About Current Account Deficit (CAD)
- The current account measures the flow of goods, services and investments into and out of the country.
- A country runs into a deficit if the value of the goods and services it imports exceed the value of those it exports.
- The current account includes net income, including interest and dividends, and transfers, like foreign aid.
- It indicates a country (say India) is borrowing and is net debtor to rest of the world.
- Depending on why the country is running the deficit, it could be a positive sign of growth, or it could be a negative sign that the country is a credit risk.
Consequences of the Current Account Deficit
- A deficit in the current account leads to depletion of foreign currency assets as these assets are used as a source to fund deficit which forms part of capital account.
- Depletion of foreign currency assets reduces money supply which in turn results to liquidity issues.
- High imports results in higher demand for dollar causing rupee to weaken (rupee depreciation) which in turn impacts liquidity.
- In the long run, a current account deficit can sap economic vitality.
- Foreign investors may begin to question whether economic growth can provide an adequate return on their investment.
- Demand could weaken for the country’s assets, including the country’s government bonds.
- As this happens, the national currency will gradually lose value relative to other currencies.
- As the value of its currency declines, the value of the foreign assets rise, thus further reducing the current account deficit.
- The consequences of a current account deficit can be a lower standard of living for the country’s residents.
- As, the central bank wants to see the current account gap within 2.5% of the GDP, which is seen as crucial for currency stability, it should intervene and control depreciation of currency.
- Import of unnecessary items can be reduced.
- Import duties can be increased.
- Exports can be increased to maintain foreign currency reserves.
Section : Economics