India’s current account deficit came down to 0.2% of GDP in the fourth quarter (January-March 2023) of the last financial year due to a sharp reduction in the trade deficit. Strong export earnings from services (essentially computer services) and remittances of Indian workers abroad, which represent a form of service exports, contributed to a trade deficit of $52.6 billion to widen the current account deficit to $1.3 billion. Almost compensated.
The reduction in the current account deficit has been cited as a welcome development in reports on the development. This approach is intuitively attractive because we are trained to see deficits as a sign of weakness and surpluses as a sign of strength. But when it comes to macroeconomics, intuition is a poor guide.
For example, during an economic downturn, saving may seem like a virtue in times of scarcity. But if everyone cuts spending, the economy shrinks even more. What may seem instinctively rational at the individual level becomes illogical at the macro level. To get people out of the austerity trap, the government should step in and spend, directly boosting demand and putting purchasing power in the hands of the people. In turn they will start spending, increasing demand, prompting companies to make more and invest to make more. It was, in essence, prescribed by John Maynard Keynes for economies with unused excess production capacity and suppressed growth.
To understand why a low current-account deficit can be unhealthy, we need to understand primary national-income accounting. Thankfully, it’s quite simple. Whatever is produced in a given period of time in an economy is either invested or consumed (When something is not used for consumption or capital formation in that period, it forms an inventory and inventory is counted as part of investment). So total output must be equal to the sum of investment and consumption, right? not enough. Some part of what is produced is also exported and some part of what we consume or invest is imported. Therefore, what is consumed and invested must be added to what is exported and subtracted from what is imported to get the total value of output. The difference between exports and imports is the current account balance.
So, output is the sum of investment, consumption and current account balance. It’s a simple equation. Let us take away consumption from both sides. This would mean that output less consumption is equal to the current account balance. That which is not consumed out of the total production is called savings. So now we have the equation: savings equals investment plus current account balance.
Suppose the current account balance is zero – that is, exports were exactly equal to imports. Domestic savings equals domestic investment. Suppose exports exceed imports during this period, resulting in a current account surplus. This means that saving equals investment and is a positive sum. In this situation, the economy has not been able to invest domestically all that it has saved. In fact, it has exported some of its savings to other economies.
When imports exceed exports, we have a current account deficit. In this case, you would have to withdraw an amount equal to the current account deficit from investments to maintain the equation. In other words, when we have a current account deficit, domestic investment is greater than domestic savings. What is better for a developing economy: limiting investment to domestic savings or increasing domestic savings with savings from abroad, provided by countries running current account surpluses?
Obviously, the more we invest, the faster our growth and the better our position. Therefore, it is prudent to widen the current account deficit and attract external savings. But there is a caveat: We are able to increase the current account deficit only when someone is willing to finance that deficit – that is, create a future payment obligation for us. If such a payment obligation is too large for us to meet, it will lead us to a crisis path. Even if the payment obligation is manageable, if those who have financed our current account deficit believe that we are not able to service our loans, we could be in trouble. This means that the current account deficit should be kept modestly low and should be in the context of overall economic health, which in turn boosts external confidence in the economy.
For 2022-23 as a whole, the current account deficit was 2% of GDP, and higher than the deficit of 1.2% in 2021-22. A deficit in the range of 2.5% to 3% of GDP is perfectly manageable and acceptable to global investors. It is when the deficit becomes large in proportion to GDP that the people who have provided us with the financing capital – whether in the form of equity or debt – start to worry. When the most paranoid people withdraw their money, their stress is passed on to others and we are burdened with the currency. A weak rupee makes imports costlier, especially energy, and worsens our economic situation. When the current deficit is less than 2.5% of GDP, we are forsaking investment and development that should benefit our people.
Thus we should focus on a moderate current-account deficit rather than a surplus, without giving external investors any reason to worry about our ability to service our liabilities, just to accelerate the growth that comes from domestic savings. Invest more than save.
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Updated: June 29, 2023, 11:16 AM IST