the years, moreover Indias grain yield hasnt improved. India could increase its agricultural exports through drastic measures like the Green Revolution of the 1970s. 6. Use of Monetary policy India can use monetary policy to offset unfavourable exchange rates. E.g. use open market operations to increase/decrease liquidity and interest rates to regulate capital flows. 7. Reduction in demand of gold through education of investors of alternative sources of investment and increase domestic production of gold. 8. Alternative sources of energy encourage through policies and investments in development of alternative sources of energy like Shale gas. Following model of Gujarat of boosting investments in solar panels which would go a long way in reducing Indias oil imports over a long period of time.

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Case Study 1 - US Current Account Deficit and the 2008 Financial Crisis
With its citizens and corporations borrowing heavily, the United States ran a current account deficit that, beginning in 1992, deepened each year. The deficit was not due an increase in investment; rather, Americans switched habits from being net savers to net debtors. US Current Account Deficit started spiraling upwards at an accelerated rate as citizens and corporations started borrowing heavily. The unfortunate part was that the deficit was not majorly due to increased investment but due to the paradigm shift in habits of US Consumers from being net savers to net debtors. The graph below shows the trend in US current account deficit from 1992 till 2008-the year sub-prime crisis set in.

US Economy started becoming more leveraged as deficit increased and in order to finance the deficit, they had to borrow from countries having surpluses. The US issued magnanimous levels of treasury debt to raise the funds. Countries with emerging economies that had enjoyed trade surpluses were more than willing to invest their money in a safe haven like US. For instance, the income of oil-exporting countries had ballooned since 2004 because of higher prices for crude. It would have been neither feasible nor wise for oil-rich nations to spend this windfall within their own borders, and so, much of it was saved and sent abroad. Economists who have sought a unifying reason to explain the saving behavior of a disparate group of countries have converged on one important motive: the need to invest in reliable assets that may be easily converted to cash in the event of an emergency. Because U.S. assets were considered to be of high quality and the U.S. financial markets were well developed, and thus liquid, the U.S. attracted more investment in its debt than it needed. As foreign investment bought up large amounts of U.S. Treasuries, the yield on those investments dropped to a level where foreign investors sought out riskier assets to improve their return. Those 12

investors then looked to another U.S. asset: real estate. Owning a mortgage on a single property represented too much risk for a foreign investor, but securities and derivative financial products provided an avenue to diversify both systematic and credit risk in a liquid (or what seemed to be liquid) asset. Thus the explosion in mortgage-backed securities and derivatives, and the hedge funds that traded them, do find an explanation, to a great extent, in the current account deficit

Figure Deficits, equity prices, and housing prices

Notes: Current account deficit is measured as percentage of national income. Price indexes are for the United States for 19902010. Source: http://www.frbsf.org/publications/economics/letter/2011/el2011-37.html The above figure consolidates the hypothesis of how widening current account deficit in US was one an implicit cause responsible for the sub-prime crisis in 2008. Though it isnt a directly observable variable, the correlation between the two is not at all spurious and there is a significant relationship between a nationss CAD and the potential of any future economic turmoil.

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Case Study 2 - Brazil: A unique transition from current account surplus to current account deficit
Brazil, one of the BRICks of the future of tomorrows growth has a unique story to share with respect to its current account balances. Looking at the last 10 years of their economy, it can be seen that it ran current account surpluses during the global boom period from 2002 to the end of 2006. Though the magnitude of the surplus wasnt that high, it was still considered to be an extremely positive indicator for a developing country to have a trade surplus.

