In a recently released report on economic indicators, RBI reported the current account deficit

(CAD) to have touched a record high of 6.7% of Gross Domestic product

(http://www.thehindu.com/opinion/columns/C_R_L__Narasimhan/cad-the-danger-is-
real/article4591795.ece) up from 4.4% last year for the December quarter. According to
finance ministry, the upswing was expected though the magnitude of rise is beyond
comprehension.
We will attempt to decipher this issue and try to understand whats happening here. But first
let us go back to basics to understand how the capital flows into and out of an economy is
measured, what constitutes Current Account in Balance of Payment and what it tells about
health of an economy.
In this globalized world, countries are becoming increasingly integrated with each other in their
trades and have become much more interdependent and vulnerable with respect to economic
and political developments. Recent impact on Indian economy due to Euro Crisis and Iran
imbroglio proves this point. As the financial health of a company is ascertained from its Balance
sheet (which is a snapshot of its assets and liabilities at a point in time) and cash flow
statements, similarly, a countrys economic health can be known by determining its Balance of
Payment.
As per the definition provided in IMFs BoP manual
The balance of payments is a statistical statement that systematically summarizes, for a specific time
period, the economic transactions of an economy with the rest of the world. A transaction itself is
defined as an economic flow that reflects the creation, transformation, exchange, transfer, or extinction
of economic value and involves changes in ownership of goods and/or financial assets, the provision of
services, or the provision of labor and capital.

BoP account for India typically comprises of the following standard components
a) Current Account b) Capital & Financial Account c)Errors and Omissions d) Change in Foreign
Exchange reserve. Theoretically, BoP for any economy is zero i.e. the current account should
balance out the Capital/finance account. However, this does not happen in reality. Let us
analyze a bit closely the current Accounts.
Under current account of the BoP, transactions are classified into merchandise (exports and
imports) and invisibles. As the country participates in global trades of good and services with
other countries, investors and industries from one country invest capital and resources in
foreign countries, there is bound to be a strong correlation between the Gross domestic
Product (GDP) of a country with its Current Account. Let us see how with an algebraic
expression.
GDP of a country = C+G+I+X-M (1)
where, C = Private Consumption Expenditure i.e. the expenditure by private households or non-
profit institutions serving households (such as religious societies, sports and clubs, political
parties) on consumption of goods and services such as housing fees and transportation
G = Government Consumption Expenditure. It includes goods and services produced by
government, as well as purchases of goods and services by governments that are supplied to
households as social transfers in kind.
I = Gross Domestic Investment which includes residential type of investment (e.g housing), non-
residential investment (by corporations on building capital such as plant, machinery, tools) and
Change in inventories of firms (stocks, change in assets)
X-M = Net of Export minus Import. Depending on the relative volume of exports and imports, it
can be positive (a surplus) or negative (a deficit).
Why corporations do not feature in this equation? This is because, in the system of national
accounts (which is what BoP and GDP along with other economic indicators collectively are part
of), only households, non-profit institutions serving households (NPISH) and government have
final consumption, whereas corporations have intermediate consumption.
Now we shall define Current Account Balance (CAB) in BoP as
CAB = X-M +NY+NCT (2)
Where, NY = Net income from abroad and includes the net income from labor, property and
entrepreneurial ventures. Labor income covers compensation of employees paid to
nonresident workers. Property and entrepreneurial income covers investment income from the
claims on foreign financial assets/ownerships (interest, dividends, rent, etc.) and nonfinancial
property income (patents, copyright)
NCT = Net current transfers mean unilateral transfer of currency capital from/to India such as
workers remitting their income to India, donations, aids and grants by institutions like IMF,
official assistance and pensions.
Now Gross National Income can be written as
GNI = C + G + I +X-M + NCT+ NY (3) or
GNI = Expenditure by (government + private) + Investment +Net income from labor(foreign-
domestic) +Net payment from abroad
If we rearrange the equation, we get GNI = GDP +CAB (X-M)
Now, Gross Income (GNI) Gross Expenditure (C+G) = Gross Savings (S) (4)
Hence, Savings - Investments = CAB (5)
The above equation means that the current account balance mirrors the saving and investment
behavior of the domestic economy.
With this background, let us try and analyze in my next post why India has a Current Account
deficit and how it is able to sustain itself for all these years.

Current account for India is said to be in deficit due to following reasons
(http://finmin.nic.in/press_room/2013/FM_statementCAD.pdf)
Widening of trade deficit due to a sharper decline in exports relative to decline in imports.
This was primarily attributed to the sudden surge of gold and oil imports which caused a
drain on Current account
Net services import recorded a rise mainly on account of travel, transport, software services
and financial services
Rise in remittances
Let us examine why gold imports surged. In India, traditional motive of gold demand has been
for jewelry. However, apart from an unusually strong cultural affinity for this yellow metal, gold
also seems to have become a safe investment asset and a hedge against inflation in India. To
curb this surge government decided to impose import duty on gold imports. Agents expecting higher
future duties for forwarded gold imports raised CAD.

