GS Notes

6. Economics Notes 43

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Elaborate Notes

Balance in Current Account

The Current Account is a critical component of a country’s Balance of Payments (BoP). It systematically records all economic transactions between the residents of a country and the rest of the world over a specific period, typically a year or a quarter. These transactions are of a “current” nature, meaning they do not create future claims. The account is an indicator of a nation’s trade and income flows.

It is broadly divided into two sub-accounts:

  • Balance of Visibles (Balance of Trade - BoT):

    • Definition: The Balance of Trade measures the difference between the monetary value of a country’s exports and imports of tangible, physical goods (merchandise) over a period. It is the most significant component of the current account.
    • Formula: BoT = Value of Exports (Goods) - Value of Imports (Goods).
    • Historical Context for India: Post-independence, India has consistently run a trade deficit, with exceptions in only a few years (e.g., 1972-73, 1976-77). This persistent deficit is historically attributed to the import of capital goods for industrialization, food grains during shortages, and, more recently, a heavy reliance on crude oil and gold imports. The Economic Survey of India annually provides detailed data on the composition and direction of India’s trade, highlighting these trends.
    • Trade Surplus: This occurs when the value of a country’s goods exports exceeds its goods imports (Exports > Imports). It indicates that the country is earning more from its merchandise sales abroad than it is spending on foreign merchandise.
    • Trade Deficit: This occurs when the value of goods imports is greater than the value of goods exports (Imports > Exports). A persistent trade deficit can put pressure on the country’s currency.
    • Balanced Trade: A situation where the value of goods exports is exactly equal to the value of goods imports. This is a rare theoretical state.

  • Balance of Invisibles:

    • Definition: This account records all transactions that do not involve physical goods. It includes services, international income flows, and unilateral transfers.
    • India’s Context: India has historically maintained a surplus on the Balance of Invisibles, which partially offsets the deficit on the Balance of Trade. This surplus has been a pillar of stability for India’s BoP.
    • Components of Invisibles:
      1. Services: This includes the export and import of services like tourism, transportation, insurance, banking, and software services. India has a significant surplus in this category, primarily driven by its Information Technology (IT) and IT-enabled Services (ITeS) sector. Reports by NASSCOM (National Association of Software and Service Companies) consistently highlight India’s dominance in the global software and business process outsourcing (BPO) market.
      2. Income: This sub-account records earnings from investments and compensation to employees. It includes profits, dividends, and interest earned by residents from their investments abroad (credit) and payments made to non-residents for their investments in the country (debit). For India, this component is typically negative as payments on foreign investments (FDI and FPI) in India exceed the income earned by Indians from their investments abroad.
      3. Transfers (Unilateral Transfers): These are one-way transactions where no economic value is received in return. They include private remittances (money sent home by workers abroad), grants, gifts, and donations. India is the world’s largest recipient of private remittances, a fact consistently reported by the World Bank’s “Migration and Development Brief.” The Indian diaspora, particularly in the Gulf countries, North America, and Europe, is the primary source of these inflows.

The overall Balance on Current Account is the sum of the Balance of Trade and the Balance of Invisibles. A Current Account Deficit (CAD) implies that a country’s total imports (goods and services) and other payments exceed its total exports and other receipts.

Twin Deficit Hypothesis

This is a macroeconomic theory which posits a strong causal link between a nation’s government budget deficit (Fiscal Deficit) and its current account deficit (CAD).

  • Mechanism: The theory, often explained through the Mundell-Fleming model (developed by Robert Mundell and Marcus Fleming in the 1960s), suggests the following chain of events:
    1. An increase in the fiscal deficit (government spending > revenue) means the government must borrow more from the market.
    2. This increased borrowing demand pushes up domestic interest rates.
    3. Higher interest rates attract foreign capital (FPI and loans), leading to a surplus in the capital account.
    4. The inflow of foreign currency increases the demand for the domestic currency, causing it to appreciate.
    5. An appreciated currency makes the country’s exports more expensive and its imports cheaper, thus widening the trade deficit and, consequently, the current account deficit.
  • Indian Context: The relationship has been observed in India at various times, for example, during the high-growth phase in the mid-2000s and again in the early 2010s. However, some economists argue the link is not always direct or strong in India, as a fiscal deficit can also be financed by domestic savings, which might ‘crowd out’ private investment instead of attracting foreign capital.

Desirable Current Account Deficit (CAD)

A CAD is not inherently negative, especially for a developing economy. It can signify that the country is importing capital goods to build future productive capacity. The key is its sustainability.