But come 2008 sub-prime crisis and the graph completely reverses. The country starts having a huge trade deficit. And unfortunately, looking at the trend of last 4 years these levels seem to be increasing at a constant pace. As it is in a developing phase, the demand for goods and services is increasing at a great pace leading to high import levels but a weak global demand is depressing the exports leading to higher trade deficits. Brazil could be hit hard in case of the ongoing global crisis, mainly because of the country's heavy dependence on external financing and the increasingly impending current account deficit. If Brazil doesnt take these looming current account deficit seriously and fund it to reduce it, it might see itself in a big debt trap as the world starts to demand what Brazil owes them. It might lead to a foreign exchange, financial and currency crisis of a destructive level. The IMF estimates that Brazils current account deficit may hit $120 billion by 2016. A higher CAD would lead to weakening of the currency leading to wider balance of payment gaps. Once it gets into this trap, CAD would increase to unsustainable levels and the might come when it would have to devalue its currency and print more money. But this would fuel a high inflation which might cause hyperinflation too. Nothing destroys a developing nation like inflation. Higher inflationary pressures might further depreciate the currency, increase fiscal deficit and consequently force government to reduce its spending leading to a vicious circle of falling growth levels, unemployment and social unrest. 14

The above two examples of US and Brazil which happen to be very different countries is to show how increasing current account deficit levels lead to a contagion effect causing collateral damage to the economy as a whole. No country is an exception to this rule. Spending more than one can earn at an unrelenting, uncontrolled pace would cause an inevitable and an irreparable damage.

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Appendix:
Calculation of CAD A regression based approach

Exports Exports are a function of global demand, which is determined by world GDP as well as the Indian exchange rate. Exports= f (World GDP, REER) Imports Import demands, especially for India can be determined for oil and non-oil products, since oil imports have such a major impact on Indias trade balance. Non-oil import is expected to be determined by domestic economic activity and exchange rates whereas oil imports are determined by global crude oil prices and domestic GDP. Non-oil Imports = f (domestic GDP, REER) Net Oil Imports = f (domestic GDP, crude oil prices) Private Transfers Remittances will depend on world GDP and the difference in the growth rate of the two countries. Net Pvt. Transfers = f (World GDP, growth differential) Services exports can be determined by growth in world GDP and exchange rates. On the other hand, services imports can be determined by domestic economic activities (i.e., domestic GDP) and exchange rates Services Receipts = f (World GDP, REER) Services Payments = f (Domestic GDP, REER) Investment income receipts depends on the level of foreign currency assets held by the RBI as well as the interest rates on the debt (can be approximated to be held in US treasury bonds) Investment Income Receipts = f (FCA, interest rate on US Govt. bond) Investment income payments could be influenced by both debt and non debt payments. Debt liabilities could be determined by LIBOR and those related to non-debt liabilities would relate to growth rate of the domestic economy. Investment Income Payments = f (external debt, domestic GDP growth)

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References
1. www.tradingeconomics.com 2. Euromonitor International (graphs) 3. http://www.economist.com/blogs/graphicdetail/2012/09/focus-0 4. http://www.google.com/publicdata/explore?ds=k3s92bru78li6_#!ctype=l&strail=false&bcs= d&nselm=h&met_y=bca&scale_y=lin&ind_y=false&rdim=country&idim=country:IN:CN:BR:R U:ZA&ifdim=country&hl=en_US&dl=en_US&ind=false 5. http://www.imf.org/external/np/pp/eng/2012/070212.pdf 6. http://www.imf.org/external/pubs/ft/bop/2007/pdf/chap14.pdf 7. http://www.palgrave-journals.com/imfsp/journal/v54/n2/full/9450013a.html 8. http://fpc.state.gov/documents/organization/141590.pdf 9. http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/WPSSLI070812.pdf 10. The X Factor, Game Changer Report (2011), Kotak Institutional Securities 11. Report of the Sub-Group on Inflow of Foreign Savings: Twelfth Five-Year Plan (2012-13 to 2016-17) 12. Indias Gold Rush: Its Impact and Sustainability, Assocham Report 13. Indias Experience With Capital Flows: The Elusive Quest For A Sustainable Current Account Deficit, Ajay Shah, Ila Patnaik - Working Paper 11387 (http://www.nber.org/papers/w11387)

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