Source: FT
Second addition to the trade deficit is due to oil imports. India has always been a net importer
of oil and oil imports are one of the biggest chunks of our import bill. As we can see the effect
of raising oil imports on Current account. Volatility in international oil prices and domestic
subsidies on oil products exert a lot of pressure on import bill. Hence there is a strong need to
align the domestic pricing of oil with international oil prices to rationalize the oil consumption.

Second component of Indias CAD comprises of net invisibles which can further be classified
into three components. The first is Services comprising travel, transportation, insurance,
government not included elsewhere (GNIE), and miscellaneous. Miscellaneous services include
communication, construction, financial, software, news agency, royalties, management, and
business services. The second component of invisibles is income. And the third one is Transfers
which include grants, gifts, remittances, etc. Ney invisibles saw a rise mainly on account of rise
in receipts of software services, insurance, transportation etc. Net private remittances by non-
resident Indians and overseas workers to home country also increased. Also, Investment
income outflows are rising rapidly due to higher dividend and interest payments on existing
liabilities.
However, due to higher trade deficit there was a net pull-down effect on CAD despite rise in net
invisibles. However, increase in net invisible did moderate the worsening CAD.

Source: economic survey of India
Economists feel that there is nothing wrong with a high CAD/GDP ratio, as long as it can be
financed. At present, the current-account deficit is being funded by a surplus on capital account
as there are net capital inflows. These capital inflows are in primarily on account of portfolio
flows (majorly FIIs) or foreign direct investment (FDI). FDI tends to be also associated with non-
financial aspects, such as transfer of technology, infusion of management and supply chain
practices, etc. and are generally on a longer term. In that sense, it has a greater impact on
growth. Whereas FII flows are for a short term and are susceptible to sudden reversals.
In case of India, record FII capital inflows have supported the stock market and hence able to
sustain a massive current account deficit so far without too much economic impairment. But
the risks are very high for If FII inflows slow down or suddenly stops, funding the current
account deficit will be a huge problem. This would directly impact the rupee and it will
depreciate causing imports to become costlier as a result companies that have borrowed
abroad will get into trouble, and monetary easing may not yield any fruitful result. The
economy may go into a tailspin.
Let us now analyze from savings and investment perspective. As seen in equation (5) CAD also
reflects the balance of national savings and investments in the economy. The role of savings
here is crucial. Adequate savings is required to boost the corporate investment which in turn
increases economic growth. i.e investments will be financed by savings which include
Government savings and Private savings (Aggregate income minus aggregate expenditure). In
the equilibrium following identity should hold
Gross domestic investments = Private savings +Gov. savings + Foreign Savings (6)
i.e. all real investment in factories, housing, capital spending, and so forth has to be financed by
savings. Note here that foreign savings is considered as flipside of Current Account balance in
the national accounts identity. If you stare at equation (6) a bit, youll realize that it is nothing
but a rearrangement of components in equation (5). So another interpretation of Current
account deficit would be, we are importing savings from other countries to finance our
domestic investments.
CAD in India is reflective of low savings rather than high investment. India has been witnessing
a savings investment gaps on account of low private (household+corporate) savings. The
widening non-household saving-investment gap rose to a historical high of -7.8 per cent of GDP
in FY12 after rising to -3.5 per cent in FY11. This could mean RBI will draw down on forex
reserves to fund deficits and monetize the governments deficits through open market
operations (http://www.business-standard.com/article/opinion/fall-in-savings-must-be-
arrested-before-rate-cuts-112031600029_1.html).

Anticipating a worsening CAD, the government has been working on incentivizing foreign capital inflows
into the country. To enhace external debt flow, finance minister P. Chidambaram announced a
rationalization in foreign investment limits in the government securities and corporate bond market by
merging all existing sub-limits under two broad categories from 1 April.
These numbers reflect that the rupee is becoming a weaker currency. It may in turn fuel gold purchases,
which could again worsen the trade deficit. Spurring exports may be the only option left with the
government since it has not been able to curb imports, especially gold.
The BoP data showed that CAD was financed through capital flows, and there was no drawdown on
foreign exchange reserves. This was mainly on account of the surge in foreign portfolio investments,
which rose to $8.6 billion from $1.8 billion in the year-ago period.
The large costs to the economy of a possible balance of payments crisis due to a sudden stop can be
avoided if public authorities pay certain small price up front for a credit line from IMF.