Who's Afraid of a Big Current Account Deficit

7/27/2019 Who's Afraid of a Big Current Account Deficit

1/15

Ajay Shah's blog

Wednesday, October 02, 2013

Who's afraid of a big current account deficit?

A big CAD is a bad thing -- much like a big fiscal deficit.

A country is always betteroff with a smallorzero CAD orideally

a surplus.

The CAD is a drag on growth.

The large CAD is a profound drag on India's outlook.

Ifwe managed to reduce the CAD, things would getbetter.

Statements like this are rife. They are wrong.

The CAD is three things, all of which are identical. It is the gap betweenrevenues from selling goods and services versus the payments made for

buying goods and services. This has to be exactly matched by the capital

inflow into the country. This is exactly equal to the gap between

investment and savings. These three relationships are accounting

identities.

If there was no capital account, then the proceeds from selling goods andservices would have to exactly match the payments for goods and

services, in every minute. Every small mismatch between the two would

generate extreme currency f luctuations (large enough to incite a current

account response).

The capital account is what smooths these things out. Let us imagine the

currency market for one minute in which someone is buying $1 billion in

order to import something. In that very same minute, it is very unlikely that

there will be a double coincidence of wants, in the form of an exporter

who wishes to sell $1 billion. What fills the breach is the capital account.Some speculator comes in and supplies that $1 billion in the hope of

scoring a short-term speculative prof it. The real economy demands

liquidity in the currency market and f inance supplies this, through the

capital account.

What is the CAD?

What if there was no capital account?

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The CAD is exactly equal to the gap between savings and investment. A

CAD of zero is tantamount to only investing what we have saved. In

general, this is a bad idea. If the country is all set to invest 35% of GDP,

and savings are only 30% of GDP, it is a goodthing if capital flows of 5%

of GDP show up, through which investment exceeds savings.

Should you be unhappy that investment is bigger than domestic savings

by 5 per cent of GDP? If we insisted that the CAD should be 0 (i.e. we

had no capital account) then investment would have to be lowerand

savings would be higher (which in turn implies reduced consumption).

This would give reduced GDP growth.

Financial autarky implies that we live within our means. With savings of

30% of GDP, investment is forced to 30% of GDP under autarky.

Opening up to the world makes it possible for a country to import orexport capital.

If a country has good prospects but low savings, running a CAD is a way

to f ront-load the investment, and service the foreign capital through a

stream of dividends, interest payments and debt repayments into the

future. If a country has poor prospects, it is better off sending capital to

good uses overseas, instead of investing it domestically. For these

gains, we have to have an open capital account and run large and

variable CADs.

(There are also gains from risk sharing from large gross capital flows,

even if the CAD is 0, but that's a separate topic of discussion).

In 1991, FERA (1973) was in force. Capital account transactions by

private parties had been criminalised. The only mechanism that

generated flows on the capital account was the government. The entireCAD had to be f inanced by government borrowing. When the government

lost creditworthiness in the eyes of the world, we had a funding crisis on

the capital account.

On a day to day basis, imports required dollars which came from the

government. The Ministry of Finance monitored daily inflows and

outflows of dollars, and controlled who could access foreign exchange.

When GOI lost credit-worthiness in the eyes of overseas lenders, this

was a collapse in the flow of dollars. If you wanted to import penicillin,

you needed to get dollars, and RBI had none. That's where it came to

crunch: when an importer is told that he cannot import as there are no

dollars.

Nothing remotely like this can happen in the present environment. With

Should we bemoan the large Indian CAD?

A big CAD got us into trouble in 1991. Won't that

happen again?

failed toreduceuncertainty

Today RBIsaid theywill: -reduce themarginalstanding

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accountdeficit?

A big CADis a badthing --much like abig fiscaldeficit. Acountry isalwaysbetter offwith a smallor zeroCAD orideally asurpl...

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In judgingwhat a

universitydoes to astudent, akeyproblemlies indistinguishingdifferencesin rawmaterial vs.differences

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3/15

capital account liberalisation, many channels have opened. There is FII

investment in equity and debt, there is FDI, there is ECB, and so on. The

money moving in these channels dwarfs the borrowing by the

government. India is now well connected into financial globalisation. All

these channels won't choke.

