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Understanding 'What Is CAD?'
Understanding 'What Is CAD?'
Submitted By:
Omkar K.
Shweta Pillai
Date: 30.06.2013
Index
1. Introduction
2. Current Account Deficit
2.1 Introduction
2.2 Causes of the Current Account Deficit
3. Movement of the Indian Rupee
4. Financing the Current Account Deficit
4.1 Successive Software Services
4.2 Capital Account
4.3 Foreign Exchange Reserves
5. Reforms in the Financial Sector
6. Conclusion
Bibliography
Abstract:
Current Account Deficit is one of the major macroeconomic problems that India faced in the
fiscal years 2011-12 and 2012-13.CAD touched record highs of 6.7% of GDP in the third
quarter of fiscal 2012-13. In this study we have tried to investigate the relationship between
the CAD, the Foreign Investment and the Exchange Rate of the Indian Rupee. Studying the
data of these variables and their movements, we can say that there is theoretically
interdependence between these three variables. The CAD is affected by negative movements
of the exchange rate and negative Foreign Investments. The RBI is now following a more
market determined exchange rate. The exchange rate is influenced, amongst other factors, by
the movement of Foreign Investments, which are dependent on the monetary policies of
global central banks. The state of the world economy in comparison with the domestic
economy is another factor that explains the change in the direction of flow of capital. The
effect of depreciation of the Rupee also affects the import bill leading to increased strain on
the CAD.
1. Introduction:
Indias travails on the Balance of Payments front started from the Second Five-Year Plan
(1956), and continued till the crisis of 1991. The 1991 Balance of Payments crisis forced
India to open her long shut doors to foreign investments. This was done in a gradual manner
by removing various restrictions, which caused India to be under a License Raj. During the
License Raj, eighty government agencies had to be satisfied for private companies to produce
goods and, the government would regulate production. After the reforms the economy saw a
turnaround, from the ease of doing or starting a business to attracting capital flows from
abroad.
The opening up the economy led to the inflow of capital from the world. The inflow of
foreign capital was good for the economy. India was more connected to the outer world.
However, India also had to bear with the uncertainty and speculation surrounding the global
financial markets.
The free flow of capital can be a blessing and a curse. Heavy dependence on the inflow of
capital in the Capital Account to balance the Balance Of Payments account is dangerous.
India is a developing economy and heavily dependent on oil and petroleum products, not just
for transport, but for many other industries as well. India is not rich in oil reserves and
depends on oil imports for her needs.
CAD has gone up sharply in the last two years on the back of higher oil and gold imports.
Export growth slowdown has also hit the CAD.
Oil imports make up a large portion of the total imports and rupee depreciate pushes up the
oil bill causing problems to the CAD. In addition to oil, gold also has joined in to cause
trouble to the CAD. The metal is a favourite with Indians and is seen as a very attractive
investment. Gold imports are increasing and this is adding to the CAD.
The exports sector is not growing at a rate to cover the import bill. The Import bill has
increased at a rate of31% during 2011-12, while exports only grew at 23% for the same
period. Oil imports have increased at a rate of 46% and gold 38%. This rise in oil and gold
imports is alarming and can negatively impact the CAD if not checked.
A high and uncontrollable CAD may scare foreign investors which in turn would weaken the
rupee, which then would cause a further strain on the CAD. This effect is a chain-effect.
Hence in this study we analyse the cause and effects of the CAD, and the Indian Rupee
(INR)-to-US Dollar (USD) exchange rate, and their interdependence. The ways of financing
the CAD is analysed. In order to understand the volatility in the INR exchange rate, a brief
analysis is done on the major components of the capital account, namely, types of foreign
investment.
1. Merchandise Trade
2. Invisibles
Merchandise Trade
Merchandise Trade refers to the foreign trade of India . Basically it is the export and import
of goods.
Imports
India has experienced heavy imports since independence. Imports have always been greater
than exports.
In the data that we have taken, 1999-2011, the imports have increased on an average of 21%
CAGR. In the last period 2011-2012, imports have risen by almost 32%.
The main components of imports are Oil and Gold.
Oil and Gold comprise of around 42.27% of total imports in 2011-2012.
