ET in the classroom: Funding of current account deficit

The current account deficit ( CAD) in a country's balance of payments measures the gap between import and export of goods, services and transfers.

This deficit is not necessarily a bad thing. Developing countries may run a CAD in the short term to increase local productivity and exports in the future. But in the long run, a current account deficit can sap economic vitality. Gayatri Nayak explains

HOW IS THE CAD FUNDED?

A deficit in the current account is funded by various capital inflows, including portfolio investments, external commercial borrowings, foreign direct investments and NRI deposits. nadequate resources to finance CAD may put pressure on the local currency.

WHAT IS THE IDEAL WAY TO FUND IT?

The best way to fund the current account deficit is through non-debt creating long-term inflows such as foreign direct investments. Volatile inflows like portfolio investments, sometimes referred to as hot money, could threaten the stability of the external sector balance sheet.

WHAT HAS BEEN INDIA’S EXPERIENCE?

Of late, India's current account deficit has widened to nearly 4% of GDP. At the same time, there have not been adequate capital inflows and this has led to a significant weakening of the rupee vis-à-vis the US dollar. As a result, the Reserve Bank of India has had to sell its stock of dollars to meet the dollar demand.

WHY ARE REGULATORS AND POLICYMAKERS CONCERNED?

Because there is very little that can be done to restrict the current account deficit as prices of essential items of imports are rising and exports are not picking up. A CAD not higher than 2.5% of India’s GDP is considered prudent. The challenge before the government is to devise policies that will boost exports and reduce unnecessary imports such as those of gold.