Suppose there is some big mess abroad and all fixed income funds stop

buying Indian bonds. Under these circumstances, capital inflow will comethrough the other channels. The more we open up to a diverse array of

investors into a diverse array of asset classes, the safer the environment

becomes, the lowerthe exchange rate volatility becomes.

We require a capital inflow, on average, of Rs.20 billion per day. That's

the gap, on the currency market, which has to be filled. If foreign capital

does not come in, there is a supply-demand mismatch on the currencymarket. This gives a currency depreciation.

Ex-post, supply always equals demand. On the market, this demand will

be met. Every day, the CAD of the day willequalthe capital inflow of the

day. The only question is: At what price?

When bad news comes out in India, foreign capital becomes more

circumspect. They require a more attractive exchange rate at which to get

in. Or, to say it differently, suppose INR/USD is at Rs.65 to the dollar.

Suppose bad news come out. The inflow of Rs.20 billion is not

forthcoming. The market has a gap. The rupee starts falling. At Rs.70 to

the dollar, some foreign investors think `Hmm, maybe at this price, it's a

good deal, and I should get in'.

How far does the depreciation go? Minute by minute, the rupee moves

to elicitthe netcapital inflow (oroutflow) required to clearthe currency

market. In response to bad news, the INR drops till a speculator feels that

it might be a good idea to come into India, buy a 91 day treasury bill, and

hope that the rupee will do well in a few minutes or few days. That's how

the current account deficit always gets financed under a floating exchange

rate.

Rupee depreciation makes Indian assets more attractive. It would be

nice if foreign capital found Indian assets attractive for other reasons. But

when all else fails, rupee depreciation is what gets the job done.

Sharp spikes of the rupee are fertile ground for currency speculators. The

more currency speculators that we have, who are operating on the rupee

market, the smaller is the INR movement associated with an event.

Imagine an INR depreciation of 5% in one day. A currency speculator

Why won't all channels choke all at once?

What kinds of foreign investors respond the most to

rupee depreciation?

nce Group

All thematerialsare up onthewebsite.

RaghuramRajan's day

1 statement

Everyoneshould readit .


4/15

believes this is over done and wishes to come in. What does he do? He

sells dollars, buys INR, and invests in short-dated government bonds.

This would add up to a pure play on INR. Currency speculators are not

comfortable holding Nifty in India. They want a pure exposure to INR.

Hence, the best way to obtain a deep and liquid currency market, where

shocks will lead to small exchange rate fluctuations, is to remove capital

controls on the rupee denominated debt market.

Sudden stops are ultimately about asymmetric information in the hands

of foreign investors. If India has a deep engagement with financial

globalisation, then the informational asymmetry will be removed.

Our policy goal should be to have thousands of global financial firms who

are running business activities connected with India, who have large scale

organisational and human capital that is devoted to understanding India.

This deep engagement will deter problems such as home bias, sudden

stops, etc.

The Indian capital controls are damaging this deep engagement. As an

example, repeated stop-go policies f rustrate the development of teams

inside global financial firms that have deep knowledge about India. When

these teams know less about India, there is a greaterlikelihood ofencountering the pathologies of international finance.

When India does silly things like trying to ` crush the speculators' through

various means fair and foul, this hinders a mature engagement with

financial globalisation. When global capital feels that India operates on

stable rules of the game and has mature policy makers, the resources

committed for building organisational capital connected with India will be

greater.

In order to avoid international finance pathologies such as sudden stops,our engagement with financial globalisation should be a deep

engagement. While this issue becomes particularly salient when the CAD

is large, but there is no short term solution. Over the years, we have to

chip away at building a deep engagement with financial globalisation at all

times, so as to reduce the risk when there is a large CAD.

This is like a rules versus discretion problem. When discretion is used at

a time of a large CAD, it contaminates credibility at all times. A mature

approach to public policy involves establishing capable institutions that

implement stable rules of the game and not tactical dogfights.

A big CAD increases the damage caused by a sudden

stop in capital inflows. What should the country do to

forestall this?

What is the role of MOF or RBI in ensuring adequate

capital comes into the country to match the CAD?


5/15

On a day to day basis -- nothing. It's a purely market process. The market

does it. There are no gray men who look at the CAD and figure out how

to finance it and then undertake actions through which it gets f inanced.

The financing of the CAD is purely a market process.

The role for MOF and RBI is to get out of the way by removing capital

controls, so as to reduce the magnitude of INR depreciation required

when a certain negative event takes place.