Table 1:
Years
Gold
Oil
Oil and
Gold as
Oil (% Gold(%of %
of
Total
of total total
total
Imports imports) imports)
imports
1999-00
4151.8
12611.4
55383
22.77
7.49
30.26
2000-01
4121.6
15650.1
57912
27.02
7.11
34.14
4.56
2001-02
4170.4
14000.3
56277
24.87
7.41
32.28
-2.82
2002-03
3844.9
17639.5
64464
27.36
5.96
33.32
14.54
2003-04
6516.9
20569.5
80003
25.71
8.14
33.85
24.10
2004-05
10537.7
29844.1
118908
25.09
8.86
33.96
48.62
2005-06
10830.5
43963.1
157056
27.99
6.89
34.88
32.08
2006-07
14461.9
56945.3
190670
29.86
7.58
37.45
21.40
2007-08
16723.6
79644.5
257629
30.91
6.49
37.40
35.11
2008-09
20725.6
93671.7
308520
30.36
6.71
37.07
19.75
2009-10
28640.0
87135.9
300644
28.98
9.52
38.50
-2.55
2010-11
40546.9
105964.4
381061
27.80
10.64
38.44
26.74
2011-12
56249.3
154905.9
499533
31.01
11.26
42.27
31.09
%
Increase
in
Imports
As we can see from table 1, the imports have risen by about 32% in the year 2011-2012 and
by an average of 21 percent for the entire time period taken into consideration. Oil comprises
on an average nearly 30% of imports and gold around 8% of imports. Imports of oil and gold
have increased during this time period by around 25%. Hence the increase of the imports of
gold and oil has contributed to the overall increase of imports, which grew at an average of
21%.The Exports sector has not witnessed the same rise. Exports that are required to pay for
the imports of a country are not enough, growing at only 20% during this period.
We also analyse the quantity of oil imported and the value of this quantity. This helps in
understanding if the increase in the oil bill is due to increase in demand by India in terms of
quantity or is it the exchange rate depreciation and the price level of oil that inflates the oil
bill
Table 2:
Total
Qty.
(000
tonnes)
107189
117910
135972
152454
159421
182752
189359
196429
Year
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
Total
Value
(Rs
crores)
133586
203039
265839
340896
419008
419374
520101
746759
The value of oil imports has been rising at greater proportion than the quantity. This is mainly
due to depreciation of the rupee and also the price of oil.
Chart 1:
800000
700000
Oil imports
600000
500000
400000
300000
Total Qty.
200000
Total Value
100000
0
Years
The Quantity of oil imports has doubled in the time period taken in to consideration from
107189 thousand tonnes to almost 200000 thousand tonnes. But the value of these imports
has risen by 5 times to Rs. 746759 Crores from a mere Rs. 133586 Crores in 1999-00.
The second part of the Current Account is the Invisibles section. This section includes
receipts and payments from the services sector and unilateral transfers.
The services sector includes transportation, tourism, professional and other services, interest
and other investment income.
Invisibles have grown on an average of 22% in this time period though in the two years 20012002 and 2003-2004, they have grown by 52% and 62% respectively.
Chart 2:
INR
60.0000
50.0000
40.0000
30.0000
INR
20.0000
10.0000
0.0000
Chart 3:
Current Account
150000
100000
50000
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
-50000
1999
Trade balance
Invisibles
Services
-100000
Transfers
-150000
-200000
-250000
Years
The receipts from software services had started to rise during the early 2000s. This caused a
dip in the CAD initially, but the deficit soon recovered. This is due to excess income that had
come into the economy from the invisibles account that encouraged imports, which increased
continuously since 2001, from 14% to a high of 48% in 2004. The boost from the software
services and transfers account provided a temporary offset to the CAD.
The Continuous increase in the trade deficit continued till the recent financial crisis, where in
the trade deficit decreased by 1% compared to a 30% increase in the previous year of 20082009. But this was only short lived as the bad state of the global economy hit Indias exports
while imports werent as damaged as exports as India continued to grow and demand
commodities. The imports increased by about 45% in 2010-2011 while exports had only
increased by 23%.
The Invisibles account covers almost two-thirds of the trade deficit. But the weakening of the
global economy is threatening software businesses, which is affecting the receipts of software
services and transfers.
The foreign investment account has witnessed continuous inflows and it has been in the
positive square always. However this inflow is very volatile due to its heavy dependence on
foreign portfolio Investment rather than direct investment.
Hence what we can see is that if the financing of the CAD is being done by the inflows of the
FPI, then there is a reason to worry as this inflow is volatile and may anytime turn back due
to speculative reasons. Whereas the FDI is a more stable and reliable source of inflow.
Though it would be perfect to have the FDI in charge of the Foreign Investment, in reality it
is not so. The FPI is a much larger source of capital inflow than the FDI and the trend and
movement of foreign investment graphs move as an imitation of the FPI graph.
