- Wealth PMS (50L+)
Ajay Shah writes on the CAD:
Under a floating rate, the current account deficit is the same as net capital flows. Net capital flows finance the current account deficit. The exchange rate is moving constantly so that the two are equalised. It’s no longer the case that each of these have a distinct and unrelated causal story.
Under a fixed exchange rate, such decoupled thinking was okay! You would look at the trade side and talk about why the CAD moved. You would look at capital flows and talk about why the net capital inflow moved. The two stories would take place on their own without a tight connection. That intuition has to be jettisoned once a country grows up into a market determined (i.e. floating) exchange rate, where there is a new macroeconomics which shapes both pieces.
First, read a more detailed post by him on the Current Account Deficit myth.
Second, you might think this is obvious. The Current Account Deficit is comprised of stuff we buy (Imports) minus stuff we sell (Exports) minus any Net Income (from investments or interest or such) minus Net Transfers (Money sent from abroad, like aid or remittances).
So add all of this up, and you get the business flow of transactions that have resulting in real income to India. This is usually a positive figure – that is, our imports are greater than the rest of the stuff we should minus. That’s why it’s a deficit. Countries like China have a surplus.
Now the Current Account Deficit for last quarter was 1.35 lakh crore or nearly $30 billion. Oh my god, you think, we are in trouble – that’s $120 billion a year, what are we to do?
There’s the other two pieces that are important. The Capital Account and the Foreign Exchange Rate of the Rupee.
The Capital account is what we get when people abroad invest in India. Foreign investors buy Indian debt and equity. NRIs buy stocks. Indian companies get loans or have ADRs. This capital account is usually in a surplus – that is, we get more capital inflows than outflows. And this, says Ajay, and I agree, finances the current account deficit.
Basically, people lend you money and you buy their stuff. This is the way it’s financed. But the third variable to look for here, is the rupee exchange rate.
Let’s say, that there were HUGE capital inflows suddenly. Whoever’s investing will buy rupees. THe rupee will therefore go up. From Rs. 45 to a dollar today, let’s say it goes to Rs. 40. With this as the exchange rate, exports will likely go down (as the rupee gets less competitive) and imports will go up. This will result in an increase in the current account deficit.
Three variables. If the rupee gets weaker, capital inflows reduce because people who invested in India have lost money in dollar terms. But exports go up, imports come down, making the current account higher.
This is simple. The complex part is where RBI pokes its nose inside and decides that it wants the dollar to be at Rs. 42.5, not Rs. 40. So instead of letting the market dictate rates, it buys the dollars as a participant, and prints rupees. (RBI has a printing machine, the only legal one).
Exports then don’t fall that much, and imports don’t go up that much. So the current account deficit is smaller.
Now, you have a stupid distortion. What we have is:
Net net, the RBI intervention does nothing? But it does:
This is the monetary impact of trying to manipulate the exchange rate. The other way is to actually curtail flows itself by restrictions: foreigners can’t buy Indian Government Rupee debt, foreigners can’t keep rupees with them, and so on.
These are distortions. They are now ingrained in the minds of people so much that we think the interventionist approach is the correct one. It’s not.
A current account deficit is ALWAYS financed, by definition. We pay for it via capital inflows, and a change in the exchange rate. If the CAD went up a lot and Capital Flows remained constant, the rupee would depreciate. Simple.
Ajay thinks the RBI isn’t doing much. My data says they are. I need to probe much more. Your thoughts?