Current Account Deficit
- March 11, 2022
- Posted by: OptimizeIAS Team
- Category: DPN Topics
Current Account Deficit
Section: External sector
Context: It is expected that the current account deficit of India will widen to a 10-year high of 3 percent of GDP in FY23 due to the Ukraine War
Balance of Payments
Balance of Payments (BoP) of a country can be defined as a systematic statement of all economic transactions of a country with the rest of the world during a specific period usually one year.
For preparing BoP accounts, economic transactions between a country and the rest of the world are grouped under – Current account, Capital account and Errors and Omissions. It also shows changes in Foreign Exchange Reserves.
- 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.
- Errors and Omissions: Sometimes the balance of payments does not balance. This imbalance is shown in the BoP as errors and omissions. It reflects the country’s inability to record all international transactions accurately.
- Changes in Foreign Exchange Reserves: Movements in the reserves comprises changes in the foreign currency assets held by the Reserve Bank of India (RBI) and also in Special Drawing Rights (SDR) balances.
Overall the BoP account can be a surplus or a deficit. If there is a deficit then it can be bridged by taking money from the Foreign Exchange (Forex) Account
Current Account Deficit-
It is expected that the current account deficit of India will widen to a 10-year high of 3 percent of GDP in FY23 due to the Ukraine War
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.
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