The Foreign Investment in the decade taken into consideration shows a continues rise, except
for a fall in 2008-09 due to the global financial crisis, which originated in the developed and
advanced economies causing the investments that came from these countries to fall. Hence
there was a dramatic decrease in the inflow though foreign investment. The year 2009-10
witnessed an increase in the foreign investment more than the years before the crisis, but this
lasted only a year and the foreign investment fell again though not as bad as in 2008-09.
Table 3:
Years
Foreign
FDI
Investments (Rs
(Rs crores) crores)
FPI
(Rs
crores)
1999
5117
2167
3024
2000
5862
3272
2590
2001
6686
4734
1952
2002
4161
3217
944
2003
13744
2388
11356
2004
13000
3713
9287
2005
15528
3034
12494
2006
14753
7693
7060
2007
43326
15893
27433
2008
8342
22372
-14031
2009
50362
17966
32396
2010
39653
9360
30292
2011
39231
22060
17170
The graph below shows the extent to which foreign investment depends on Foreign Portfolio
Investment.
Chart 4:
Foreign investment
60000
50000
40000
30000
Foreign inv
20000
FPI
FDI
10000
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
-10000
1999
-20000
Chart 5:
ECB
25000
20000
15000
10000
ECB
5000
0
-5000
Years
(i.e., through foreign direct investment or private equity/foreign venture capital investment
route), investment through American Depository Receipts/Global Depository Receipts, or
investment by NRI's and Persons of Indian Origin(PIO).
ForeignInvestment in India
Investment in
listed/unlisted
companies (except
through the route
of stock exchange)
FDI
PE/F
VCI
Institutional
investment in
listed companies
through stock
exchange
FII
ADR/GDR
Investment
by NRI and
PIOs
We take into consideration FII inflow into the country and see how it is affected by the INR
Table 4:
Years
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
FPI
(USD
million)
3024
2590
1952
944
11356
9287
12494
7060
27433
-14031
32396
30292
17170
CAD/GDP
-1.0
-0.6
0.7
1.2
2.3
-0.4
-1.2
-1.0
-1.3
-2.3
-2.8
-2.7
-4.2
USD/INR
43.60
46.64
48.80
47.50
43.44
43.75
44.60
43.59
39.98
50.94
45.13
44.64
51.16
In the early part of 2000-2010 periods the CAD continued to fall in view of increasing
receipts from the services section of the Current Account. This increase is mainly due to the
sudden rise in software services receipts. The software services contribution increased from
US$5,750 mn in 2000-01 to US$12,324 mn in 2003-04 an increase of 114%. This increase
had caused a reversal in the CAD, from -1.0% of GDP in 1999-00 to2.3% of GDP in 200304. This reversal in the CAD gave a positive outlook for the economy causing the rupee to
strengthen. The exchange rate which was Rs 48.8 to the USD in 2001-02 rose to Rs 43.44 in
2003-04. The rupee remained strong from then onwards and rose to Rs 39 during 2007-08
the year before the 2007-08 financial crisis, which then caused a major outflow of Foreign
Institutional Investment. The FPI ran into negative numbers as a consequence of the financial
crisis. It was US$14,031 mn in 2008-09. The CAD continued downward to -2.3% of GDP.
The financial crisis affected the exports sector and this lead to the rise in the CAD. Though
the FPI flows returned the following year, this was mainly due to the relative stable Indian
Economy as compared to the other developed economies which were affected badly by the
crisis. The inflow of Foreign Investments continued, but the CAD increased ever more
rapidly due to heavy imports of oil and gold. Due to the unsustainable level of CAD the rupee
weakened, reaching to a level of Rs 51 in 2010-11. The Rupee depreciation has continued
and the currency touched all time lows of Rs 61.21 in July 2013.
Table 5:
Years
Actual
Change in
Forex
Forex
reserves Forex(reserves
(USD
/+) (USD (USD
Million) Million) Million)
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
38036
42281
54106
76100
112959
141514
151622
199179
309723
251985
279057
304818
294398
-6142
-5842
-11757
-16985
-31421
-26159
-15052
-36606
-92164
20080
-13441
-13050
12831
-4245
-11825
-21994
-36859
-28555
-10108
-47557
-110544
57738
-27072
-25761
10420
Purchase Sale
Net
(USD
(USD
(USD
Year
Million) Million) Million)
1999-00 24077
20828
3249
-10,129
2000-01 28203
25847
2356
-20,324
2001-02 22822
15759
7063
-7,225
2002-03 30635
14926
15709
10,254
2003-04 55414
24941
30473
27,592
2004-05 31398
10551
20847
781
2005-06 15239
7096
8143
0
2006-07 26824
0
26824
0
2007-08 79696
1493
78203
68,323
2008-09 26563
61485
-34922
62,533
2009-10 4010
6645
-2635
4,643
2010-11 2450
760
1690
1,970
2011-12 1665
21803
-20138
-8,999
Source: RBI Handbook of Statistics 2011-12.
