Current Account Deficit (CAD) is perhaps amongst the hottest term of 2013 being used by economists, strategists, investment advisors, stock brokers, bankers, politicians and regulators. If so many people are using it repetitively and blaming it to be one of the root causes behind India’s current economic situation, then certainly it should be an important economic indicator having far reaching impact. This article aims to demystify CAD and put it in extremely easy to understand language so that a layman can relate it to his day to day life.
So to begin with, let me refer you to the table below. It is a hypothetical example of Tom’s 3 years financial position. Column 2 shows how much he earns and if his earning falls short of his expenses, how much does he borrow to meet his expenses. Column 3 shows his expenses and Column 4 shows how much his income stream falls short of his expenses.
Year 1, Tom earned Rs. 10, but his expenses were Rs. 11. He was reputable amongst his friends so he was able to fund an extra Rs. 1 to meet his additional outflow of Rs. 1 (Deficit)
Year 2 : Tom is under the weather and his incomes have reduced to Rs. 8, but his expenses have increased to Rs. 12. He now has a shortfall of Rs. 4 which is again easily funded by him by taking a loan. So overall his expenses of Rs. 12 are balanced as shown by the green line.
Year 3 : Tom is not doing good at all. His incomes have further reduced to Rs. 6 and even though this expenses have remained the same at Rs. 12 level, he has a shortfall of Rs. 6. He attempted to approach externally for help, but people are worried that his deficit is not sustainable and hence they are not comfortable to lend him in full. He is able to source just Rs. 3, and has an overall short fall of Rs. 3 to fund his cash outflows. This now has an impact on his credit worthiness !
If you understand the above illustration, the CAD is some what similar. Current Account on a simply means Exports – Imports. Okay I admit that CAD is more technical than what I just wrote, but for the sake of making it simple, it materially is a relationship between exports and imports. For exports India gets Dollars (and other foreign currencies) and for Imports India pays Dollars. To relate with my example above, Exports could be considered as incomes and Imports as expenses. If India exports more than imports, it has a surplus else a deficit. In order to fund the payments (deficit) of our import bills, India needs to get additional dollars which could either be sourced by taking loans from foreign countries or in the form of FDIs or Foreign investments in India which results in large amount of foreign exchange coming into the country. India is a net importer in the world of external trade and has been funding its CAD by foreign investment flows. However, as the growth rate in India slowed down combined with a betterment of global economic situation, Foreigners have reduced the amount of the investments into India.
Now comes in the India’s exchange rate element. It is very much a demand supply mathematics. If the demand of dollars in India to pay for Import bills is more than what India sources via exports and FDI, then it results in Depreciation of Rupee and vice versa. The diagram below will perhaps remind many of you of the classic economics demand / supply relationship. You would notice that the demand for $s increases from A-A1 to B-B1. This resulted in shifting the equilibrium price from E to E1. Effectively it results in Rupee depreciating to from Rs. 45 to Rs. 50 level.
Is CAD really bad ?
This is very subjective and has to be looked in a case by case basis. Essentially a CAD means that we are importing more resources than exporting. It all depends on what these imports are and how are they being used. If the imports are resources which the economy is consuming for enhancing its productive capacity and increasing its exports, it will result in future benefits when such assets will start to deliver the returns. However, if the imports are not for productive purposes (e.g. Gold import for investment), then perhaps it is a worrying sign. Below is an example of India’s import structure. POL stands for Oil product imports. You would notice that ~45% of India’s import is Oil & Gold. Gold was 12.2% of half year import in 2011-12 and is reduced to 9.1% in half year 2012-13 owing to conscious efforts on part of the government to reduce unproductive imports.
CAD resulting in currency depreciation can be a win win strategy for boosting exports and domestic industries. With a depreciating currency, imported goods will be costlier for domestic consumption, e.g. an imported TV which was costing Rs. 50,000 ($1000 when Rs. was 50 to a dollar), would cost Rs. 60,000 when dollar is quoting at Rs. 60. This will promote local TV manufacturers to start manufacturing TVs as now they can compete with 60K price tag of an imported TV and command enhanced margins.