  • Rangarajan Committee (1993): The High-Level Committee on Balance of Payments, chaired by Dr. C. Rangarajan, was set up in the aftermath of the 1991 BoP crisis. Its report suggested that a CAD of around 2% of GDP was sustainable for India. This level was considered manageable as it could be financed through non-debt-creating, stable capital inflows like Foreign Direct Investment (FDI) without adding excessively to external debt.
  • Recent Views: In recent years, both the RBI and the Government have indicated that a CAD in the range of 2.5% to 3% of GDP could be manageable, provided the global economic environment is stable and capital inflows are robust.
  • Conditionality: The sustainable level of CAD is not a fixed number. It depends on factors like the global risk appetite, the composition of capital flows (dominance of FDI over FPI is preferred), the level of foreign exchange reserves, and the growth rate of the economy. A sudden stop or reversal of capital flows, as witnessed during the “Taper Tantrum” of 2013, can make even a moderate CAD unsustainable.

Balance in the Capital Account

The Capital Account records all international transactions that involve a change in the ownership of assets. These transactions create future claims. A surplus in the capital account indicates a net inflow of capital, which can be used to finance a deficit in the current account.

  • Components of the Capital Account:
    1. Foreign Investments: These are non-debt-creating inflows and are considered the most stable source of external finance. They are further divided into:
      • Foreign Direct Investment (FDI)
      • Foreign Portfolio Investment (FPI)
    2. Loans: These are debt-creating capital flows. They include:
      • External Commercial Borrowings (ECBs)
      • External Assistance (concessional loans)
      • Trade Credit
    3. Banking Capital: This primarily consists of movements in the deposits of Non-Resident Indians (NRIs).

Foreign Investments

  • Foreign Direct Investment (FDI):

    • Definition: FDI refers to a cross-border investment where an investor from one country establishes a lasting interest in and a significant degree of influence over an enterprise in another country. It implies a long-term relationship and control. For example, when Suzuki Motor Corporation of Japan established Maruti Udyog Ltd. in India in 1982, it was a landmark greenfield FDI. Similarly, Tata Steel’s acquisition of Corus Group in the UK (2007) is an example of brownfield FDI.
    • Mayaram Panel Recommendations (2013): To bring clarity and align with global standards (like those of the OECD), the Arvind Mayaram Committee rationalized the definition of FDI and FPI. Key recommendations adopted were:
      1. Any foreign investment constituting 10% or more of the post-issue paid-up equity capital in a listed company is treated as FDI.
      2. Any foreign investment in an unlisted company, irrespective of the percentage, is treated as FDI.
      3. The 10% threshold is the defining line between FDI and FPI for listed companies.
      4. “Once an FDI, always an FDI”: If an investment is classified as FDI, it remains so even if the shareholding later falls below the 10% threshold. This prevents frequent reclassification due to market fluctuations.
    • Investment Types:
      • Greenfield Investment: Building new facilities from the ground up.
      • Brownfield Investment: Purchasing or leasing existing facilities.
    • Entry Routes:
      • Automatic Route: FDI is permitted without prior approval from the government or RBI in most sectors.
      • Government Route (Non-automatic): Prior approval is required from the concerned administrative ministry/department for investment in specific sensitive sectors.
    • Institutional Changes: The Foreign Investment Promotion Board (FIPB), an inter-ministerial body, was the single window for processing government-route FDI proposals. It was abolished in 2017 to streamline the approval process as part of the ‘Ease of Doing Business’ reforms. Now, proposals are handled directly by the relevant ministries.
    • Reporting: All FDI inflows, whether through the automatic or government route, must be reported to the RBI.
    • Prohibited Sectors: FDI is prohibited in sectors of strategic or social concern, including Atomic Energy generation, specific Railway operations (though many areas have been opened up), lottery business, chit funds, and manufacturing of tobacco products.
    • Transferable Development Rights (TDRs): This is an urban planning tool. When land is acquired for public projects, instead of monetary compensation, the government can issue a Development Rights Certificate (DRC). This certificate grants the owner the right to build additional floor space (Floor Space Index - FSI) on their remaining land or sell this right to a developer for use elsewhere in a designated zone. TDRs are prohibited for FDI as they are linked to real estate, a sensitive sector.

  • Portfolio Investment:

    • Definition: This involves the purchase of financial assets like stocks and bonds in a foreign country without acquiring control. As per the Mayaram Panel definition, any investment less than 10% in a listed company is treated as a portfolio investment.
    • Categories:
      1. Foreign Institutional Investments (FII): Investments by institutions like pension funds, mutual funds, and insurance companies. They are often referred to as “hot money” because they are short-term and can be withdrawn quickly during periods of economic uncertainty, potentially causing market volatility and currency depreciation. FIIs in India are regulated by the Securities and Exchange Board of India (SEBI).
      2. Depository Receipts (DRs): These are negotiable certificates issued by a depository bank representing a certain number of a foreign company’s shares.
        • American Depository Receipts (ADRs): Traded on US stock exchanges (e.g., NYSE, NASDAQ). Infosys was one of the first Indian companies to issue an ADR in 1999.
        • Global Depository Receipts (GDRs): Traded on stock exchanges outside the US, typically in Europe (e.g., London Stock Exchange, Luxembourg Stock Exchange).
        • Definitional Ambiguity: There is a notable difference in classification. The RBI, in its BoP statistics, classifies funds raised through DRs as portfolio investment. However, under the Foreign Exchange Management Act (FEMA) and as per the Department for Promotion of Industry and Internal Trade (DPIIT), they are treated as FDI, as the investment directly goes to the company.

