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Saturday, August 24, 2013

What is current account deficit (CAD)

When dealing with equity, and in general the market and economy trend, one of the most commonly heard of terms to assess the country's creditworthiness is called as CAD (Current Account Deficit). A controlled CAD in general is a healthy sign for a growing economy. This is one of the macro factors to be looked at when taking a long term view of where you invest your hard earned money. So, let us try and understand more about CAD.


What is Current Account Deficit (CAD)
As the name suggests, Current Account Deficit occurs when a country's total imports of goods, services and transfers is greater than the country's total export of goods, services and transfers. This situation makes a country a net debtor to the rest of the world.

What causes Deficit
Countries with current account deficits generally spend more, but are considered credit worthy. The businesses in these countries’ can’t borrow from their own residents, because they haven’t saved enough in their local banks. They would prefer to spend than save their income. Businesses in a country like this can’t expand unless they borrow from foreigners. That’s where the credit-worthiness also comes into the picture. Basically, the lender country also exports a lot of goods and possibly even some services to the borrower. Therefore, the lender country can manufacture more goods and give jobs to more of its people by lending to the spendthrift country. Both countries benefit.

Is CAD bad
A substantial current account deficit is not necessarily a bad thing for certain countries. Developing counties may run a current account deficit in the short term to increase local productivity and exports in the future. If you look at it at an individual level, you take loan from a bank to fund a house, which you otherwise cannot afford to buy. Of course, you need to repay the same in time, and keep it under control.

How is CAD calculated
Generally, CAD is expressed as the total deficit (in USD or any other currency) as a percentage of the GDP of the country. This % gives us an optimum picture of the capability of a country to settle the deficit.

What is current situation in India wrt CAD
The current account deficit, after hitting a historic high of 6.7 per cent of GDP in Q3 of last financial year(2012-13), improved sharply to 3.8 per cent in Q4, closing the fiscal year with a deficit of 4.8 per cent of GDP, which was a 60 bps higher than the previous fiscal year.
The main reasons put forth by the finance ministry for the widening of the CAD are lower exports and higher degree of imports of oil, coal and yellow metal gold.

What is the likely CAD in future
The reports say that, however that "trends in initial trade data suggest that CAD may remain high in Q1 of the current fiscal year. But in subsequent quarters, CAD is expected to improve, since the import demand for gold may moderate".
In India, it is expected that the CAD would be tamed to 4.7% of nation's GDP by the FY'2014. Though, in the normal economic conditions, CAD figures of 2.5% of a nation's GDP is acceptable.

What are the components of CAD
1) Trade deficit: The first component of a current account deficit is usually a trade deficit. This means the country imports more goods and services than it exports. The trade deficit happens when a country’s total import of goods and services are greater than it total exports. An ongoing trade deficit weakens a country’s economy over the long term because it is financed with debt.
2) Net income: The second component is usually a deficit in the net income. If the income paid out by a country’s individuals, businesses and government to their foreign counterparts is more than they receive, it contributes to a deficit. Specifically, these are payments of interest and dividends to foreigners who own assets in the country, and wages paid to foreigners who work in the country. On the other side, the opposite will cut the deficit like Income earned on foreign assets owned by a country’s residents and businesses, receipts such as interest and dividends earned on investments, Income earned by a country’s residents who work overseas.
3) Direct transfers: The third component of the deficit is direct transfers, which includes government grants to foreigners. It also includes any money sent back to their home countries by foreigners. Direct transfers refer to money transferred without exchanging any goods or services. For example: An Indian worker, who works abroad and sending money (remittance) to his family in India.

Why is the CAD likely to continue in high zone in India
In order to keep the balance of payment intact, high CAD figures then have to be financed (just like your home loan), which thus increases the reliance on foreign funds or capital account. The Indian economy was safeguarded and in fact was at the mercy of the foreign capital which came in through FDI and FII. The bond buying programme or quantitative easing (QE) measures that were undertaken by the US Federal Reserve in the wake of the sub-prime crisis of 2008-2009 is likely to be wind down as the economy has shown signs of recovery. What this means is that easy liquidity through QE measures would ensure that foreign institutional investors gradually pull off from the Indian markets (and similarly other developing markets), raising fresh worries for financing the CAD.
And when capital flows are insufficient to meet the deficit, the country’s currency starts to depreciate on concerns that it may find it difficult to meet its international commitment or fund its current purchases
The surge in foreign funds outflow has already hit the domestic currency hard which slumped to record low levels recently. Rupee slump or depreciation is in turn likely to put further pressure on the fiscal deficit of the government as fuel bill is likely to be inflated with no signs of revenue growth.

Consequences of a high CAD
In the short-term, a current account deficit is mostly advantageous. Foreigners are willing to invest capital into a country to drive economic growth beyond what it could manage on its own. However, in the long term, a current account deficit can drain economic vitality. Demand could weaken for the country’s assets, including the country’s government bonds. As this happens, yields will rise (because more bonds will be sold) and the national currency will gradually lose value relative to other currencies. This automatically lowers the value of the assets in the foreign investors' currency, which is now getting stronger. This further depresses the demand for the country's assets. This could lead to a tipping point, at which investors will dump the assets at any price.

So, look on to CAD trending of the past, and also the expected CAD in future to get a macro level idea of the country's stability before you try and invest in any specific country.

Cheers

Manoj Arora
Lead a Financially Free Life !!

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