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Revisiting the Basics

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Economics | Current Account Deficit Explained


Countries trade with one another to buy goods not produced in domestic economy. With the advent of globalization, investment to and fro have also increased many fold. A country’s trade and other economic exchanges with the world are recorded on its external account in the form of balance of payment (BoP) transactions.

There are two components of BoP

  1.  Current Account
  2.  Capital Account

Let’s understand about these 2 accounts in detail and analyse what happens in case of deficit or surplus in any of the accounts.

#1. Current Account – It deals with current, ongoing, short term transactions like trade in goods, services (invisible) etc. It reflects the nation’s net income.

For instance, if you a buy a laptop from US, it will be a current account transaction and it will be debit on current account as you have to pay to US.

There are 4 components of Current Account-

  1. Goods – trade in goods
  2. Services (invisible) – trade in services eg. tourism
  3. Income – investment income
  4. Current unilateral transfers – donations, gifts, grants, remittances

Note that grants might appear as component of capital account but are included in current account as they are unilateral, create no liability. Recipient does not have to give anything back in return.

#2. Capital Account – It deal with capital transactions i.e. those transactions which create assets or liabilities. It reflects the net changes in the ownership of national assets.

For instance, if you buy a stocks or property in US, it will be a capital account transaction and it will be debit on capital account as you have to pay to US to buy the asset.

Components of Capital Account

  1. Foreign Direct Investment (FDI)
  2. Foreign Portfolio Investment (FPI)
  3. External Borrowings such as ECB
  4. Reserve Account with the Central Bank

Note here that foreign investment is under capital account but dividends and income from investment comes under current account in the category income from abroad as dividend is transferred periodically, does not result in creation of asset or liability.

Balance of Payment (BoP) = Current Account + Capital Account = 0

Why?

Current Account and Capital Account always balance each other because a country always has to pay for its imports. It does so by exports or other two components of current account. If it can not, it runs deficit on current account and has to pay off by drawing off on its assets i.e. running capital account surplus.

What is Current Account Deficit?

  • It’s simply deficit on all 4 components of current account.
  • (Export – Import) + Net income from abroad + Net Transfers
  • (Export – Import) is trade deficit
  • CAD = Trade Deficit + Net Income From Abroad + Net transfers

Note that Trade Deficit and CAD are not one and the same. Trade deficit is only a component of CAD.

What does deficit on Current Account imply?

If we forget income and transfers for a moment, what it means is that we import more than what we export.

How do we pay for that extra import?

Either we get more foreign investment (FDI & FII) and pay via that or we borrow from foreign banks (ECB) or we will have to dip into our external reserves to pay for that amount and in the process our forex reserves come down. When forex reserves come down below a critical level, country appears on the brink of BoP crisis.

So, is CAD such a bad thing?

Depends on what you do with those extra imports and how you finance the deficit!

CAD is bad because –

  1. If a CAD is financed through borrowing, it is unsustainable because borrowing lead to high interest payments in the future
  2. Attracting capital flows (hot money, FII) to finance the deficit is risky as when confidence falls, hot money flows dry up, leading to a rapid devaluation and crisis of confidence. Eg. East Asian Crisis
  3. Run a CAD necessarily means running a surplus on the capital account. This means foreigners have an increasing claim on your assets, which they could redeem any time

However a current account deficit is not necessarily harmful

  1. CAD during a period of inward investment particularly stable long term FDI may not be a bad things as investment can create jobs. Investments will lead to higher growth will be able to pay debts back
  2. Developing countries may use CAD to buy Capital goods and later export consumer goods and thus repay the debt

Moderate current account deficit (2% of GDP) financed mainly by stable foreign investments which creates jobs and infrastructure in the economy can be helpful in the long run as it improves productivity.

What is this twin deficits?

Current Account Deficit and Fiscal Deficit together are knows as twin deficits and often both reinforce each other i.e. High fiscal deficit leads to higher CAD and vice versa.

Now it’s time to answer a few questions-

#1. which of the following constitutes/constitute the Current Account?

  1. Balance of trade
  2. Foreign assets
  3. Balance of invisibles
  4. Special Drawing Right

Select the correct answer using the code given below.

  1. 1 only
  2. 2 and 3
  3. 1 and 3
  4. 1, 2 and 4

#2. The balance of payments of a country is a systematic record of

  1. all import and export transactions of a country during a given period of time, normally a year
  2. goods exported from a country during a year
  3. economic transaction between the government of one country to another
  4. capital movements from one country to another

#3. Which of the following constitute Capital Account?

  1. Foreign Loans
  2. Foreign Direct Investment
  3. Private Remittances
  4. Portfolio Investment

Select the correct answer using the codes given below.

  1. 1, 2 and 3
  2. 1, 2 and 4
  3. 2, 3 and 4
  4. 1, 3 and 4

Want to read more –

  1. Budget Deficits Explained 
  2. GDP Calculation 
  3. Beggar thy neighbour

Questions, suggestions and comments


  1. Techno Destination

    I think in question 1 option balance of trade includes balance of invisible and it is a part of balance of trade.

  2. shardul aeer

    3,1,2

  3. manik basu

    Why don’t we consider remittance as an asset?

  4. Sonam jakhar

    Is balance of payment surplus necessarily good?

