Current Account Deficit

PRESENTED BY:
GROUP II
AMOL KATKAR (PGP/17/130)
ANKIT LUTHRA (PGP/17/131)
ANKITA KUMARI(PGP/17/133)
ANSHUMAN PRADHAN (PGP/17/134)
DEBIPRASAD BEHERA (PGP/17/139)
ESHITA AGARWAL(PGP/17/143)

What is BOP??
It is where countries record their monetary

transactions with the rest of the world

Transactions: Credit or Debit
Three different categories
o
o
o

Current Account
Capital Account
Financial Account

Components of Current Account

Goods
Services
Income
Current Transfers

CAB = X - M + NY + NCT

Does it matter how long a country runs a current account deficit?

Depends on
o
o

Extent of its foreign liabilities

Whether borrowing will be financing investment that has a
higher marginal product than the interest rate the country has
to pay on its foreign liabilities

Reversal in CAD
Influential Factors:
o
o
o
o
o
o

Overvalued real exchange rate

Inadequate foreign exchange reserves
Excessively fast domestic credit growth
Unfavourable terms of trade shocks
Low growth in partner countries
Higher interest rates

Causes of Current Account Deficit

CAD is caused by the following:
Trade Deficit both merchandise and services
Deficit in the Net Income
Deficit in Direct Transfers
Countries with current account deficits generally spend more, but are considered
credit worthy. The businesses in these countries cant borrow from their own
residents, because they havent saved enough in their local banks. They would
prefer to spend than save their income. Businesses in a country like this cant
expand unless they borrow from foreigners. Thats 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.

Factors affecting Trade Deficit

1. Fixed

Exchange Rate
If the currency is overvalued, imports will be cheaper and
therefore there will be a higher Quantity of imports. Exports
will become uncompetitive and therefore there will be a fall
in the quantity of exports.
2. Economic Growth
If there is an increase in national income, people will tend to
have more disposable income to consume goods. If domestic
producers can not meet the domestic demand, consumers
will have to import goods from abroad.

Factors affecting Trade Deficit

3. Decline in Competitiveness.
A decline in the exporting manufacturing sector, because it has struggled to
compete with developing countries in the far east has led to a persistent deficit in
the balance of trade.
Higher inflation
This makes exports less competitive and imports more competitive. However this
factor may be offset by a decline in the value of currency.
Recession in other countries.
If a countrys main trading partners experience negative economic growth then
they will buy less of our exports, worsening the current account.
4. High MPM:
In the UK there is high Marginal propensity to imports mpm because they do not
have a comparative advantage in the production of manufactured goods.
Therefore if there is fast economic growth there tends to be a significant increase
in the quantity of imports

Factors affecting Net Income

The second component is usually a deficit in the net income. If

the income paid out by a countrys 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:
i. Income earned on foreign assets owned by a countrys
residents and businesses. This is usually receipts, such as
interest and dividends, earned on investments.
ii. Income earned by a countrys residents who work overseas.

Factors affecting 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 foreigners home country.
Government grants made to foreigners.
Direct investments made abroad by a countrys residents.
Bank loans to foreigners.

Factors behind CAD of India

Over the years, its seen the trade deficit has been widening on back of higher
imports and slower growth of exports.
Till first half of 2013, exports and imports stand at $146.549bn and
$237.221bn respectively resulting in trade deficit of $90.672bn.
Increasing oil and gold imports are major contributors to the increase of
imports.

Overall import and oil and gold in absolute terms

From the chart, its

seen oil and gold

import has been
continuously rising.
Till first half of 2013,
oil and gold imports
stand at $80.28bn and
$20.25bn respectively.

Oil and Gold imports as percentage of total imports in the

country

Year
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

Oil
25.4
31
27.2
28.7
26.3
26.8
29.5
30.7
31.7
31.3
30.2
28.7
31.7

Gold
8.4
8.2
8.1
6.3
8.3
9.4
7.3
7.8
6.7
6.9
9.9
11
11.5

Consequences of CAD in India

Cutback of FDI(15.7 billion to 12.8 billion)
Slow economic growth( GDP 6.2% to 5%) Unemployment

Higher Inflation(4.86-5.79 in terms of CPI)

Currency depreciation(1 INR=65.2 USD)

Indian Economy policy-1993-2004

The major changes during 1993-2004

Liberalization of current account

Opening up to FDI for foreign and domestic firms
Opening up to portfolio flows for foreigners
Restricting debt flows

Liberalization of current account

Highly successful
Positive technological shocks and dropping price of international
communication helped in growth rate of service exports
Removal of quantitative restriction and sharp drop in tariffs
served to spur exports and imports

Indian Economy policy-1993-2004

Restricting debt flows

Policy bias debt flow restricted the inflow at 1% as a result gross

debt flow dropped from 13.5%(1994) to 10.6%(2003)

Opening up to FDI for foreign and domestic firms

FDI inflows are very small as compared to Indian GDP and

global FDI flows
This is because of infirmities in Transportation infrastructure
and indirect taxes

Opening up to portfolio flows for foreigners

Indias share in global portfolio is higher than the global

average

All these initiatives led to 5% increase in growth in capital account(15%

in 1992-93 and 20% in 2003)

Does such a large CAD imply that the

countrys aggregate demand
(consumption plus investment) hugely
exceeded its aggregate domestic output or
income?

