India’s need for consistent capital inflows
GS 3 Indian Economy & Related Issues
- According to the RBI’s quarterly data, the current account deficit (CAD) increased to 4.4% of GDP in the second quarter of 2022-23, from 2.2% in the previous quarter.
About the “Current Account”
- A country’s Current Account is a record of its transactions with other countries. It consists of the following elements:
- commerce of products and services,
- net earnings on overseas investments, and net transfer of funds over time, including remittances.
- This account falls into the red when outgoing funds outweigh incoming funds.
- commerce of products and services,
- It is expressed as a proportion of GDP.
- Trade deficit = Exports – Imports.
- Current Account = Trade deficit plus net current transfers plus net international income.
About Current Account Deficit (CAD)
- o The current account deficit occurs when the value of a nation’s imported goods and services exceeds the value of its exports.
- CAD and the fiscal deficit together make up the twin deficits – the enemies of the stock market and investors.
Different from the Balance of Trade:
- It is slightly different from the Balance of Trade, which measures only the gap in earnings and expenditure on exports and imports of goods and services.
- Whereas, the current account also factors in the payments from domestic capital deployed overseas.
- For example, rental income from an Indian owning a house in the UK would be computed in the Current Account, but not in the Balance of Trade.
Country’s trade and transactions:
- If the current account – the country’s trade and dealings with other countries – shows a surplus, it implies that money is coming into the country, hence increasing the foreign exchange reserves and the value of the rupee against the dollar.
- These factors will have an impact on the economy, the financial markets, and the profits people receive on their investments.
Indicator of Economy:
CAD may be a positive or bad indicator of an economy’s health, depending on the reasons behind its deficit.
- It is believed that foreign capital has been utilised to finance investments in a number of economies.
- It may benefit a debtor nation in the short-term, but it may cause concern in the long-term if investors begin to question the return on their investments.
Characteristic features of India’s CAD
India’s CADs have both desirable and undesirable components:
- A desirable deficit is a natural result of increased investment, portfolio decisions, and the country’s demographics.
- Nonetheless, high and persistent CADs might be problematic if they reflect larger issues, such as a lack of export competitiveness, and are backed by unreliable financing.
The countercyclical nature of India’s CAD is a matter of concern:
- According to research, the country’s current account deficit increases when output decreases rather than when demand rises, indicating that external shocks predominate.
- For instance, a spike in oil prices, as oil is an input in the production process, rises production costs and reduces economic growth.
- Due to the inelastic demand for oil imports and oil’s disproportionate part of India’s total imports, the current account deficit rises with a decline in GDP.
Risks associated with financing:
- Substantial and chronic current account deficits expose India to risks related to its funding.
- According to economic theory, CADs financed by stable capital inflows, such as FDI inflows, are preferable since they are less susceptible to capital flight.
- If, however, deficits are financed by fluctuating capital flows, such as portfolio movements, this may be cause for concern.
- Portfolio flows are erratic and more prone to reversal in the event of a global financial disaster. So, the structure of finance is vital.
- While FDI inflows were sufficient to cover the deficit in 2021-22, they have been inadequate during the current fiscal year.
- Foreign direct investment and portfolio inflows financed barely 18 percent of CADs in the second quarter of 2022-23. So, there is a financial problem.
- Remittances and services exports have provided a counter-balance to rising merchandise trade deficits.
- While capital flows are pro-cyclical and react negatively to contractionary monetary policy by the Fed, remittances have exhibited remarkable stability.
Suggestions & way ahead
- Controlling negative spillovers from global changes:
- For the medium run, policymakers must prevent the detrimental effects of the global trade slowdown on merchandise exports.
- Further rate hikes by the US Federal Reserve could result in capital outflows and increased currency rate market pressures.
- This could be difficult given the current circumstances, as a weakened currency and a sticky import basket will result in imported inflation.
- Making exports competitive:
- Policy measures must therefore encourage exports by emphasising structural reforms to enhance trade competitiveness, and the government must also sign free trade agreements.
- Ensuring stable financing:
o India is currently confronting a budget and current account deficit challenge.
o Although dramatic fiscal consolidation may be unattractive in the face of mounting fears of a worldwide economic slowdown, a comfortable external environment can be maintained by providing stable financing and using exchange rates as a shock absorber to weather the poor global economic situation.
Daily Mains Question
The Current Account Deficit (CAD) of India contains both favourable and unwanted elements. Examine. Examine the importance of consistent capital flows in managing India’s current account deficit.