What Is Current Account Deficit (CAD)?

Components of Current Account

Introduction

India’s economy tentatively depending 50%-60% on imports, the trade scenario is going to have an impact on the economic growth of the country.  In this article, we will discuss what is current account deficit, components of current account, how it is financed etc.

Meaning : Current Account Deficit

• The current account measures the flow of goods, services and investments into and out of the country. The current account measures trade plus transfers of capital. 
• Current account deficit implies a situation where value of goods and services imported by the country ie. country’s imports exceeds the value of goods and services exported from the country ie. country’ exports.
• On the other hand, A Current account surplus is a situation when country’s imports are less than than its exports.
• A current account deficit is created when a country relies on foreigners for the capital to invest and spend. Depending on why the country is running the deficit, it could be a positive sign of growth. It could also be a negative sign that the country is a credit risk.

Components of Current Account

Current Account Deficit (CAD) = Trade Deficit + Net Income + Net Transfers

1.Trade Deficit :

• Trade Deficit = Imports – Exports
• A Country is said to have a trade deficit when it imports more goods and services than it exports.
• Trade deficit is an economic measure of a negative balance of trade in which a country’s imports exceeds its exports.
• A trade deficit represents an outflow of domestic currency to foreign markets.

2.Net Income :

• Net Income = Income Earned by MNCs from their investments in India.
• When foreign investment income exceeds the savings of the country’s residents, then the country has net income deficit. This foreign investment can help a country’s economy grow. But if foreign investors worry they won’t get a return in a reasonable amount of time, they will cut off funding. That causes widespread panic.
• Net income is measured by the following things:

1. Payments made to foreigners in the form of dividends of domestic stocks.
2. Interest payments on bonds.
3. Wages paid to foreigners working in the country.

3.Net Transfers

• In Net Transfers, foreign residents send back money to their home countries. It also includes government grants to foreigners.
• It Includes Remittances, Gifts, Donation etc

Current Account Transaction

While understanding Current Account Deficit in detail, it is important to understand what are the current account transactions. Current account transactions are the transactions which require foreign currency. Following transactions with from which component these transaction belong to :

• Component 1 : Payments connection with Foreign trade – Import & Export
• Component 2 : Interest on loans to other countries and Net income from investments in other countries
• Component 3 : Remittances for living expenses of parents, spouse and children residing abroad, and Expenses in connection with Foreign travel, Education and Medical care of parents, spouse and children

Example : Calculation of CAD

Let us understand with the help of an example:

Total value of goods and services coming into the country :

• Imports: 1000 million dollars
• Expenses in connection with Foreign Travel, education, health etc.: 200 million dollars
• Interest and dividends paid to other countries: 150 million dollars
• Other outflow: 100 million dollars
• Total value = 1450 million dollars

Total value of goods and services going out of the country :

• Exports: 900 million dollars
• Income from Foreigners Travelling to India, education, health etc: 150 million dollars
• Interest and dividends earned: 200 million dollars
• Other inflow: 150 million dollars
• Total Value = 1400 million dollars

• CAD = 1450-1400 = 50 million dollars
• So, we can say that current account deficit occurs when the value of goods and services coming into the country exceeds the value of goods and services going out of the country.

Difference Between Current Account Deficit and Trade Deficit

In the example above,

1. Trade deficit = Imports – Exports = 100 million dollars
2. Current account deficit = 50 million dollars

Trade deficit only measures the difference in exports and imports and does not consider transfers or interest or dividends.

how the current account deficit is financeD?

The current account deficit can be financed by capital account or financial account:

• The government buys and sells the foreign currency and that may change the value of current account. This type of financing is done via financial account.
• Another way of financing CAD is through Capital Account Transactions. These are major Capital Account Transactions –

1. FDI – This is the best way to fund CAD and is a long term money in the country
2. FII – In Equity & Debt. These are also called hot money and can go out of the country very quickly and cannot be dependent on for long.
3. Remittance as Investments in India

Summary

• A current account is a measurement of the flow of goods, services, and investments in and out of the country. Current account deficit implies a situation where imports exceed exports. A surplus is when the opposite is true.
• Current Account = Trade Deficit + Net Income + Net Transfers
• A current account deficit is not always detrimental to a nation’s economy—external debt may be used to finance lucrative investments.