Similarly an exporter who was selling his TV at $1000 in external markets can enjoy higher profits as he would now make Rs. 60K instead of 50K revenue. If he wants to increase his market share, he can slightly reduce his prices in international markets from $1000 to $833 and still have the same margins. This will make his product cheaper amongst other foreign sellers and hence attract more buyers.
For more effects of Rupee depreciation on the economy in general, you can refer to my article Rupee Depreciation – How Does it Affect YOU
Summary
CAD and Rupee depreciation is painful in short run, but it bring with it future hidden opportunities. With an increased production for both domestic and export demand, not only would the economy spring back into growth path, but the CAD would start to balance automatically. Imports will reduce as they will be expensive and Exports will increase as products will be cheaper in foreign markets. However, this whole cycle takes a couple of years and is not an over night change in an economy’s fortune. In the interim a lot of companies may show painful signs of poor profitability where their cost of production may jump up if they have been importers of raw material and have foreign payments to make on their loans. Once such business models stabilise and change to suit the depreciated Rupee situation, things will improve and hopefully bring such companies back into profits.
Japan & China are the biggest examples where currency depreciation was used to bolster economic growth and exports. Hopefully India follows similar footsteps.
First question
How does India secure US dollars form FDI? When a foregin company want to setup a office in India; doesnt it pay locally in Ruppes for all the good and services it procures? How did the indians get US dollars in this case?
Wouldnt an american company have sold american dollars in the foregin exchane market at home; arrived in India with a bag of rupees and paid for whatever it was completing its FDI in?
Second question
How come india; when it has a short fall in dollars to pay for imports; cant sell its own currency in the markets and raise the needed dollars this way. It can print an unlimited amount of its own currency. Yes its own currency would fall in value due to this new prinitg but its it an option?
Third question
The indian central bank has several billion dollars on reverse. Can those be used to pay for the imports and cover the trade deficit?
Final question.
Why does the deficit have to be financed by foreginers? Can local indians use their savings to pay for any deficit that might arise in any given year.
Say we export 50 units worth of exports and import 90 units; paying the difference of 40 units with savings we have from previous years? Is this not an option?
Please help me understand..
thanks
Paul
You have brilliant queries. In some of them you have self answered them as well. However, the flow to get $s in India is – Foreign company sends / remits dollars an authorised dealer in India which gives them INR in return. While you could source limited INR outside India, but major supply will be within India. You can look it this way, a Foreign company will buy INR by paying India $s.
2. India does not get $s automatically. It gets them via export earnings or by capital inflows (FDIs) or loans. So even if India keeps on printing INR, it won’t increase the stock of $s.
3. Indeed, the existing stock of $s is being used to pay for imports. When an importer or even a holiday maker needs $s to pay for the goods, it goes to a bank which gets the $s from the stock from RBI. But if RBI doesn’t get its $ stock re-filled via exports, then a point will come where there won’t be any $ left for imports resulting in 1991 crises.
4. No – Deficit needs to be financed via exports or via foreign loans / FDIs. Think this way, your savings are in INR which can not be converted in $s, unless you receive your income in $s. The only way residents can participate in reducing the deficit is by avoiding items which are imported, e.g. Oil, Gold.
So you are saying:
1. FDI investors give their US dollars to the RBI central bank and in return they are given INR to invest in India locally.
2. RBI may print INR; but that still doesnt mean they will get dollars; someone who has US$ would have to want those INR. It is not an automatic right.
The only way india normally gets US$ is via exports, foregin loans, or FDI.
India RBI can print all the INR they want; but this doesn’t mean they can get new US$ for those INR.
Is this all correct?
Finally many US dollars does the RBI have;
How many US$ do local people ask for in US dollars from the INR each year for imports?
How much get replenished via exports, FDI and loans each year?
Why suddenly are we near a crisis point?
Thanks
Paul