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Ajay Shah on the Current Account Deficit

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.

Note this:

  • The Capital Account went higher.
  • The Current Account went lower.
  • And the exchange rate made the rupee stronger.

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:

  • The Capital Account went higher (just as high, let’s say)
  • The Current Account changes lesser
  • The exchange rate changes lesser.

Net net, the RBI intervention does nothing? But it does:

  • Now the RBI is holding dollars.
  • There are more rupees in the system, this will stoke inflation.

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?

  • austrian_man says:

    of course RBI is printing money. why else would M3 be exponentially increasing?
    In a floating exchange rate system, countries such as china and india have only two choices: domestic price stability or exchange rate stability, they can’t have both. they always choose exchange rate stability because they don’t want to lose value of the dollar foreign reserves that they hold. instead, they inflict the inflation on the common population.
    Triffin’s dilemma, where one domestic currency is the world reserve currency causes conflicts between the domestic monetary policy of the country and the international monetary policy adopted with the world. This is what US faces, and it always chooses domestic monetary policy over international. So US in essence, is exporting inflation. Wouldn’t you say?

  • deb says:

    Deepak Bhai,
    RBI is being run by the will of real estate goons. That is why liquidity is plenty in the market. There is absolutely no effect of rate rise yet. SBI is the kingpin of Indian real estate scam after 2008. Before 2008 , the mafia operated via private banks.

  • Sanjeev B says:

    We cannot sustain a perpetual policy of funding CAD with Capital Account inflows. It’s like collecting money to build a house, and spending it on fuel for your car and gold from the jewelry store. This is just bad economics.

  • Sanjeev B says:

    I disagree with the classic economic theory of substitution of goods and services. You say:
    “…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…”
    Will exports really go down if the rupee gets stronger? Are all the products and services that we provide 100% substitutable by another country? If yes, then we have failed in building a moat.
    Does Singapore’s export go down when their currency appreciates? Perhaps not, and it’s because they export a unique proposition in terms of location, laws, infrastructure and quality of life.
    Can we build a unique proposition? It would have to be pivoted around our strengths: human capital and market. We can have a unique proposition based on:
    – knowledge industries (software, ITES, finance, education, health, electronic entertainment, travel is possible too),
    – high-end manufacturing (bio-pharma)
    – our market size and depth
    If we can do this, then the substitutable goods theory will not apply and we will be strong regardless of the value of our currency.

    • Sanjeev,
      If imports are used to push out exports (which is what countries like Singapore do a lot, and India a little with oil refining etc) then the import-export structure doesn’t change.
      We can create a moat like you said but no country ever has a perfect moat. Every country will have some items that are subsitutable, and if their currency rises, they will see some exports at least reduce, with a lag.
      Unique wise – I agree with you, but I don’t think we have a great unique prop right now. Software/ITES wise we do the bottom of the food chain wala work. We don’t have the legal framework to build confidence in healthcare or pharma. We should strive to build our stuff better that both Indians and foreignerswant them…