Loans

These are debt-creating capital transactions that must be repaid with interest.

  • External Commercial Borrowings (ECBs):

    • Definition: These are commercial loans raised by eligible resident entities from recognized non-resident lenders. They are availed at market-determined interest rates.
    • Eligibility: All entities eligible to receive FDI can raise ECBs. Additionally, specialized institutions like Port Trusts, units in SEZs, SIDBI, and EXIM Bank are also permitted.
    • Features: ECBs have a minimum average maturity period, generally three years (with exceptions for specific sectors), to prevent excessive short-term debt. They can be denominated in any freely convertible foreign currency.
    • Types: ECBs can be in the form of bank loans, bonds, debentures, or Foreign Currency Convertible Bonds (FCCBs). An FCCB is a hybrid instrument that is issued as a bond but can be converted into equity shares of the issuing company at a later date. Until conversion, it is treated as ECB (debt); upon conversion, it is reclassified as FDI (equity).

  • Trade Credit:

    • Definition: This refers to credit extended for imports directly by the overseas supplier, a bank, or a financial institution for maturity periods up to three years (for capital goods) and one year (for non-capital goods). It facilitates international trade by allowing importers a grace period for payment.

  • External Assistance:

    • Definition: These are concessional loans, often called “soft loans,” characterized by lower interest rates and longer repayment periods than commercial loans.
    • Sources: They are typically provided by foreign governments (bilateral aid) or multilateral institutions like the World Bank (IBRD & IDA), the International Monetary Fund (IMF), and the Asian Development Bank (ADB) for developmental purposes.

Banking Capital Transactions

This component primarily captures the change in NRI deposits held in Indian banks.

  • Foreign Currency Non-Resident (Bank) Account - FCNR(B):

    • Maintained in foreign currencies (e.g., USD, EUR, JPY).
    • Held only as term deposits (1 to 5 years).
    • The exchange rate risk is borne by the bank, not the depositor.
    • Both principal and interest are fully repatriable and tax-free in India.

  • Non-Resident External (NRE) Rupee Account:

    • Maintained in Indian Rupees, but funded by inward remittance of foreign currency.
    • Can be savings, current, or term deposit accounts.
    • The exchange rate risk is borne by the depositor.
    • Both principal and interest are fully repatriable and the interest earned is tax-free in India.

  • Non-Resident Ordinary (NRO) Rupee Account:

    • Maintained in Indian Rupees to manage income earned in India (e.g., rent, dividends, pension).
    • Can be opened by any person residing outside India.
    • The interest earned is taxable in India.
    • Repatriation is restricted (current income and up to USD 1 million per financial year from the balances).
    • The exchange rate risk is borne by the depositor, but it’s primarily for managing local rupee funds.

Autonomous and Accommodating Transactions

This is an analytical classification of BoP transactions.

  • Autonomous Transactions:

    • These are all international economic transactions undertaken for their own sake, driven by economic motives like profit maximization or consumption.
    • They are independent of the BoP position of the country.
    • They include all transactions in the current account and most transactions in the capital account (like FDI, FPI, ECBs).
    • They are referred to as “above-the-line” items because the sum of all autonomous transactions determines whether the BoP is in surplus or deficit.

  • Accommodating Transactions:

    • These are transactions undertaken specifically to cover the deficit or absorb the surplus arising from autonomous transactions.
    • They are also known as “below-the-line” items and their purpose is to balance the BoP.
    • The primary example is the Official Reserve Transactions carried out by the central bank (RBI). If there is a BoP deficit (autonomous payments > autonomous receipts), the RBI will finance it by selling foreign currency from its forex reserves. If there is a surplus, it will buy foreign currency, thereby increasing its reserves. Borrowing from the IMF is also an accommodating transaction.

