Unsustainable Current Account Deficit

Unsustainable Current Account Deficit

Subject :Economy

Section :External Sector

Why in the news?

The Current Account Deficit is at an unsustainable level and the RBI’s measures are expected to work merely as short-term fixes.

Details:

• The BoP data for 2021-22 recorded CAD at $38.9 billion (or 1.2 percent of GDP) and with the net capital inflows of $86.3 billion, there was an accretion of $7.5 billion to forex reserves.
• Trade data for April-June 2022 showed a trade deficit of $70.25 billion with a 22.22 per cent increase in exports and a 47.31 per cent rise in imports.
• It estimates various trade related related indicators for 2022-23:

Causes:

• War in Europe- Russia’s continuing conflict with Ukraine since late February this year has propped up commodity prices globally reducing global growth prospects and trade demands.
• Net capital outflows-particularly foreign portfolio investment in the event of higher interest rates in the US
• The strengthening of the US dollar- increasing import bill. 
• An unprecedented increase in crude oil prices-increasing import bill as India depends around more than 80% of oil needs on imports.
• Decline of export in June and higher imports especially core imports( non-oil and non-gold imports)  which grew by a robust 31.7% in June -due to higher inflation.

Are we heading towards an unsustainable BOP deficit?

• According to the RBI Report on Currency and Finance, April 2022-growth begins to decelerate with a CAD-GDP ratio beyond 2.3 per cent.
• Higher Current account deficit along with inadequate capital inflows-it would lead to overall BOP deficit and reduction of forex.
  • The overall BOP deficit is expected to be of $30 billion in 2022, which translates to sale of US dollars by the RBI to the tune of $30 billion.
• Decline in the foreign currency asset -It may be noted that over March 2022, these assets have declined by $11.5 billion due to ongoing appreciation of the US$.
  • FCAs are assets that are valued based on a currency other than the country’s own currency.
  • For instance, if a portion of the reserves are in euros and the euro depreciates against the dollar, this would cause a drop in the value of forex reserves.
• Volatile depreciation of Indian rupee-The exchange rate is determined by demand and supply and with a deficit in the overall BoP position, the pressure on the rupee increases.
  • The currency depreciation can impact further BOP deficit by
    • reducing export earning
    • increasing cost of external borrowings.
    • increases the interest payments on foreign loans
  • According to the RBI Report-a 10 percent increase in the average exchange rate volatility decreases export earnings by 1.6 percent while a 10 percent depreciation of the NR against the US dollar decreases profits by 21 per cent.
• India’s short-term external debt on residual maturity constituted 43.1 percent of total external debt and 44.1 percent of foreign exchange reserves- increasing near term (within 1 year) payment burden and further fall in forex/increasing BOP deficit.

Policy need?

• Enhance export competitiveness and
• Ease processes to encourage FDI inflows (long term investments which are of non debt creating nature).

Concept:

Balance of payments equilibrium

• In a floating exchange rate the supply of currency will always equal the demand for currency, and the balance of payments is zero.
• Therefore if there is a deficit on the current account there will be a surplus on the financial/capital account.
• And a deficit in both current and capital accounts is balanced through sale of forex by the RBI in the open market in return of domestic currency.

Factors affecting the balance of payments

• A current account deficit could be caused by factors such as.
  • The rate of consumer spending on imports- For example, during an economic boom, there will be increased spending and this will cause a deficit on the current account.
  • International competitiveness-If a country experiences higher inflation than its competitors, exports will be less competitive leading to lower demand.
  • Exchange rate-If the exchange rate is overvalued, it makes exports relatively more expensive leading to a deterioration in the current account.
  • Structure of economy – deindustrialisation can harm the export sector.
• Factors affecting Capital Account:
  • Government may impose controls on the free movement of capital-
  • The government may impose a tax on income accrued to the local investors who invested in foreign markets. It discourages outflow of capital.
  • The anticipated change in exchange rate affects capital flows because it tends to change the expectation about the rate of return on foreign investment.

Changes in interest rate also affect the international capital flows. An increase in interest rates relative to other countries may affect capital