CAD widens to 2.8 percent of GDP

CAD widens to 2.8 percent of GDP

Subject :Economics

Context: Reserve Bank of India data shows that India’s current account deficit has widened to 2.8% of GDP in April- June period when compared to 1.5 % in the preceding quarter. It is also observed that India’s external debt has declined by 2.5 billion USD to 617.1 billion dollars.

Concept :

• CAD has widened mainly due to high merchandise trade deficit and net outflow of investment income payments.

What is investment income?

• Investment Income is the income that is generated through dividends, payment of interest, and capital gains through the sale of any asset or security and profits made by any kind of investment vehicles like bonds, mutual funds, etc.

Current Account Deficit–

• A current account deficit occurs when the total value of goods and services a country imports exceeds the total value of goods and services it exports.
• If there is a deficit on the current account, there will be a surplus on the Financial/Capital account to compensate for the net withdrawals.
• Current Account: It shows export and import of visibles (also called merchandise or goods – represent trade balance) and invisibles (also called non-merchandise). Invisibles include services, transfers and income.Thus,
• The balance of trade in goods
• The balance of trade in services.
• Net current income e.g. profit from overseas investment.
• Transfer payments e.g. payments to the EU.
• The balance of exports and imports of goods is referred to as the trade balance. Trade Balance is a part of ‘Current Account Balance’.
• Capital Account: It shows a capital expenditure and income for a country. It gives a summary of the net flow of both private and public investment into an economy.
• External Commercial Borrowing (ECB), Foreign Direct Investment, Foreign Portfolio Investment, etc form a part of capital account.

The size of current account deficit/surplus is affected by several factors including:

• Overvalued 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
• Economic growth-If there is an increase in national income, people will tend to have more disposable income to consume goods. If domestic producers cannot meet the domestic demand, consumers will have to import goods from abroad.
• Saving rates – influencing the level of import spending, thus increasing the deficit.
• Decline in competitiveness/export sector-In the UK, there has been a decline in the exporting manufacturing sector because it has struggled to compete with developing countries in the far east. This has led to a persistent deficit in the balance of trade.
• Higher inflation-If India’s inflation rises faster than our main competitors then it will make UK exports less competitive and imports more competitive. However, inflation may also lead to a depreciation in the currency to offset this decline in competitiveness.
• Recession in other countries-If India’s main trading partners experience negative economic growth, then they will buy less of our exports, worsening India’s current account.
• Borrowing money-If countries are borrowing money to invest e.g. third world countries, then this will lead to deterioration in current account position.
• Financial flows to finance the current account deficit.-If a country can attract more financial flows (either short-term portfolio investment or long-term direct investment), then these flows on the financial account will enable the country to run a larger current account deficit.

Impact for the economy

• Cost Push inflation- due to supply shortage
• Rise in import bill
• Decline in forex reserve
• Rise capital inflows- If there is a deficit on the current account, there will be a surplus on the Financial/Capital account to compensate for the net withdrawals. However, capital flows are likely to be lower than the current account deficit due to war led outflows.
• Higher external borrowing

Dip in external debt

• The external debt to GDP ratio declined to 19.4 % at June end, from 19.9% at March end.
• The external debt-to-GDP ratio is the ratio between a country’s external debt and its gross domestic product (GDP).
• RBI stated that the valuation gains due to the appreciation of the USD and other major currencies like the Japanese yen and euro were responsible for the decline. Otherwise, the external debt would have increased by 11.9 billion USD.

External debt

• It refers to money borrowed from a source outside the country. External debt has to be paid back in the currency in which it is borrowed.
• External debt can be obtained from foreign commercial banks, international financial institutions like IMF, World Bank, ADB etc and from the government of foreign nations.
• External debt is money borrowed by a government or corporation from a foreign source. It includes both public and publicly guaranteed debt and non-guaranteed private sector external debt.
• Normally these types of debts are in the form of tied loans, meaning that these have to be used for a predefined purpose as determined by a consensus of the borrower and the lender.
• Sovereign debt is a central government’s debt. It is debt issued by the national government in a foreign currency in order to finance the issuing country’s growth and development.