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Widening (CAD) Current Account Deficit

Context

India’s current account deficit (CAD) increased to 2.8% of GDP in the April-June quarter (Q1 FY22), the highest in four years but lower than the 3-3.5% forecast by many economists.

Relevance

GS Paper 3: Indian Economy and issues relating to planning, mobilisation of resources, growth, development and employment

Mains Question

How do you define Current Account Deficit? Do you believe that a rising CAD is inherently bad and should be monitored by the country’s central bank? Discuss (150 Words) (150 Words)


Rupee exchange rate:

  • Every day, Indians and Indian entities such as firms and governments import foreign goods and services, export domestic goods and services, receive foreign investments, and invest in other countries.
  • Each of these transactions involves either a demand for foreign currency (for example, to import something from the United States or to invest in one of the United States’ stock exchanges) or a demand for Indian currency (by the same logic).
  • The interaction of these transactions determines the exchange rate of the Indian rupee in relation to foreign currency (say the US dollar).

Transaction Recording:

  • The Balance of Payment is a notebook, slate, or ledger that records all of the above-mentioned transactions (BoP).
  • The BoP is divided into two parts
    • Investment Account:
  • This includes all types of capital trading.
  • In other words, all investments and loans made within and outside the country are recorded here — for example, if an Indian firm invests money in the United States to establish a new business there, or if an Indian buys stocks on an American exchange.
  • This account includes foreign direct investments, portfolio investments, and so on. It summarises the net flow of both private and public investment into a country’s economy.
    • Checking Account:
  • All trade in goods and services is recorded here.
  • For example, if an Indian imports an American gadget or software developed by an American company, or if an American entity imports Indian steel or hires an Indian IT firm to develop software.
    • The Current Account is divided into two sections:
  • Import and export of goods constitute the “trade account.”
  • Import and export of services is referred to as the “invisibles account.”

Concerning the Current Account Balance:

  • It is possible that a country, such as India, imports more goods than it exports (everything from cars to phones to machinery to food grains, etc.).
  • It would have a “deficit” on its trade account in this case.
    • In other words, more money is leaving the country than entering through physical goods trade.
  • India, on the other hand, may be enjoying a “surplus” on the invisibles account.
    • This is possible because its software industry is highly capable, efficient, and competitive, and it exports a large number of software solutions.
  • The current account balance is the net effect of the surplus (or deficit) on the invisibles account and the deficit (or surplus) on the trade account.

The Current Account Deficit in India:

• In the case of India, there is a large trade deficit and a smaller surplus on the invisibles, resulting in an overall current account deficit — or Current Account Deficit.

• Having a CAD or a current account deficit means that India imports more goods and services than it exports in monetary terms.

• This implies that demand for a foreign currency (say, the US dollar) is greater than demand for the Indian rupee.

Causes of increased CAD:

  • Despite the fact that India’s trade deficit has increased, the Invisibles account has provided significant support.
  • With higher net inflows of USD 30 billion and USD 23 billion, respectively, in the IT industry and foreign remittances.
    • A foreign remittance is a monetary transfer from a foreign worker to family or other individuals in their home country.
  • India’s export earnings have also begun to fall.

The Capital Account

  • Capital flows from foreign investors, which helped to ensure the Balance of Payments, have also decreased as global funds became risk-averse following the US Federal Reserve System’s interest rate hike.
  • The Federal Reserve System is the United States’ central bank.
  • Net foreign portfolio investment outflows totaled USD 14.6 billion in Q1 FY22, compared to inflows of USD 0.4 billion.

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