Sustainability of current account deficit, Macroeconomics

Sustainability of Current Account Deficit:

Theoretically speaking, a current account deficit can be sustained as long as the growth rate of national income exceeds the rate of interest on the nation's liabilities. Sufficient condition for sustainability of this deficit is a constant foreign debt  - GDP  ratio  over  a  time period.  In  the  reverse gear, non-sustainability implies  

(a)  large  current account deficit  - GDP ratio 

(b) persistent  low domestic savings  rate on  account  of current account imbalance. 

Implications and effects of persistent current account deficit are far and wide. For, foreign investors may take a pessimistic view of country's ability to meet its foreign obligations and even reduce the capital inflows. Second, a current account deficit represents an imbalance between demand for and supply of foreign exchange as a result of which there might be speculative attack on the currency,  fiaught with serious consequences for  the whole economy. Third, if caused primarily  by widening trade deficit,  a  current account imbalance indicates structural competitiveness problem.  Such a structural constraint  is reflected in  lower export - GDP ratio and continuous higher  import - GDP ratio.  Fourth,  it  has been  empirically observed  that  high current account deficits are at the bottom of external payments crisis worldwide. A bench-mark suggests  that a current account deficit (CAD) GDP  ratio of 5 percent should be a cause for concern  from  the viewpoint of its sustainability.

Fifth, the  size, composition as well as financing of the current account deficit is critical in determining the future sustainability  sector. This becomes even more important when with the relaxing barriers to capital mobility, current account deficit can increase vulnerability of these economies to external shocks. The Mexican peso crisis of 1994-95, the East Asian currency turmoil of 1997, the Russian and Brazilian cisis of 1998-98 and that of Argentine of 2001-02 are reminder  of  the  vulnerability  of  these economies  to massive build-up  of current account imbalances non-sustainability and proved disastrous for their financial stability. 

In  India,  the  issue of  a sustainable current account deficit assumed crucial significance in the aftermath of 1990-91 crisis. A current account deficit of 3 percent of GDP triggered a crisis in India in the same year. It was argued  in' some quarters  that a distinct decline in invisible earnings during 1985-90 was a key factor in precipitating the crisis of 1990-91.

In terms of the size of the current  account  deficit,  its  range  of  1.5 to  2.5 percent  of GDP has been considered consisted with the stabilisation of India's net  external liabilities. Further,  the High Level  Committee on BOP (Chaired by C. Rangarajan) recommended a CADI GDP ratio of  1.6 percent Similarly, the document on Tenth Five year plan (2002-07) projects a current account deficit of 1.6  percent of GDP as against 0.9 percent  of GDP  in  the Ninth  Plan.

This deficit was consistent with macro variables  of domestic savings, investment and incremental capital output-ratio  to achieve a growth rate of 8 over the plan period. What  has been the experience of  India in post reform period? Has  current account deficit been consistent with macro variables and its  projections during 1990s and beyond? These aspects merit some consideration.

As against many developing countries, the Indian experience turns out to be different from those countries with its high saving-investment correlation and low capital mobility (RBI, Report on Currency and Finance 2002-03 p. 132). Following RBI analysis, it can be said that a high positive saving - investment gap of the private sector was a reflection of stagnation in investment demand during a large part of 1990s. The negative public sector saving investment gap in India seems to have been adjusted within the economy without spilling over to the external sector. And thus despite massive fiscal deficit, India's current account deficit has remained insulated by rising private savings. 

Posted Date: 11/9/2012 5:05:20 AM | Location : United States

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