Current account deficit

Also written CAD · Current account deficit (CAD)

The gap that arises when a country imports more goods and services than it exports, making it a net borrower of foreign currency from the rest of the world.

In plain language

A country buys things from abroad and sells things abroad. When it buys more than it sells, the difference has to be paid for somehow, in foreign currency.

That shortfall is the current account deficit. It means the country, as a whole, owes the rest of the world money.

How it works

The current account balance is the difference between total exports and total imports of goods and services; the narrower difference in goods alone is the trade balance.

Emerging economies often run large current account deficits, because they need to import commodities and other inputs to keep their economies running. India is a net importer of commodities, so its CAD depends heavily on the rupee's exchange rate and world oil prices.

The deficit has to be funded one of two ways: foreign capital inflows — foreign direct or portfolio investment — can offset the gap in net exports; or, if those inflows are insufficient, the central bank runs down its forex reserves to cover the shortfall.

A worked example

Illustrative figures — the workbook explains the current account deficit in words only and gives no CAD figure of its own, so these numbers are for illustration.

Suppose India's GDP for a year is Rs 300 lakh crore, and the current account deficit for that year works out to 1.5% of GDP — a shortfall of Rs 4.5 lakh crore that has to be funded in foreign currency.

India imports crude oil, electronics and gold worth more than it exports in software services and other goods combined, resulting in a current account deficit for the year. Global oil prices then rise sharply, widening India's oil import bill and pushing the CAD from 1.5% of GDP to 2.2% of GDP — an extra Rs 2.1 lakh crore of shortfall to fund.

If foreign portfolio and direct investment inflows into India remain strong that year, those inflows can offset the wider trade gap without pressuring the rupee much. But if foreign investors pull money out at the same time oil prices are rising, the Reserve Bank of India has to draw down its foreign exchange reserves to meet the shortfall — and the rupee typically weakens against the dollar as a result, which in turn raises the rupee cost of the next round of oil imports.

Why NISM asks about it

Chapter 2, section 2.8 (Impact of Macro-Economic Factors on Asset Classes), covers the current account deficit as one of the macro factors that move asset classes, with its own short sub-section. Expect a definitional question and one on how a CAD is financed (capital inflows versus reserve drawdown).

Common exam traps

Trade balance is goods only; the current account balance also includes services. India often narrows a wide goods deficit with a services (especially software) surplus.
A CAD is not automatically a crisis — it can be comfortably financed by strong capital inflows; the risk arises when inflows dry up and reserves have to be run down instead.
India's CAD is described as depending critically on oil prices and the exchange rate because the country is a net commodity importer — do not generalise this driver to every emerging economy without qualification.

Check yourself

1.India's current account deficit is said to depend critically on which two variables, and what happens if capital account inflows are insufficient to cover it?
1. a)The repo rate and the fiscal deficit; the government issues additional bonds
2. b)The rupee exchange rate and world oil prices; the country's forex reserves have to be run down by the central bank
3. c)GDP growth and the inflation rate; imports are banned by the government
4. d)The trade balance and the WPI; the RBI raises the cash reserve ratio
Show the answer
Answer: (b) The rupee exchange rate and world oil prices; the country's forex reserves have to be run down by the central bank
Because India is a net importer of commodities, the CAD depends critically on the exchange rate of the rupee and world oil prices. A weaker rupee or costlier oil widens the deficit through the import bill.

There are only two ways to manage it. First, foreign inflows on the capital account, such as foreign direct or portfolio investment, can offset the gap in net exports. Second, and only when those fall short, the country's forex reserves have to be run down by the central bank.

A CAD means the country is importing more from the rest of the world than it exports, so it is a net debtor of foreign currency — a position the workbook notes emerging economies often occupy because they must import inputs for economic activity.
2.What do health insurance policies in India cover, and what does that imply for retirement planning?
1. a)All medical expenses including medicines and long-term care, so no separate provision is needed
2. b)Only hospitalisation and related expenses, so a medical corpus is needed for medicines, doctors' visits, tests and long-term care
3. c)Only long-term care, with hospitalisation met from savings
4. d)Only expenses incurred after age 60
Show the answer
Answer: (b) Only hospitalisation and related expenses, so a medical corpus is needed for medicines, doctors' visits, tests and long-term care
⚠️ "HEALTH INSURANCE POLICIES IN INDIA COVER ONLY HOSPITALISATION AND RELATED EXPENSES. IT IS IMPORTANT TO BUILD A MEDICAL CORPUS TO TAKE CARE OF THE OTHER EXPENSES."

And those other expenses are substantial: ⚠️ "MEDICAL COSTS ARE NOT LIMITED TO HOSPITALISATION EXPENSES ALONE. THERE ARE OUT OF POCKET EXPENSES FOR MEDICINES, DOCTORS' VISITS AND TESTS, APART FROM LONG-TERM CARE COSTS THAT HAVE TO BE ACCOUNTED FOR AND PROVIDED FOR."

A client with a Rs 10 lakh policy and no medical corpus is well protected against one surgery and entirely unprotected against a decade of monthly prescriptions and consultations. Two instruments for two different problems.

⚠️ How the corpus should be held at retirement: "THE MEDICAL CORPUS... HAS TO BE MOVED TO LIQUID ASSETS FOR AT LEAST 3 YEARS OF EXPENSES, WHILE THE REST CAN BE HELD IN PRODUCTS WITH BETTER RETURNS THOUGH NOT VERY RISKY."

And a further reason estimates run short: ⚠️ "INFLATION APPLICABLE TO HEALTH EXPENSES ARE TYPICALLY MUCH HIGHER THAN THAT RELATED TO OTHER CONSUMER COSTS."
3.A fund with an average return of 12 percent delivers 21 percent, then 13 percent, then 16 percent. How does the workbook describe its riskiness?
1. a)Not risky at all, since every period beat the average
2. b)Statistically risky because returns varied from the average — but investors will see it as risky only if returns fall below 12 percent
3. c)Risky only because the returns are high, which always implies high risk
4. d)Impossible to assess without knowing the benchmark
Show the answer
Answer: (b) Statistically risky because returns varied from the average — but investors will see it as risky only if returns fall below 12 percent
This is the chapter's sharpest distinction. "An investment is considered risky IF THERE IS A VARIATION IN THE ACTUAL RETURNS FROM THE AVERAGE RETURN, IRRESPECTIVE OF WHETHER THE VARIATION IS ON THE HIGHER SIDE OR LOWER SIDE. INVESTORS HOWEVER CONSIDER ONLY VARIATION TO THE DOWNSIDE AS RISKY."

Applied to this fund: it is seen as a risky investment BECAUSE THE RETURNS WERE VARIED. HOWEVER, INVESTORS WILL SEE THIS INVESTMENT AS RISKY ONLY IF THE RETURNS ARE LOWER THAN 12 PERCENT.

⚠️ Every one of the three periods beat the average, so nobody holding it experienced any loss — yet the statistic correctly flags volatility.

Understanding this gap is practical, not academic. When you show a client a high standard deviation, they will point at three good years and disagree. The honest reply is that the same volatility which produced 21 percent can produce 3 percent — the measure describes the machine, not its last three outputs.

Where this is taught

Series XVII · Chapter 2: Financial Markets & Investment Products

Free preparation for NISM Series XVII

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