What is current account
deficit (CAD)?
The
inflow of money into the country and outflows from it are summarized in what is
called the balance of payments (BoP). You could think of it as a balance sheet
vis-à-vis the rest of the world. The BoP is broken down into two major
components — the current account and the capital account.
The current account includes all inflows
and outflows of a routine nature. Thus, exports of goods and services,
remittances received from Indians abroad, foreign tourists bringing money into
India and similar other items form part of the inflows or the credit side of
the current account. Conversely, imports, remittances by expatriates to their
home countries, Indians travelling abroad form part of the outflows or debit.
When outflows exceed inflows, you have a current account deficit. Of course, if
inflows exceeded outflows, it would be a surplus.
The capital account deals with longer-term
flows, like borrowings, investments, assistance by India to other countries or
to India by others, and so on. The broad principle is that any inflow or
outflow that tends to necessitate future transactions (like loans being
returned) will be part of the capital account. Here again, the difference
between outflows and inflows would be the capital account surplus — if inflows
exceed outflows — or deficit. If the capital surplus is not enough to cover
CAD, the country will have to take money out of its forex reserves to bridge
the difference, thereby reducing its reserves. If the capital account surplus
is larger than CAD, the difference gets added to the reserves.
Why is CAD so
important?
In
effect, it is a measure of how much an economy is dependent on capital flows
from abroad to help it meet its current needs. Obviously, if this dependency is
high, it is a sign of a problem. To see how high the dependency is, economists
look not at the absolute level of CAD, but its level in relation to the size of
the economy, since a tiny economy with, say, a CAD of $200 billion is clearly in
a bigger hole than a large economy with the same absolute level. Hence, what is
looked at is the CAD as a percentage of GDP. In India’s case, this is now at
about 4.8%, a significant rise from about 1.3% in 2007-08. What this means is
that India’s demand for foreign currency, particularly dollars, has gone up
dramatically in the last few years (mainly on account of oil and gold imports)
while supply hasn’t quite kept pace (thanks to weak exports).
The widening CAD could have been funded by
a heavy inflow of foreign investments — direct (FDI) and/or institutional
(FII), but that hasn’t happened either. Policy paralysis, political
uncertainty, sliding industrial output and a weakening economy (as evident from
a quarter-on-quarter drop in growth figures) has turned off foreign investors,
who now find they can get better returns
on their capital elsewhere in the world.
This demand-supply mismatch of dollars is
at the core of the US currency becoming more expensive.
How are US bonds
connected to all this?
US treasury bonds are essentially
instruments floated by the US Federal Reserve (the American equivalent of the
RBI) to borrow money. All other things being equal, the status of the US as the
world’s largest economy and the dollar as a global reserve currency means that
investors see putting their money in US bonds as arguably the most risk-free
option.
However,
when US treasury bonds offer very low rates of interest, this advantage can be
offset by others offering significantly higher rates. In such a situation,
portfolio investors, who roam the world looking for the best possible returns,
are more likely to invest elsewhere. Emerging markets, including India, are
often the biggest gainers in such situations.
When
the US economy is doing well, the flows can reverse. This is what is happening
as the US economy shows visible signs of recovering after a prolonged crisis
(starting late-2008).
What is the QE and why
is its tapering seen as a problem?
Following
the 2008 crisis, the US Fed resorted to bond-buying as a means of boosting the
economy. When the Fed buys up bonds, it is effectively releasing more money
into the markets and hence reducing interest rates (since interest rate is
essentially the cost of demand for money, so when supply rises to meet demand,
interest rate comes down — just as, say, the price of onion will fall when
supply in the market rises). This was dubbed a ‘quantitative easing’ measure,
hence the QE. This made borrowing in the US cheaper and hence incentivized
borrowers to invest (in housing or in their businesses). In June this year, Fed
chief Ben Bernanke signaled that the QE process might be tapered off. That
would imply interest rates in the US climbing again. That, as we saw earlier,
could lead to investors flocking to the US and pulling out of emerging markets,
including India.