Prelims Pointers

  • Current Account Components: Balance of Trade (Visibles) and Balance of Invisibles.
  • Invisibles Components: Services, Income, and Unilateral Transfers.
  • Balance of Trade (BoT): Difference between the value of export and import of only physical goods.
  • Twin Deficit Hypothesis: Links Fiscal Deficit with Current Account Deficit (CAD).
  • Rangarajan Committee (1993): Recommended a sustainable CAD of around 2% of GDP for India.
  • Capital Account Components: Foreign Investments (FDI, FPI), Loans (ECB, External Assistance, Trade Credit), and Banking Capital.
  • FDI Definition (Mayaram Panel): Investment of 10% or more in a listed company; any investment in an unlisted company.
  • FDI Principle: “Once an FDI, always an FDI.”
  • FDI Routes: Automatic (no prior approval) and Government (prior approval required).
  • FIPB: Foreign Investment Promotion Board was abolished in 2017.
  • Sectors Prohibited for FDI: Atomic Energy, Lottery Business, Chit Funds, Trading in TDRs, Manufacture of tobacco products.
  • TDR: Transferable Development Rights, a tool for land acquisition in urban planning.
  • Portfolio Investment: Investment of less than 10% in a listed company.
  • FII (Hot Money): Short-term, volatile portfolio investments regulated by SEBI.
  • Depository Receipts: ADRs (traded in the US) and GDRs (traded globally).
  • ECBs: External Commercial Borrowings are commercial loans from international markets.
  • FCCB: Foreign Currency Convertible Bond, a hybrid instrument treated as ECB until converted to equity.
  • External Assistance: Concessional or “soft loans” from foreign governments or international institutions.
  • NRI Deposits:
    1. FCNR(B): Maintained in foreign currency; term deposits only; tax-free.
    2. NRE Account: Maintained in Rupee; funded from abroad; fully repatriable; tax-free.
    3. NRO Account: Maintained in Rupee; for income earned in India; taxable; restricted repatriation.
  • Autonomous Transactions: “Above-the-line” items; undertaken for economic motives (e.g., trade, FDI).
  • Accommodating Transactions: “Below-the-line” items; undertaken to balance the BoP (e.g., use of forex reserves).

Mains Insights

  • Analyzing India’s Current Account Deficit (CAD):

    • Causes: A persistent CAD in India is primarily driven by a high trade deficit (due to large oil and gold imports) and a negative income balance. While the surplus in services and remittances provides a cushion, it often isn’t enough to cover the trade gap.
    • Consequences of High CAD: A high and unsustainable CAD makes the economy vulnerable to external shocks. It can lead to a sharp depreciation of the rupee, trigger capital flight (especially ‘hot money’), and deplete foreign exchange reserves, potentially leading to a BoP crisis like in 1991 and the scare during the 2013 Taper Tantrum.
    • Financing the CAD: The quality of financing matters more than the quantum. A CAD financed by stable, long-term FDI is sustainable as it builds productive capacity. Conversely, a CAD financed by volatile FPI or short-term debt is risky and can unravel quickly.

  • Debate on the Twin Deficit Hypothesis in India:

    • For the Hypothesis: Proponents argue that periods of high fiscal deficit in India have often coincided with a widening CAD, demonstrating the link through interest rates and currency appreciation.
    • Against the Hypothesis: Critics argue the relationship is not consistent. India’s CAD is often more influenced by global commodity prices (especially oil) and the private sector’s investment-saving gap. A high fiscal deficit might be financed domestically, leading to the ‘crowding out’ of private investment rather than attracting foreign capital. The policy focus, therefore, should be on both fiscal consolidation and structural reforms to boost exports and private savings.

  • FDI vs. FPI: The Quality of Capital Inflow:

    • FDI (Preferred): It is considered ‘sticky’ or long-term capital. It brings not just funds but also technology, managerial skills, and access to global markets, leading to job creation and economic growth. Government policies like ‘Make in India’ and Production Linked Incentive (PLI) schemes are aimed at attracting more FDI.
    • FPI (Necessary but Volatile): It provides crucial liquidity to capital markets but is prone to sudden reversals based on global risk sentiment. This volatility (‘hot money’) can cause macroeconomic instability. The policy challenge is to attract FPI for market depth while having mechanisms (like robust forex reserves and macro-prudential norms) to manage its volatility.

  • Policy Management of the External Sector:

    • Government Role: Focuses on trade policy (promoting exports, rationalizing imports), improving the ease of doing business to attract FDI, and maintaining fiscal discipline to manage one half of the ‘twin deficit’.
    • RBI’s Role: Manages the capital account and exchange rate. It uses monetary policy to influence interest rates and capital flows, intervenes in the forex market to curb excessive volatility, and builds up foreign exchange reserves as a buffer against external shocks. It also regulates ECBs and other forms of external debt to maintain debt sustainability.

  • Implications of Capital Account Liberalization:

    • The components of the capital account, like FDI, FPI, and ECBs, are governed by regulations. India has followed a gradual approach to capital account convertibility, as recommended by the S.S. Tarapore Committees (1997, 2006).
    • Benefits: Full convertibility could increase capital inflows, lower the cost of capital for Indian firms, and improve financial market efficiency.
    • Risks: It would also expose the economy to greater volatility and the risk of massive capital flight during crises. The consensus is that full convertibility should be pursued only after achieving pre-conditions like a low fiscal deficit, moderate inflation, and a strong financial system.

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