A large CAD is dangerous when there is a managed exchange rate.

Under a managed exchange rate, there is a propensity to borrow in

foreign currency and leave it unhedged. These borrowers (whether

corporations or governments) get into big trouble when there is a large

exchange rate depreciation.

The central bank is much more likely to fail on exchange rate

management when there is a large CAD.

The witches' brew that adds up to trouble is a central bank that believes

there should be exchange rate policy + borrowers who believe the central

bank will pursue exchange rate policy + a large CAD.

While India has a de facto floating exchange rate, RBI has not yet

stopped talking about dreams of exchange rate management. We are

relatively safe because borrowers don't believe RBI can do much about

the exchange rate. Hence, there is no moral hazard and a large CADposes no threat.

With a large CAD, India is beholden to foreign capital inflows. If foreign

investors are displeased, we get a big rupee depreciation. This generates

accountability.

When India enacts capital controls, orthe Food Security Bill, we get arupee depreciation. This irritates policy makers, who feel that mirrors

should reflect a little before throwing back images.

Nobody likes accountability. Hence, people in positions of power do not

like a large CAD.

In a mature market economy, a key channel of accountability for the

government is the bond market. When the government does bad things,

their cost of financing goes up, and this directly hits the ability of

politicians to spend on their pet projects. In India, the bond market hasbeen muzzled by setting up a system of financial repression. The job of

intimidating the authorities is then left to Nifty and the rupee. The voice of

the latter is amplified when there is a large CAD.

Does this work differently for other countries?

Why is a large CAD seen as a big problem?


6/15

at 9:22 AM

Labels: capital controls, currency regime, GDP growth, policy process

If you look at the world from the viewpoint of the people who run the

place, there is a desire to muzzle Nifty and the rupee (particularly when

the latter is speaking loudly thanks to a large CAD). From that viewpoint,

a large CAD is a bad thing. Because the establishment has a

disproportionate impact upon the climate of ideas, we have started

accepting their claim, that a large CAD is a bad thing.

If you care about India's future, a large CAD is a good thing, as itenhances accountability. By this logic, other things being equal, the Indian

policy process generates superior outcomes when there is a large CAD.

If we had a small CAD, Mr. Mukherjee might have been finance minister

today.

Financial globalisation is work in progress. Capital controls and source-

based taxation hinder international capital mobility. Even if there are norestrictions, it is hard for investors in country i to properly utilise the

investment opportunities in country j, for reasons of ` information

distance'. All too often, there is home bias (people in a country holding

vastly greater domestic assets than is optimal from the viewpoint of

diversification). There are international f inance pathologies such as

capital surges, sudden stops, investments by foreigners in wrong assets,

and so on. These are the hurdles along the road.

In the destination state, there is no good reason why the investment

opportunities in country i at time t should match the savings of country i attime t. We should judge the success of the project of financial integration

by the extent to which we are able to achieve large and variable current

accounts.

In addition, in a place like India, a big CAD generates greater

accountability on the part of the government. One would predict better

economic policy when there is a large CAD.

The widespread mistrust of a large CAD may reflect two things. Some

don't see the extent to which we're not in 1991 anymore: there is much

more of a deep engagement with financial globalisation, and the

exchange rate floats enough that the borrowers are not unhedged. And,

establishment figures resent accountability.

I am grateful to Josh Felman for illuminating discussions on these issues.

Conclusion


7/15

Replies

Reply

15 comments:

RMB Wednesday, October 2, 2013 at 10:14:00 AM GMT+5:30

When rupee depreciates, indian assets earning rupees won't change

profitability.

If asset price goes down in dollar terms, earnings also go down in dollar

terms.

So how does rupee depreciation make assets cheaper for outsiders?

Are we confusing currency calls with asset valuations?

Or I have a vacuum somewhere in the way I have understood it?

Reply

Ajay Shah Wednesday, October 2, 2013 at 4:19:00 PM

GMT+5:30

A sharp rupee depreciation offers a possibility that INR has

overshot. If so, a speculator who comes in to buy INR will get agood return in a short time when the rupee comes back closer to

fair value.

Walking is controlled falling.

Anonymous Wednesday, October 2, 2013 at 1:01:00 PM GMT+5:30

Quite remarkable. Please try and get this published somewhere, such as

American Economic Review. This is the stuff that makes our academics in

our great public institutions such great economists, universally lauded for

their insights worldwide. I enjoyed it immensely. Such wisdom is rare.

