Over the last few days, a lot of sound and fury has been on display over the current account deficit (CAD). Mr. Duvvuri Subba Rao weighs in here declaring the CAD unsustainable at 5% of GDP. Mr. Raghuram Rajan says out here that it (the CAD) is India’s biggest concern. The wisest of them all, the man who carries the onerous burden of managing such a large and complex economy says out here that managing the CAD is one of the major challenges, on par with managing the fiscal deficit. But how important an issue is the Current Account Deficit? Is it a problem at all? Is all the hand-wringing over this issue worth it at all? What is the real issue that we need to understand in this esoteric discussion?
Understanding the concept of the Current Account Deficit
The concept Current Account Deficit refers to the net flow of foreign exchange from an economy in transactions relating to income of the current period of financial transactions, say the current financial year. In simple terms, it includes
• Net Income from trade – (Export – Import)
• Net Income from investments – (Dividends + Interest)
• Net cash transfers – Remittances, Gifts, Donations, Aid
So, if we do one or more of the following
• import more than we export
• pay out more dividends + interest than we receive
• receive lower cash transfers than we make to others
we may encounter a Current Account Deficit (CAD).
What a CAD translates into
A deficit on the current account is supposed to result in a fall in the forex reserves held by the Central Bank (the RBI in India’s case). It may be mitigated by a net forex inflow on the capital account, i.e., investment and borrowing. Simplifying it even further, if more foreign investment and lending comes into the country, it can more than make up for the CAD.
Why is the Current Account Deficit seen as a problem?
What would happen if an economy faces sustained current account deficits without compensating surpluses on the capital account? Over a period of time, the stock of the foreign currency would fall and supply would lag behind demand, leading to steady depreciation in the value of the domestic currency. This would lead, on the export side, to a situation of lower export prices, greater export competitiveness, greater volume of exports and, possibly, greater export value. It would also lead, on the import side, to higher domestic landed prices of imported goods, lowered attractiveness of imported goods, lower volume of imports and an overall lower import bill. The net result is a lower CAD. Thus, we see that there is scope for self-correcting action on the market.
But what if there is a sustained and large current account deficit not compensated for by greater investment inflows in an environment (as it exists today) of economic uncertainty and possible slower growth or, worse, a fall in exports and foreign investments? Under such circumstances, a steady current account deficit could lead to a steady depletion of foreign exchange reserves, eventually leading to a Balance of Payments (BoP) crisis of the kind witnessed in 1990-91 in this country. This is why Mr. Subba Rao calls the CAD unsustainable at the current level of a little over 5% of GDP.
Would a Current Account Deficit be a problem in a free market?
Before we get to CAD, we need to understand money and foreign exchange on the free market. Free market money would be a commodity such as gold or silver. Different societies that trade with each other would end up defining their monetary unit as a certain weight of the money commodity (as was the case historically). The American Dollar (USD) could be defined as a 1/20.6 oz silver coin while the Australian Dollar (AUD) could be defined as a 1/41.2 oz silver coin. Since 1/20.6 = 2*(1/41.2), the forex rate between the USD and the AUD would be a fixed USD 1 = AUD 2.
Further, on a free market, there would be no Central Bank where everyone would be required to deposit their foreign currency to obtain the local currency. Foreign trade would only be enabled by banks just as it is today. The American exporter would in effect be paid in AUD, which could be credited to his account as USD, with
1. the exporter’s and importer’s banks exchanging USD for AUD
2. the exporter’s bank accepting AUD into its reserve crediting the exporter’s account with USD 1 for every AUD 2 received
Looked at from the importing country’s side, more imports would mean greater flow of AUD from Australia to America. Silver reserves of Australian banks would come down but then so would the deposit accounts that they would have to redeem. In order to be able to pay for their imports in silver, it would be necessary for Australians to produce and export goods and receive payment in an acceptable unit of money, i.e., silver coins of reliable weight and purity or any other equally reliable money that could be exchanged for silver money.
Under the free market, we therefore see that the concept of foreign exchange reserves would be completely redundant. There would only be banks’ reserves of units of the money commodity, which would move from bank to bank as transactions happen. The concept of the Current Account Deficit would be non-existent and there would never be such a thing as a Balance of Payments crisis.
Why then do we hear about things like the CAD and a BoP Crisis
Issues like the CAD matter today because of the limited range of internationally accepted currencies. For people from a country like India, whose currency is not accepted in international trade, imports require them to offer an acceptable currency like the USD. But how is an Indian importer to obtain USD given that only the US Federal Reserve and the American banking system may produce USD’s? Where else is he to obtain USD’s from if not the RBI, which has arrogated to itself the monopoly over holding dollar reserves within Indian borders? Where else are USD’s going to come from if not through exports, foreign investment or external borrowing? How else is even a foreign investor holding USD’s to engage in productive business activity in India without depositing his USD’s with the RBI, obtaining INR in exchange and using those to make payments to factor owners in India?
If, on the other hand, the INR were an accepted currency in international trade, issues like the CAD and the BoP crisis would just not exist. They would not exist just as they do not exist for America or the Euro Zone. Indian importers would be able to pay for imports in INR just as American importers pay today in USD. It would be the headache of the exporters to India to figure out what to do with their INR holdings. India would be able to run a current account deficit as long as it is in a position to issue more INR and still have the INR accepted in international trade. This is precisely the position America is in today.
Why is the Rupee not accepted in international trade?
Like every other currency in circulation today, the INR too is pure fiat money whose issue is a monopoly of the Indian Central Bank (the RBI). Within their domain of influence, the RBI and its backer, the Indian government, are in a position to enforce the INR as the sole money in circulation. Internationally, however, no one has any guarantee that the INR will be accepted in further exchange in any other part of the world except India. Therefore, it is unreasonable to expect exporters in other countries to accept INR as money in trade.
There however exist currencies like the USD and the Euro, which are also pure fiat currencies that are widely accepted in international trade due to various historical and geo-political reasons. Exporters from countries like India may accept payments in one of these global currencies with the confidence that at least their own Central Bank will exchange it for their local currency. Importers from such countries are left with no option but to make payments in one of these global currencies by buying them from their Central Bank. Thus comes into existence the system that leaves international traders in countries like India dependent on the system of foreign exchange as enforced by the cartel of Central Bankers, the banking system and Governments.
What do we therefore make of this hand-wringing over the CAD?
Fundamentally, the entire issue of the CAD being a problem that has the potential to lead to a BoP crisis is a manufactured crisis manufactured by the international cabal of Central Bankers, the banking system and the governments that back them. It is a result of the system of fiat money that we live under. As long as this system exists, there will be some countries that, like America today, can produce their money as long as everyone else is ready to accept them in exchange and many others, like India today, that will have to contend with completely manufactured issues such as the CAD and manufactured crises like the BoP crisis. Mr. D Subba Rao and Mr. P Chidambaram are just engaging in a classic case of running with the hares and hunting with the hounds.