Understanding Current Account Deficit: Tata MF

	You must have come across the term Current Account Deficit (CAD) in various newspapers. But do we really understand what exactly this mean to us and the country? Let's make an attempt to understand this concept through an interesting story! Rajendra and Vinay travel together to work by train every day. As a usual morning practice, Vinay was reading a business paper when he came across the term 'Current Account Deficit'. He wondered what it meant and asked Rajendra to explain. Rajendra tells him that if he answers a few questions, the meaning of the term Current Account Deficit will get clear. Rajendra: Tell me Vinay what are your sources of income? Vinay: Hmm… Salary, Interest income from Fixed Deposits and Dividends from mutual funds. Rajendra: What about festival grants and birthday gifts received in cash? Vinay: Yes, sometimes. Rajendra: Ok. Now tell me about your expenses? Vinay: Monthly house expenses, Children's school fees, Birthdays & Anniversary, occasional shopping and medical expenses. Rajendra: Right. Now assume your expenses exceed your income this month. So what will you do? Vinay: Oh… then I will have to borrow money from someone. Rajendra: Exactly. When your expenses exceed incomes, it is known as 'Deficit'. And you become indebted to the lender who lends you money. Vinay: Ok. That is easy to understand. Rajendra: Similarly, Current Account for a country is expressed as the difference between the value of export of goods and services and the value of import of goods and services. Exports in this context are like “earnings” while imports are like “expenses”. A deficit then means that the “expenses” of the country are more than the income. In other words the country is importing more goods and services than it is exporting. (Please also understand that the current account also includes net income (such as interest and dividends from Capital Inflows or Outflows) and transfers from abroad (such as Workers' Remittances, Foreign Donations, Aids & Grants and Official Assistance), which are usually a small fraction of the total.) A deficit would thus occur when total imports are greater than exports. A deficit implies that India is a net debtor to the world. Vinay: Now I got it! Hope the story has explained the concept of 'Current Account Deficit'! We have listed down a few questions and answers for your thorough understanding. How is it different from Capital Account? While Current Account flows arise out of sale or purchase of goods and services, and hence permanent in nature, Capital Account inflows arise when there is inflow by way of equity or debt into the country. But what sets the two apart is that while Current Account flows are permanent and irreversible, capital inflows are reversible depending on the nature of such inflows, like whether they are for long term or short term. Capital Account thus comprises of long-term flows such as Foreign Direct Investments (FDI), External Commercial Borrowings (ECB) and longer-tenor NRI deposits and short-term flows are essentially Foreign Institutional Investments (FII) in Equity or Debt and short-term trade credit which can move out of the country. How is the Current Account Deficit funded? A deficit in the Current Account is funded by various capital inflows, including Portfolio Investments (FII), ECB, FDI and NRI deposits. Inadequate resources to finance the Current Account Deficit may put pressure on the local currency leading to inflationary pressures which works as a tax on all citizens. Finance Minister Mr. P Chidambaram in his budget speech said “This year, and perhaps next year too, we have to find over US$ 75 billion to finance the CAD. There are only three ways before us: FDI, FII or External Commercial Borrowing (ECB).” India majorly depends on Foreign Capital Inflows by way of FII, FDI, ECB and NRI deposits for this Current Account Deposits funding. Kindly refer to the table below for more insights.
(In US$ Billion) FY11 FY12 Item     Current Account -46.0 -78.2 % of GDP -2.7 -4.2 Trade balance -130.6 -189.8 - Exports 250.6 309.8 - Imports 381.2 499.6 o/w Oil imports 106.1 155.6 Invisibles 84.6 111.6 Capital Account 62.1 67.8 Foreign investment 39.7 39.2 - FDI 9.4 22.1 - FII+ 30.3 17.2 Banking capital 5.0 16.2 - NRI deposits 3.2 11.9 Short term credit 11.0 6.7 ECBs 12.5 10.3 External assistance 4.9 2.3 Others -11.0 -6.9 Overall balance 16.1 -10.4 Memo     RBI's forex intervention 1.7 -20.1
Source: RBI, BofA Merrill Lynch Global Research estimates
	What is the ideal way to fund it? The best way to fund the Current Account Deficit is through non-debt creating long-term inflows such as Foreign Direct Investments. Volatile inflows like Portfolio Investments, sometimes referred to as hot money, could threaten the financial stability of the country. This is because if the funds flow out all of a sudden the impact would fall on the currency causing it to depreciate and also bringing in inflation. Is it good to have a Current Account Deficit? Conventional economic thinking is that a country should be in a current account surplus, and the surplus ideally should be used to offset capital flows. However, for emerging countries, which have more investment opportunities than they can afford to undertake because of low levels of domestic savings, a moderate Current Account Deficit may be natural. A deficit potentially spurs faster output growth and economic development. However, a high Current Account Deficit may create Balance of Payment problems.
India's average Current Account Deficit for the period FY07 to FY11 has been around -2% of GDP, which according to many economists is considered prudent. However, the Current Account Deficit for FY12 widened to all-time high of -4.2% of GDP (US$ -78.2 billion) because of burgeoning trade deficit. It is estimated that the Current Account Deficit for FY13 may widen even further to -5.1% of GDP (US$ -93.0 billion). However, many believe FY14 may see some moderation due to continued fall in gold imports, pickup in merchandise exports on the back of improvement in global growth, improvement in software exports and continued traction in private transfers. Despite this moderation, the Current Account Deficit is still likely to remain fairly high due to sizeable import of oil.
	What are the reasons for rise in Current Account Deficit? The rise in Current Account Deficit is mainly attributed to excessive dependence on oil imports, high volume of coal imports, our passion for gold and slowdown in exports. Also, the rupee depreciation has worsened the current account as a large portion of imports, including crude oil, are largely price inelastic. But economists expect imports to come down in future as costlier inputs dampen demand, as is evident in the case of gold. Simultaneously, exports will pick up as they have become more competitive/cheaper in the global market. This will lead to an improvement in trade balance & consequently in Current Account Deficit.
	Why are regulators and policymakers concerned? Because there is very little that can be done to restrict the Current Account Deficit as prices of essential items of imports are rising and exports are not picking up. A Current Account Deficit for India should ideally be not higher than 2.5% of GDP. The challenge before the government is to devise policies that will boost exports and reduce unnecessary imports such as those of gold. What are the risks posed by a widening Current Account Deficit? An increasing current account can pose serious problems for an economy. Payments are dependent on long-term capital inflows, which, in turn, depend on the growth prospects of an economy. A pause in these flows can lead to payment problems and pressures on the local currency. It can then encourage outflow of foreign capital.
	Disclaimer:The views expressed in this lesson are for information purposes only and do not construe to be any investment, legal or taxation advice. The contents are topical in nature and held true at the time of creation of the lesson. This is not indicative of future market trends, nor is Tata Asset Management Ltd. attempting to predict the same. Reprinting any part of this presentation will be at your own risk. Tata Asset Management Ltd. will not be liable for the consequences of such action.

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