    1. Vmlprzd

      It is not clear that a surplus on the current account is a bad thing. It has certain advantages such as being able to invest in foreign countries and build up foreign exchange reserves. It may also indicate that the country is quite competitive relative to other countries.However, a large current account surplus may indicate an unbalanced economy. For example, it may indicate the country is relying too heavily on exports and consumer spending is relatively too low.

  5. Pranav

    Sir,

    Really confused about this long term/short term effect in Economy questions.

    For example, will FDI help in reducing CAD?
    Long term – yes
    short term – No (right?)

    so out of the 4 options in the question (for one of the test series that I am attempting) I eliminated FDI and my answer was incorrect as according to the Key FDI would lead to increase in industrial productivity => more exports => reduced CAD

    Totally agreed with the solution but it seems long term to me. (or am I just plain wrong?)

    But where to draw the line in this short term/long term scenario? I almost always get such questions incorrect.

    Kripaya is kasht ka nivaran kijiye :/

    Thank you

    1. Dr V

      FDI no effect on CAD. question we discussed had to include FDI as an option as that was the most appropriate option. Other option was reduction in export subsidy which was clearly wrong.

      1. Pranav

        Sir, this is not about the question that we discussed. I was talking more on general terms. The question i am referring to here goes like this

        Q.6) Which of the following will lead to reduction of CAD?
        1. Decrease in crude oil consumption.
        2. Increase in import duty of gold.
        3. Boost to IT sector in India.
        4. Promote FDI
        Select the correct answer
        a) 1, 2 and 3 only
        b) 1, 2 and 4 only
        c) 1, 3 and 4 only
        d) All of the above

        I chose A while the answer key mentions D.

        Now my question (even if the answer key correct or otherwise) is that how do draw the line between a direct and indirect effect of something in Economics.

        You once told me that in economy questions we should concentrate on near term effects or direct effects.

        When we say that what qualifies as an indirect effect. I was going on the logic that there are too many “ifs and buts” involved in between a cause and effect then it is an indirect effect.

        Please tell If I am right/wrong here. Or perhaps partially right?

        1. Dr V

          1,2,3 would be the answer

          1. alpika verma

            Sir, I Am not very confident about Economy but have a look at this please
            http://m.timesofindia.com/business/india-business/FDI-to-reduce-Indias-current-account-deficit-Moodys/articleshow/51726726.cms
            Boost to IT and FDI both will have long term effect na? So both should be included and amswer should be D

          2. Pranav

            Thank you 🙂

  6. bala murali

    Dr.V for second question why 4th option cannot be an answer because balance of payment does not include only import and export ?

    1. bala murali

      sorry Dr.v why 3rd option cannot be an answer?

      1. Dr V

        because BOP is not transaction b/w 2 govts, it’s the transaction of the entire economy i.e when we import something, it’s included in BOP.
        None of the option s correct but option 1 which is current account is the most appropriate answer

  7. Pranav

    Dr V

    I found this on Investopedia after reading Kunal’s comment below. Do we follow a different methodology in calculating BOT? Because as per this BOT should contain both goods and services. Or am I getting this wrong?

    Please advise.

    “A crucial point to note is that both goods and services are counted for exports and imports, as a result of which a nation has a balance of trade for goods (also known as the “merchandise trade balance”) and a balance of trade for services.”

    Read more: Breaking Down The Balance Of Trade | Investopedia http://www.investopedia.com/articles/forex/082913/breaking-down-balance-trade.asp#ixzz4BX9gllxo

  8. Krishna Kunal

    1. 3/C
    2. 1/A
    3. 2/B

    PS :
    Trade deficit/surplus included both goods and services.
    Trade balance includes only goods.
    other way of looking at CAD is CAD = trade balance + trade in services + net transfers

  9. Abhijeet Narayan

    why is forex part of capital account? Forex doesn’t create any new assets.

    1. Dr V

      Forex itself is an asset just as cash in your hands is an asset.

  10. Anmol Phutela

    answers. Q1- 4
    Q2-1
    Q3-2
    please review doctor.

    1. Dr V

      check your first question again. assets come under capital account. it wil be 1 & 3

  11. Seema Dayma

    Can you explain 2nd que??
    I thought ans would be 3!

    1. Dr V

      3nd is easily wrong seema. Not only government but private transaction is taken into account. When you buy an iPhone from US its a debit on our current account as we explained in the example in the blog.

  12. Abhinandan Surana

    private remittances ???

    1. Sumer Shah

      bhai doubt to achcha poocha karo…. what can be googled should be googled. simple.

    2. Dr V

      What’s your doubt.. Remittances are funds transferred from migrants to their home country. Saudi wale jo kaerala bhejte hein voh

  13. IAS 2017

    answer please?

    1. Dr V

      #1 = 3
      #2 = 1
      #3 = 2

      1. Ravi Mantwal

        Thanks a lot! The best part is the added MCQs! And sir one more thing I am reading the 12th Introductory Macroeconomics. More than half of the things are quite technical. But your articles make it so easy and bridge the gap lucidly. (Hey Maa Mata ji! aap na hote to kya hota! :P)
        Please keep this noble work on! 🙂

  14. Pranav Pathak

    Answers?
    #1 = 3
    #2 = 1
    #3 = 2

  15. Raj Raval

    Nice Way Of Explaination…

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