Author: Parveen Kaswan (Follow for more updates)
Definition: A current account deficit is when a country’s government, businesses and individuals imports more goods, services and capital than it exports. That’s because the current account measures trade, as well as international income, direct transfers of capital, and investment income made on assets, according to the Bureau of Economic Analysis. When those within the country rely on foreigners for the capital to invest and spend, that creates a current account deficit. Depending on why the country is running the deficit, it could be a positive sign of growth, or it could be a negative sign that the country is a credit risk.
What Are the Components of a Current Account Deficit?
The largest component of a deficit usually a trade deficit. This simply means the country imports more goods and services than it exports. The second largest component is usually a deficit in the net income. This occurs when the country exports dividends on stocks, interest payments made on financial assets, and wages paid to foreigners working in the country. If all payments made to foreigners are greater than the interest, dividends and wages made by foreigners to the country’s residents, the deficit will rise.
The last component of the deficit is the smallest, but often the most hotly contested. These are direct transfers, which includes government grants to foreigners. It also includes any money sent back to their home countries by foreigners
What Causes a Current Account Deficit?
Countries with current account deficits are usually big spenders, but are considered very credit worthy. These countries’ businesses can’t borrow from their own residents, because they haven’t saved enough in local banks. They would prefer to spend than save their income. Businesses in a country like this can’t expand unless they borrow from foreigners. That’s where the credit-worthiness comes into the picture. If a country has a lot of spendthrifts, it won’t find any other country to lend to it unless it is very wealthy and looks like it will pay back the loans.
What Are the Consequences of the Current Account Deficit?
In the short-run, a current account deficit is mostly advantageous. Foreigners are willing to pump capital into a country to drive economic growth beyond what it could manage on its own.
However, in the long run, a current account deficit can sap economic vitality. Foreign investors may begin to question whether economic growth can provide an adequate return on their investment. Demand could weaken for the country’s assets, including the country’s government bonds. As this happens, yields will rise and the national currency will gradually lose value relative to other currencies.
India’s CAD story is well known and reflects an overall failure to curb imports and boost exports. This leaves India dependent on foreign capital to fund the current account. It also exposes the vulnerability of India’s overall balance of payment (BoP) in a scenario of sudden exit of foreign capital as was seen in FY09 and FY12 – the only two instances in the past 12 years when India clocked a fall in BoP and had to draw down on its foreign exchange reserves. As a result, India’s foreign exchange reserves peaked in FY08 and have stagnated ever since.
Now rising current account deficit is a big worry for the government officials. “India’s record-high current account deficit is a chief worry as it is increasing the dependence on foreign investments”, as stated by chief economic advisor. According to Mr. Rangrajan India’s Current Account Deficit (CAD) for 2012-13 is likely to be around 5 percent of the GDP in year 2012-13. But in a good move India’s trade deficit has fallen to 10-month low of USD 14.9 billion in February on improving exports and a sharp drop in imports.
1.Economic Data Source: Economic Survey