USD/INR
43.6050
46.6400
48.8000
47.5050
43.4450
43.7550
44.6050
43.5950
39.9850
50.9450
45.1350
44.6450
51.1600
The table above gives us the Purchase and Sale of USD by the RBI.
Foreign Institutional investors and trends of foreign institutional investment over the
past few years
Foreign Institutional Investors (FII) is entities established or incorporated outside India and
make proposals for investments in India. These investment proposals are made on behalf of
sub accounts which may include foreign corporate, individuals, funds, and other such
investors. FIIs have designated banks that are authorised to deal with them. The biggest
source through which FIIs invest is the issuance of Participatory Notes (P-Notes), which are
also known as Offshore Derivatives.
Table 7:
Foreign Institutional Investment Components
FII
INVESTMENT
IN
INR(CRORES)
Year
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
Average
Source: SEBI
Equity
9670
10207
8072
2527
39960
44123
48801
25236
53404
-47706
110221
110121
43738
Debt
453
-273
690
162
5805
1759
-7334
5605
12775
1895
32438
37317
49988
Total
10122
9933
8763
2689
45765
45881
41467
30840
66179
-45811
142658
146438
93726
%Equity
95.53
102.75
92.11
93.97
87.31
96.16
117.68
81.82
80.69
104.13
77.26
75.19
46.66
88.56
%Debt
4.47
-2.74
7.87
6.02
12.68
3.83
-17.68
18.17
19.30
-4.13
22.73
25.48
53.33
11.48
Foreign Institutional Investors invest in equity and debt market. Hence, the performance of
these two markets directly affects the inflows of foreign capital to the country, and in turn
affects the exchange rate through the capital movements.
Putting it all Together: The FPI, CAD and the INR
Table 8:
FPI
(USD
Years Million) CAD/GDP USD/INR
1999
3024
-1.0
43.60
2000
2590
-0.6
46.64
2001
1952
0.7
48.80
2002
944
1.2
47.50
2003
11356
2.3
43.44
2004
9287
-0.4
43.75
2005
12494
-1.2
44.60
2006
7060
-1.0
43.59
2007
27433
-1.3
39.98
2008
-14031
-2.3
50.94
2009
32396
-2.8
45.13
2010
30292
-2.7
44.64
2011
17170
-4.2
51.16
Source: RBI Handbook of Statistics 2011-12
The table 7 above shows us the trend of FPI, CAD and the exchange rate of the Indian rupee.
What can be noticed is that there has been a depreciation of the rupee, based on the flow of
FPI and also the strain on the CAD. The last year has seen a steep fall in all three variables. A
fall in the flow of foreign investment can dampen the spirit of the economy, by reducing the
funding of the Current Account and which in turn affects the INR.
6. Conclusion
It has been noticed that there is an interlink between the CAD, the INR and the FII. What has
to be noticed is the trend that they follow in comparison with each other. An outflow of
foreign investment may lead to the depreciation of the rupee, with foreign investors selling
their rupee investments for dollars, thereby increasing the supply of rupee and demand of
dollar. This may in turn affect the CAD by increasing the import bill, which has been
increasing more than the growth in exports, thereby offsetting any gains by increased exports
due to the depreciation.
This high CAD may in turn reflect badly on the market and create an outflow of investors,
due to an unsustainable CAD number. This will once again follow a similar pattern of
depreciation of the INR and then increase in the CAD.
This will lead to a slump in the economy which will decrease the imports and demand of the
economy, leading to a stable period before revival. Hence it can be interpreted that the
present slump in the economy is due to volatile foreign investment, combined with a
depreciating INR and an unsustainable number of the CAD.
Reforms have opened up the economy not only to opportunity but also to vulnerability. The
heavy dependence on the foreign investment to finance the CAD, is precarious, as we noticed
during 2007-08, there was an outflow of foreign investment leading to the RBI to dip into its
coffers for financing the CAD.
The heavy volatility of Foreign Investment needs to be stabilised if India is to possess a stable
exchange rate for a sustainable CAD. Regulations that encourage FDI and increase in the
exports are required.
The problem of CAD is mainly due to the imports of Oil and Gold. The latter can be
regulated, but the former is a necessity. The value of imports of oil has increased rapidly
owing mainly due to the depreciation of the Indian Rupee. Hence in order to ensure a
sustainable CAD it is imperative that there is stability in the exchange rate.
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