Tuesday, 30 July 2013

Back to the Basics: What is CAD and why does it matter?

By now we have all read or heard from one source or the other that India is suffering a huge Current Account Deficit (CAD). This post is for those who are wondering what this is and why does it make a difference.

A lesson in Economics

Let us forget the individual companies and corporate houses for a minute and view India as a single entity. When we purchase things from another country we have to pay them in return. Similarly, when other countries buy things from us, they pay us. A simple understanding of budgeting tells us that if we do not sell as much, if not more, than the amount we buy, we are sooner or later going to run out of money. This is what we call a current account deficit. Effectively we, as a nation, are borrowing from other countries to fund our consumption. One way to sustain such a situation is to offset the Current Account Deficit with a Capital Account Surplus.

Capital account is the measure of money that enters and leaves our country in terms of investments. There are three main forms that this can take:

  1. Foreign Direct Investment (FDI): When foreign investors pick up a large stake in an Indian company or set-up their own operations in India. This is usually a longer term investment as compared to FII (below). For example, when Etihad will buy a stake in Jetairways, they will be paying Indian shareholders with capital from their country.
  2. Foreign Institutional Investment (FII): When foreign institutional investors trade in the Indian stock exchange they bring capital from their economy into our market.
  3. External Commercial Borrowing (ECB): When Indian companies borrow from foreign entities which are able to provide capital at a lower rate of interest.
If the cumulative of such investments into the country is greater than such investments out of the country we achieve a capital account surplus. Thus while overall we are running a deficit on our current account (i.e. money is leaving the economy) we are able to sustain it because of the capital account surplus (i.e. money is entering the economy).

Why we are a mess

India has historically managed to run a CAD of around 2% of GDP without stress as the capital inflow was easily able to offset it. However, with the rising uncertainty for investors in India, capital inflow is no longer as reliable as it once was. To add to this, there is threat of capital flocking back to the US where the interest rates might be on the rise soon. The situation is further worsened as our CAD has risen from 2.7% (2011) to 4.8% (2013) of GDP making us ever more reliant on the capital inflow.

So what happens if due to macroeconomic instability, capital inflow decreases and we reach a stage where the capital account surplus cannot offset the current account deficit?

International transactions happen in the US Dollars (USD). Hence, if overall more money were to leave the economy than enter it, the demand for the USD viz a viz Indian Rupee (INR) would be greater, causing the dollar to gain value relative to INR (i.e. INR would depreciate). What does this lead to? Say a year back a good produced in India was priced at $1 in the international market and Rs 50 in the domestic one. At that exchange rate the producer was effectively receiving Rs 50 for his product and he would be indifferent between selling it on the domestic market and the foreign market. However, a year later with the new rates, the foreign consumer is now able to pay Rs 60 to the producer with no extra cost to him. The producer will thus divert his goods to the foreign market till the scarcity in the domestic market raises its price to Rs 60 at which point he will once again be indifferent.

The example above has been simplified considerably to get the basic point across: Devaluation of our currency will cause further inflation. Inflation which is already in its double digits (CPI) and is the worst enemy of the poor which the Government swears to protect.

To make things worse the government has dug us another pit fall due to lack of timely reforms. Of the $502 billion worth of imports in the financial year 2013, $170 billion was spent on oil. Oil which the government provides at a bench-marked price no matter what the price they buy it at. Thus as the currency depreciates faster than the rate at which the government is increasing the price of oil (and related products) the government is in fact forced to provide more subsidy than it previously did. Hence not only is the rise in prices causing inflation but is also increasing the government's fiscal deficit which reached 4.8 at the end of FY 2013 - another threat to our macroeconomic stability.

And so the cycle continues.

1 comment:

  1. A very simple and precise explanation on the matter. great work!