• March 2, 2023

India’s need for consistent capital inflows

GS 3 Indian Economy & Related Issues

In Context

• 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.

• Calculation:

• 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)

Meaning:

• o The current account deficit occurs when the value of a nation’s imported goods and services exceeds the value of its exports.

Twin deficits:

• • 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.
• Significance:

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.

Current example:

• 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.

Counter-balancing Remittances:

• • 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.