Trade deficit hits record high in October driven by gold imports

Trade deficit hits record high in October driven by gold imports

Subject: Economy

Section: External Economy

Context: According to official data released by the Commerce and Industry Ministry, festive demand also boosted silver imports which leaped 125 per cent to $1.31 billion,

Details:

• Driven by gold and silver imports during the festive season, India’s trade deficit in October surged to a record high even as India’s goods exports entered the positive territory after eight consecutive months of decline due to weak demand in the Western countries and in China due to its property sector crisis.
• The trade deficit swelled to $31.46 billion in October after gold imports surged by a massive 95 per cent to $7.2 billion last month compared to October last year. Festive demand also boosted Silver imports which leaped 125 per cent to $1.31 billion, official data released by the Commerce and Industry Ministry on Wednesday showed.
• While merchandise exports jumped 3 per cent to $33.57 billion compared to October last year, imports surged over 12 per cent to a record $65.03 billion. Notably, labour-intensive sectors such as gems and jewellery, textiles, and leather declined 9.82 per cent, 5 per cent, and 8.08 per cent respectively. On the contrary, outbound shipments of electronic, and engineering goods registered a steep jump of 28.23 per cent and 7.20 per cent respectively last month compared to October last year.

Why buying gold is bad for the Indian economy

• India is the largest consumer of gold. India accounts for more than 30 per cent of the global gold market. However, the domestic production of gold in India is minimal. India meets the high demand of gold from its domestic consumers by importing it.
• Though the universal acceptance, liquidity and safe haven against economic or political turmoil makes gold lucrative, it does not add much of a value to the economy.
• Most of the gold bought by us Indians is used for consumption purpose in the form of jewellery. Even from the investment perspective, majority of the Indians still prefer the traditional way of holding it in the physical form. Gold ETFs, which were first introduced in India in 2007, witnessed slow growth in the initial years. Over the past couple of years, investments in gold ETFs gained momentum.
• However, as per the statistics of Gold Council, jewellery accounts for nearly 75 per cent of the gold demand in India. When we compare this consumption rate with the global scenario, even the second largest importer of gold, i.e., China lags by more than 30 per cent in terms of consumer demand. If we compare these demand levels against the size of economy of major nations, India’s GDP is much lower than that of China or the US. The high consumption rate of gold among Indians is unproductive for the Indian economy.
• Current account deficit: The first major problem the Indian economy faces with this high gold consumption rates is the increasing current account deficit (CAD). India has to pay for its gold imports using its foreign exchange reserves.
• Foreign exchange reserves hold a key especially among the developing countries, which have to import and use the industrial metals. Higher consumption of industrial commodities supports industrial production. The goods produced by consuming such commodities can be exported and the revenues can be used to fund the current account deficit. Even during its higher prices, the demand for gold did not go down. The oil imports are a huge burden on India’s balance of payments. But oil consumption is something which India cannot reduce keeping its industrial usage in perspective. High gold imports and weak rupee have been the biggest stress points when it comes to narrowing the current account deficit.
• Mis allocation of resource: Misallocated capital is the second problem faced by the Indian economy due to its gold rush. Keeping the consumption aside, physical gold (mostly jewellery) is also considered as an investment among Indians.
• However, it is an investment that does not add much value to the productive capacity of the economy. Investments in the physical form of gold are either stored in bank lockers or get exchanged for making jewellery. It seldom gets traded for money. Imagine the same amount being invested in the capital markets. It allows the companies to raise capital in the form of debt or equity and expand their business. It can make a huge difference to the productive capacity of the economy. It not only just adds to the physical goods produced, it also has a potential to improve employment in a vastly populated country like India.
• It is a given fact that over the last decade, gold has given returns which no other asset class has been able to match. However, the demand for gold among Indians has always been price independent. Gold is a traditional investment strategy Indians follow. The effect of high prices has been minimal on the volume of gold imported. The lower prices may increase the demand in the coming days. It is the economies of the US and Europe that play a major role in determining the price movements of gold. By importing gold for our consumption, we Indians are investing in the international markets and helping their economies.
• Over the last few years, the Indian markets are supported majorly by the foreign inflows. Participation of Indian domestic investors becomes all the more important for the Indian markets to prosper. Even for the transition of India from a developing market to developed market, it is important that the domestic investors stay invested in the capital markets.
• The lack of alternative investments is one of the reasons attributed for Indian investors favoring gold over domestic capital markets. More investors in the capital markets will also drive more investment options in the domestic markets. More than looking at it as an alternative investment, we invest in gold and real estate because we understand it easily.

Some steps taken by Government to curb gold imports

Gold Monetization Scheme:

• This was introduced to mobilize fallow gold in homes and institutions, use it productively, and lower import prices.

Sovereign Gold Bond (SGB) Scheme:

• Bonds are issued by the Reserve Bank of India on behalf of the Government of India.
• The bond has a term of 8 years and has an option to terminate from the 5th year.
• Its objective is to reduce demand for physical gold by shifting a part of the gold purchase by people to invest in gold bonds.

Trade Deficit:

• Trade deficit or negative balance of trade (BOT) is the gap between exports and imports. 
• When money spent on imports exceeds that spent on exports in a country-a trade deficit occurs.
• The opposite of a trade deficit is a trade surplus.
• India tends to have a trade deficit every year because it imports far more (in terms of value, measured in $) than it exports.
• A trade deficit implies that Indians need dollars/forex more than the rest of the world needs rupees for the trades to settle.
• A trade deficit puts pressure on the rupee’s exchange rate against the dollar and persistently high trade deficits tend to weaken the rupee’s exchange rate.
• It is a part of the Current Account Deficit.
  • The current account records exports and imports in goods and services and transfer payments. It represents a country’s transactions with the rest of the world and, like the capital account, is a component of a country’s Balance of Payments (BOP).
  • There is a deficit in Current Account if the value of the goods and services imported exceeds the value of those exported.
  • Major components are:
    • Goods,
    • Services, and
    • Net earnings on overseas investments (such as interests and dividend) and net transfer of payments over a period of time, such as remittances.
  • Current Account Balance = Trade gap + Net current transfers + Net income abroad.
    • Trade gap/Trade deficit = Exports – Imports

What causes a trade deficit?

• Fall in export and rise in import volume
• Rise in Import price or fall in the export price-India’s exports of a particular commodity, say bananas, doubles in value terms ($ terms) not because India exports more bananas, but because the price of bananas in the international market has doubled.

Is a trade deficit bad for a country’s economy?

• If the trade deficit increases, a country’s GDP decreases. 
• A higher trade deficit can decrease the local currency’s value.
• Impact the jobs market and lead to an increase in unemployment. If more mobiles are imported and less produced locally, then there will be less local jobs in that sector.
• More imports contribute to imported inflation and an increase in the fiscal imbalance, which is damaging to a developing country.

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