Every now and then, we keep hearing the news that the Current Account Deficit (CAD) of a developing economy like India is increasing or widening and it leads to an imbalance in the country. For those who have minimum knowledge about the Indian economy or are planning to make an investment, then they must know about the importance of CAD and why does it matter? Let’s get started.
What is the Current Account Deficit (CAD)?
A CAD is when the total imports of the goods, services, and capital in India exceed the exports. It is also known by the name, current account imbalance. It is not a negative thing, as long as it is under control. In layman terms, CAD means, the amount of money, which is going out of the country through the imports, investments, and services is greater the money coming into the country. It is generally measured as the percentage of the Gross Domestic Product (GDP).
Components of CAD
There are three main components that affect the CAD of India, which is as follows:
- Trade in Goods and Services: It includes both the export and import of goods and services. Here the difference between the value of exports and imports is measured. Trade in goods and services are one of the most important and biggest components of CAD. Any kind of fluctuation in the trade deficit is one of the prominent causes of increase or decrease in CAD.
- Net Income from Foreign Investments: It is used to measure the income payments made to the foreigners and net income payments received from the foreigners. The deficit on the net income from foreign investments crops up when the value of the income being made to the foreigners is greater than the value of income received from the foreigners.
- Direct Money Transfers: It means the total amount of money that is being sent back by citizens working abroad to their home country. Here, the money is being transferred by the citizens without any goods or services. For example, An Indian citizen working in the United States of America (U.S.A) sending money to his/her family in India.
If the overall value (credit-debit) of these three prominent components comes to be positive, then it can be said that the CAD is under control or surplus.
Why CAD is Important?
CAD helps in measuring or determining the strength and weakness of an economy. A surplus CAD implies that a country has enough money to lend to the other nations. It basically means that the country has the resources in large quantities, which it can provide or lend to the other economies in the world. The country, which is lending, provides an opportunity for the other countries to enhance their productivity and improve trade deficit.
On the other hand, if there is a current account deficit, then it is not considered as the positive sign for an economy. A deficit basically implies that a country is in the process of investing more than saving. Moreover, a country with negative CAD borrows resources from other countries to meet its domestic consumption and investment related requirements.
Causes of CAD in India
Just consider a situation that you are a spendthrift individual. You do not have any savings left with you and there is an urgent requirement of money to meet your requirements. The question here is will you able to secure a loan from your bank or friend if you are not credit worthy? Maybe not. Similarly, if a country with a negative CAD means they are not keeping a tab on their spending and also do not have enough savings left in the financial institutions of the country. This is where the creditworthiness of a country comes into the picture. If the resources of a country are limited and also does not have sufficient savings or money left with the banks, then the other countries may not lend the money unless it improves its CAD. The main causes CAD rise in India is as follows:
- Rise in the global crude oil prices. India is one of the biggest importers of fuel in the world.
- A decrease in the value of rupee has made imports expensive.
- The trade war between the United States (U.S) and China also have a negative impact on India’s exports.
Effects of CAD on Indian Economy
A substantial or considerable CAD is not always considered negative, especially for the developing economies like India. A widening CAD for a short time period can be good as it can help the country to increase its local productivity and exports in the future. However, if there a negative CAD for the longer period of time, then it can spell more trouble for the country as it can lead to exchange rate depreciation, loss of jobs and investor confidence.
The higher or negative CAD may also put the rupee under pressure, which may ultimately go on to increase the cost of overseas borrowing. Moreover, foreign investors also do not show a keen interest in investing in countries with higher CAD. This is because the investors begin to question the economic growth of a country and its creditworthiness i.e. whether they will get better returns on their investment or not. Fearing this, the foreign investors start to withdraw funds from the market, which in turn lowers the value of rupee when compared with other global currencies.
The Bottom line – How to Improve CAD?
A country with a higher CAD must make it a point to make use of foreign investment carefully. It should concentrate more on educating its workforce and construct more ports or roads in order to improve its international trade. Furthermore, a special attention must be devoted towards enhancing the domestic industries and increasing their competitiveness. It should also spend less on the resources, which are not needed.