Tuesday, 11 June 2013

Current Account Deficit - How it Affects India's Economy

The ever increasing Current Account Deficit (CAD) seems to be the biggest issue for the nation’s economy which threatens to engulf everything else in its fold. But why is the CAD such an important factor and what are its effects? Let’s try to answer this for ourselves.

Current Account :

It is generally defined as the difference between the revenue earned by a country from its trade activities and its expenditure due to imports. The export and import of goods, services and transfers are components of the current account.

Current Account Deficit :

When the total imports into the country exceeds the total exports, then we say there is a current account deficit.

The fact that India’s CAD is huge means that we are spending/borrowing more than we are earning from our international trade. As a result, we are in debt to the rest of the world.

To some extent CAD is a good indicator for a developing country. For example, if the industrialists borrow more from outside India to expand their business activities, it leads to a growth in businesses and economic activity which in-turn leads to more revenue from the businesses in the future. In this case a comfortable CAD indicates a nation's intention to grow.

India's High CAD :

The reason for CAD in India is not any such economic activity but huge imports to meet the demands of our consumption. And that is the unfortunate scenario. The major contributor to India’s CAD is imports of Gold and Crude Oil.The high current account deficits stemming from imports which do not contribute to economic growth but only are necessary to meet the demands of domestic consumption coupled with a GDP which is not growing fast enough, has put the economy on a dangerous footing. Some of the effects of sustained CAD are :
  • Currency depreciation
  • Inflation
  • Reduction of credit rating of the country affecting foreign investment
  • Outflow of foreign currency due to fears of value erosion, leading to further economic deterioration. This also aids depreciation of rupee. For a detailed view readers can go through our post on Rupee and its Value Depreciation.

The govt. generally takes some steps to curb CAD and bring it to sustainable levels. Some of which are :
  • Decreasing imports. Levying higher taxes and import duties to discourage gold imports was one such step. To understand why we are inefficient investors when we invest in gold, you can read our post Gold -My Precious
  • Increasing growth by taking steps giving economic stimulus.
  • Promoting national savings to fund investment. Schemes like the Rajiv Gandhi Equity Savings Scheme (RGESS) and the recently implemented Inflation Indexed Bonds (IIBs) are some such steps by the govt. to encourage savings and wean away investors from gold thus reducing burden of gold imports.
  • Increasing exports from the country.
  • Promoting foreign investments to participate in productive activity of the country. The recent impetus on Foreign Direct Investments (FDIs) in various sectors is to this effect.
  • Non-resident Indian remittances to home country.
  • Controlling and suppressing demand by tightening monetary policy.
  • Curtailing the fiscal deficit of the Govt. To know more you can read our post on Fiscal Deficit - Ringside View to India's Economic Problems.
With proper implementation of reformative steps by the govt. and strict control over monetary policy by the RBI (discussed in the post on RBI and its Monetary Policy), hopefully we will get through the present CAD quagmire and bring it back to sustainable levels. We have to just wait and see...