EXCESS DEMAND OR SUPPLY SHOCKS?

Research at the Indira Gandhi Institute of Development

Research shows the Indian CAD is countercyclical. That is,

it rises when output falls and not when demand rises. This is
exactly what happened last year as well.
In this, India or the South Asian region is unusual. In all

other emerging markets, the CAD tends to be pro-cyclical,

linked to overconsumption in good times
A countercyclical CAD in Indias case suggests dominance of

external supply shocks rather than excess demand factors.

EXCESS DEMAND OR SUPPLY SHOCKS?

For example, if oil shocks raise costs, and as a result growth falls, the

CAD would rise along with falling growth. It can also be due to exportled growth: As exports rise, they raise income and reduce the CAD. On
the other hand, a sudden collapse of export markets, due to a global
shock, reduces income and increases the CAD.
In line with this analysis, 2011-12, the year of the peak CAD of 4.2 per

cent of GDP, saw both a sharp rise in oil prices and fall in growth. As
against this, the CAD was only 1.3 per cent in 2007-08, a year of high
consumption, investment and output growth.
In the first quarter of this fiscal, however, softening international oil

prices have reduced the rupee value growth of oil imports, thereby
implying the CAD may improve.

WHAT ARE THE IMPLICATIONS OF A LARGE

CURRENT ACCOUNT GAP?

CAD

Outflow of
foreign
exchange

Forex reserve
exhausted
(if capital
flows cannot
make up
deficit)

Currency
depreciates

Cannot meet
international
Commitment
or fund its
current
phases

This is why a current account deficit in excess of

2.5% of GDP is seen as worrisome in case of India.

In the last fiscal, despite getting higher capital flows,
the country is likely to have an overall BOP deficit
because of much higher current account deficit.

Is CAD good or bad?

If the deficit reflects an excess of imports over exports, it may be

indicative of competitiveness problems, but because the current

account deficit also implies an excess of investment over savings, it
could equally be pointing to a highly productive, growing economy.
If the deficit reflects low savings rather than high investment, it
could be caused by reckless fiscal policy or a consumption binge.
Or it could reflect perfectly sensible inter-temporal trade, perhaps
because of a temporary shock or shifting demographics.
Without knowing which of these is at play, it makes little sense to
talk of a deficit being good or bad: deficits reflect underlying
economic trends, which may be desirable or undesirable for a
country at a particular point in time.

Keynesian model
Expansionary Fiscal Policy

G -> Y -> C -> M -> deterioration of CAD

Expansionary Monetary policy
r -> I -> without govt intervention capital
account and current account

Inter-Temporal Model
Longer-term variations in current account balances

can also be explained by the inter-temporal model.

A small open economy, which is initially capital (and
income) poor, provided it has access to international
capital markets, will run current account deficits for
a sustained period of time in order to build its capital
stock while maintaining its long-run rate of
consumption.

Is it safe to be Inter-temporally solvent?

Inter-temporally solvent means: current liabilities will be covered by future revenues.
But even if the country is inter-temporally solvent its current account deficit may

become unsustainable if it is unable to secure the necessary financing.

While some countries (such as Australia and New Zealand) have been able to
maintain current account deficits averaging about 4 to 5 percent of GDP for several
decades, others (such as Mexico in 1995 and Thailand in 1997) experienced sharp
reversals of their current account deficits after private financing withdrew in the
midst of financial crises.
Such reversals can be highly disruptive because private consumption, investment,
and government expenditure must be curtailed abruptly when foreign financing is no
longer available and, indeed, a country is forced to run large surpluses to repay in
short order its past borrowings.
This suggests thatregardless of why the country has a current account deficit (and
even if the deficit reflects desirable underlying trends)caution is required in
running large and persistent deficits, lest the country experience an abrupt and
painful reversal of financing.

Why IS US Current Account Deficit So large ?

Large U.S. Current Account Deficit is considered to be main

reason for world macroeconomic imbalance in 1980s

United States acquires a significant portion of the worlds
savings, so other countries must adjust to the scarcity of capital
Imbalance of domestic savings and domestic investment.
Why ?

Feldsteins Hypothesis : Govt. Policy Problem

Investment Hypothesis
Productivity Hypothesis

Feldsteins Hypothesis : Government policy problem

Large U.S. Government Budget deficits attracted

foreign investment to the united states, thus causing

current account to move into further deficit.
If U.S. government do not reduce the budget deficit, it
will continue to absorb large portion of the rest of
worlds savings
Since, capital account determines current account,
policies that do not address capital movements will not
alter the current account deficit.