Thanks.

Reply

Anonymous Thursday, October 3, 2013 at 10:40:00 AM GMT+5:30

You are distorting one of the basic economic identities to suit your

arguments. I challenge if this can go beyond mere a "blog" entry and stand

up to scrutiny of any decent journal. But then the purpose here is to

influence/fool the general public.

If a country is running current account deficit then that's needs to financed

by capital account surplus which is nothing but "selling" of domestic assets

either held abroad or inside the country's boarders.

If the capital was freely flowing, as you make it to be, without any

"ownership" or any "nationality" attached to it then we would not be

discussing any current and capital account in the first place.

The trick employed by apologists of foreign ownership of domestic assets

like you (in the form of "CAD is such a good thing") is you completelycamouflage the ownership angle as if whether the Indian assets are

owned by Indians or foreigners doesn't matter at all.

But the cake will take the "accountability" argument. It's like arguing that if

I own a house I will not be accountable for it's maintenance but if I take a


8/15

Replies

Reply

house on rent I will always be accountable to the owner of the house and

that's such a good thing!!

Reply

Anonymous Thursday, October 3, 2013 at 1:59:00 PM

GMT+5:30

FDI isn't just about 'owning' domestic assets, but investment into

creating new domestic assets (which might not even be physical

assets, but IP, etc) which make a return for the foreign owner

and the local economy. So, it depends on other rules and policies

to do with FDI. That being said, I would prioritize domestic

investment over FDI. Today, domestic investors are also not

investing due to various problems and are going abroad, so those

problems should be prioritized.

We often tend towards xenophobia because of our colonial past.

But, if one looks at many MNCs, they tend to have better

governance and technology and quality standards than local

business and we get to import technology and know-how which is

pretty standard in the rest of the world. So, FDI has a lot of

benefits as long as your concerns are reflected by adequate

protections on the investment made into domestic assets.

Furthermore, foreign capital can demand greater accountability

from the government as opposed to domestic capital (which is

boxed in and has no choice). When the government is the

bottleneck as it is today, that is a good thing.

Anonymous Thursday, October 3, 2013 at 1:11:00 PM GMT+5:30

Economic well being is not equal to overall economic growth. There is the

question of inflation and how individuals are impacted by a set of policy

options. Depreciation of Ruppee (with fall in capital flows) increases

inflation and disadvantages certain people e.g., who consume a lot of

petroleum products, kids wanting to go overseas for education, people

whose incomes are fixed, etc.

Q for the author -- 5 people are earning Rs 20 each (Rs 100). As a result

of a policy, 4 people start earning Rs 15 each and one starts earning 50

(total of 110). Overall impact is an increase in income of 110. However, 4

are negatively impacted and 1 benefits. Should the policy be implemented

or not ?

Another question for the author -- if CAD was to increase to say 100% of

the economy, no capital would flow. Question for you what is a

comfortable level of CAD ?

Actually the reverse happens in Petro states -- Countries export oil and

use the earnings to fund expenditure. When prices for oil fall -- people's

income come and down and puts a huge pressure on the economy. This


9/15

Replies

happenned to esrtwhile Soviet Union. We are opposite, relying on capital

flows -- whenever it falls (we are squeezed).

Reply


GMT+5:30

Two things:

The rupee depreciation is not a root cause as you make it out to

be. For rupee to appreciate we need to fix the root causes of low

productivity and low competitiveness. It makes no sense to ask

for a stronger rupee without asking to fix the root causes which

need long term commitment and a major change in the way we

function.

Secondly, its not clear how many people benefit and how many

don't. Rupee depreciation helps exporters and pretty much every

company benefits by being more competitive in comparison to

other countries. IT industry benefits a great deal. All of that leads

to more jobs in the export services and manufacturing sector.

Although, its not as much as one would hope for because of other

hurdles put up by poor government policies. But, because of the

examples I gave, I am not sure whether we have a net benefit or

loss.

Furthermore, it is a self-corrective system. A lower currencywould promote more investment into exports which eventually

would increase productivity and lead to currency appreciation.

That is, if we implement the right policies to increase productivity

which is the only way to have a strong economy and currency, at

the end of the day.


GMT+5:30

Agree that the economy needs to be more efficient and

competitive and that the value of Ruppee is an outcome of the

relative strenth of the Indian economy and not a cause.

There are arguments for both a higher and lower Ruppee. As you

point out lower Ruppee makes products and services competitive

but reduces the buying power of the citizens. There are tradeoffs

involved. Point is not high or low Ruppee but stability in the value

and not the high level of volatility as has been witnessed. Volatility

makes planning very difficult.

Capital flows can slow down for a number of reasons --both

internal and external. High level of CAD makes the Ruppee

vulernable to high level of volatility. What happens if the capital

flows remain low for an extended period of time, Ruppee goes to

100 and petrol sells for 115 Ruppees ?


10/15

Self correcting mechanism is good in theory, but can be a

challenge in situations of high volatility e.g., during the GFC,

should the banks have been allowed to fail and go out of business

?

Point being made was that the article argues the issue from one

point of view and overlooks the trade offs involved in having a high

CAD.

Anonymous Friday, October 4, 2013 at 12:39:00 AM GMT+5:30

Well, much of the problem accumulates over times of low

volatility, when the problems are ignored for long periods. The

actual periods of volatility are actually simply resolution of long-

standing issues. The period of volatility was great from the point

of view of long term fundamentals as billion of dollars worth of

projects got cleared, many measures were taken which were

long pending - like clearance for foreign universities and FDI forother sectors. If we get the kind of urgency we saw from the govt

in pushing through policies during this volatility, I'm prepared to

have rupee go to a 100 and petrol at 115. No problem,

whatsoever. :) Just imagine how much will get done by the govt if

that happens!!

Anonymous Friday, October 4, 2013 at 2:40:00 PM GMT+5:30

Proof of the pudding lies in eating it. So a suggestion -- you could

argue to the Government to have policies that will lead to a higerlevel of CAD, as this will drive down Ruppee, spur growth and

make Indian goods and services more competitive. Make the

suggestion and find out whether you premise is implementable or

academic ?


One more comment -- policy announcements and project

clearances are not equal to inflows and investment in projects

e.g., no FDI in retailing till date.


Why would I argue THAT to the government? And, why put the

cart before the horse? Even if I had to argue anything to the

government I would argue in favor of long term policies. The CAD

is irrelevant, its a secondary measure.

Yep, very little FDI in retail. Which means that the policies need

further work. Precisely why one gets the sense that more

pressure is needed from the market. By the way, I have no desirefor FDI. It would be nicer if it were domestic investment but it

seems domestic business is not willing to play ball with the govt

given its arbitrariness. And, similarly for FDI. No wonder there is

no FDI in retail. That's exactly the point! Another example is the


11/15

Reply

Replies

Reply

policy for foreign universities - in 2008 the goal was a grand

opening up, and it has been opened up in small steps, liberalizing

marginally every time because whatever has been done hasn't

been enough. 5 years and counting... eventually, we will get to

the right policy for investment into higher education and similarly

for retail - domestic or FDI or whatever....

Anonymous Thursday, October 3, 2013 at 6:50:00 PM GMT+5:30

The statement " CAD is exactly equal to investments minus savings" is

quite misleading and partially incorrect. I believe budget deficit is the

primary mechanism to support the gap between investment and savings.

CAD is only a secondary source of support , only to the extent of the need

for importing capital assets (machineries, intellectual properties etc).

I think you should have a follow up blog to clarify your thought process.

Reply

Ajay Shah Thursday, October 3, 2013 at 7:13:00 PM

GMT+5:30

No.

RG Thursday, October 3, 2013 at 8:03:00 PM GMT+5:30

Ajay, you crack me up.

Anyway, I think the comment above it on internal vs external

drivers of capital flows is the more interesting one.

In general your piece does a good service, and I'll likely give it to

students to read. But it appears premised on the standard idea

that capital responds mostly to domestic conditions. There's a lot

more room for legitimate argument when K flows are externally

driven (e.g. Helene Rey's recent piece

http://www.voxeu.org/article/dilemma-not-trilemma-global-

financial-cycle-and-monetary-policy-independence).

In India's case, this isn't to say the rupee didn't deserve to get

hammered. Rather, the external forces of the QE-driven K inflows

probably prevented it from getting a much-deserved hammering

earlier. So India suffered because of not getting the accountability

signal earlier and having to tolerate Mr. Mukherjee longer than it

should have.


12/15

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