Investment Hypothesis : No Policy Problem

As the country accumulates debt to finance the current

deficit, it accumulates capital and therefore the

additional productive capacity to pay off the debt
Efforts to shrink deficit will destroy beneficial
investment boom
Hence, Government should take no action to reduce
CAD
But this appears to be dangerous since U.S. may face
lower standard of living in future as it pays off the debt
accumulated for todays consumption

Productivity Hypothesis
Current account balance reflects falling productivity in U.S.

compared to its trading partners.

U.S. must adopt policies to support export and improve
productivity.
Hence reducing CAD may require drastic changes in American
society
But this view does not address the source of savings-investment
imbalance
As per the various Vector Auto regressions, applied using hypothesis

tests it is found that Federal Budget Deficit is at the centre of the

large U.S. Current Account Deficit

Impact of large current account deficit: US

1.There could be problems financing the deficit in the long term. If you have a
deficit of over 6% of GDP then it is a problem if you rely on Capital flows. A
significant part of the CAD of US is finance by Chinese investors buying US
securities, at relatively low interest rates.
2. Most countries would not be able to borrow such large amounts at low interest
rates. The US currently can because the US is seen as the Worlds reserve
currency. However if attitudes to the US economy change and investors lose their
confidence in the US economy, they will stop buying US debt.
This will cause 2 problems:
US interest rates will need to rise to attract enough people to buy the debt.
If capital flows cant be attracted then the dollar will continue to devalue
further. This could cause inflationary pressures, interest rates may need to rise
to stabilise the dollar.
Basically to correct the deficit would be a painful experience for the US economy
and result in a slowdown or possibly recession

Impact of large current account deficit: US

3. In the US the current account deficit is to a large extent

caused by excess spending in the economy. A large current
account deficit is often a sign of an unbalanced economy. It
could be a sign of structural weakness and an uncompetitive
manufacturing sector.
4. A deficit on the current account increases foreign liabilities.
This means that in the future the economy will need to attract
capital flows just to pay off the investment income as well as
the deficit on goods and services.

ICELAND
Iceland is an example of a country

with a large current deficit which

later imploded.
In the years leading up to 2008,
there was a sharp inflow of capital to
Icelandic banks. This enabled
Iceland to run a record current
account deficit. Iceland was spending
more than they were earning. When
capital flows dried up, banks lost
money and there was a rapid
deterioration in the current account.

EUROZONE
In the Eurozone, current

account deficits are a bigger

cause for concern because
countries have a
permanently fixed exchange
rate (common currency).
Therefore they can't devalue
to restore competitiveness.
Therefore countries may
have to pursue internal
devaluation (deflation) to
restore competitiveness.

Reducing the current account

deficit

1. Depreciation of currency
Depreciation -> M -> X (Assumption: demand is price

elastic)
Problems:
Lead to imported inflation -> reduce countrys
competitiveness. So, improvement in CAD might be
temporary
Ways to depreciate
Exchange market intervention: buying and selling currency
on world exchange markets to manipulate the exchange
rate.
Empirical evidence suggests that sterilized intervention is
generally incapable of altering exchange rates

Fiscal policy vs Monetary policy

Permanent effects of monetary policy on the CAD may
be quite small in a system where exchange rates
fluctuate. Fiscal policy is well suited for influencing the
external balance.
Ideally monetary policy would be used to regulate
domestic economic conditions such as output and
inflation while fiscal policy would help control external
conditions such as trade deficit.

2. Deflation
T or r -> DD -> M
Also pressure on manufacturers to reduce cost ->

more competitive exports -> X

But with lower DD growth will fall causing higher
unemployment.
Govt unlikely to want to risk higher unemployment
just to reduce CAD

3. Protectionism
Increased tariffs -> M -> improvement in CAD

Dangers
o
o

Lead to retaliation so exports will decrease

Domestic industries may become uncompetitive because there
is no incentive

4. Supply side policies

Government attempts to increase productivity and

shift aggregate supply to the right

Improves the competitiveness of the economy and
make exports more attractive -> improvement in
CAD
Other benefits
o
o
o

Lower inflation (Shifting AS lowers the price level)

Lower unemployment
Improved economic growth

may take considerable time to have effect

4. Supply side policies (cont..)

Most supply side policies aim to enable the free market to work
more efficiently by reducing govt interference. Some of them are:
Privatization (more efficient in running business as they have a
profit motive to reduce cost and develop better services)
Deregulation (increases competition which lead to lower prices
and better quality of goods)
Reducing income tax (increases the incentives for people to
work harder leading to more output. Not true if income effect
outweighs substitution effect)
Reducing the power of trade unions (increase efficiency and
reduce unemployment)

4. Supply side policies (cont..)

Reducing State welfare funds (encourage

unemployed to take jobs)

Deregulation of financial markets (more competition
and lower borrowing costs for consumers and firms)
Lower tariff barriers
Removing unnecessary red tape
Deregulate labor markets

THANK YOU