Current account deficit and Unfavorable balance of payment
Current Account Deficit
The current account deficit is a measurement of a country’s trade where the value of the goods and services it imports exceeds the value of the products it exports. The current account includes net income, such as interest and dividends, and transfers, such as foreign aid, although these components make up only a small percentage of the total current account. The current account represents a country’s foreign transactions and, like the capital account, is a component of a country’s balance of payments (BOP).
The current account balance seems to be an abstruse economic concept. But in countries that are spending a lot more abroad than they are taking in, the current account is the point at which international economics collides with political reality. When countries run large deficits, businesses, trade unions, and parliamentarians are often quick to point accusing fingers at trading partners and make charges about unfair practices. Tension between the United States and China about which country is primarily responsible for the trade imbalance between the two has thrown the spotlight on the broader consequences for the international financial system when some countries run large and persistent current account deficits and others accumulate big surpluses.
- A current account deficit indicates that a country is importing more than it is exporting.
- Emerging economies often run surpluses, and developed countries tend to run deficits.
- A current account deficit is not always detrimental to a nation’s economy—external debt may be used to finance lucrative investments.
Managing a Current Account Deficit
A country can reduce its existing debt by increasing the value of its exports relative to the value of imports. It can place restrictions on imports, such as tariffs or quotas, or it can emphasize policies that promote export, such as import substitution, industrialization, or policies that improve domestic companies’ global competitiveness. The country can also use monetary policy to improve the domestic currency’s valuation relative to other currencies through devaluation, which reduces the country’s export costs.
While an existing deficit can imply that a country is spending beyond its means, having a current account deficit is not inherently disadvantageous. If a country uses external debt to finance investments that have higher returns than the interest rate on the debt, the country can remain solvent while running a current account deficit. If a country is unlikely to cover current debt levels with future revenue streams, however, it may become insolvent.
Factors which cause a current account deficit
A current account deficit occurs when the value of imports (of goods, services and investment income) is greater than the value of exports.
There are various factors which could cause a current account deficit:
- Overvalued exchange rate
If the currency is overvalued, imports will be cheaper, and therefore there will be a higher quantity of imports. Exports will become uncompetitive, and therefore there will be a fall in the quantity of exports. Countries in the Eurozone (e.g. Greece, Portugal and Spain) experienced an overvalued exchange rate (and they couldn’t devalue). In 2007, these three countries had a current account deficit equal to 10% of GDP.
- Economic growth
If there is an increase in national income, people will tend to have more disposable income to consume goods. If domestic producers cannot meet the domestic demand, consumers will have to import goods from abroad. In the UK we have a high marginal propensity to imports (mpm) because we do not have a comparative advantage in the production of manufactured goods. Therefore if there is fast economic growth there tends to be a significant increase in the quantity of imports and a deterioration in the current account.
- Decline in competitiveness/export sector
In the UK, there has been a decline in the exporting manufacturing sector because it has struggled to compete with developing countries in the far east. This has led to a persistent deficit in the balance of trade.
- Higher inflation
If UK inflation rises faster than our main competitors then it will make UK exports less competitive and imports more competitive. This will lead to deterioration in the current account. However, inflation may also lead to a depreciation in the currency to offset this decline in competitiveness.
- Recession in other countries
If the UK’s main trading partners experience negative economic growth, then they will buy less of our exports, worsening the UK current account.
- Borrowing money
If countries are borrowing money to invest e.g. third world countries, then this will lead to deterioration in current account position.
- Financial flows to finance current account deficit.
If a country can attract more financial flows (either short-term portfolio investment or long-term direct investment), then these flows on the financial account will enable the country to run a larger current account deficit. For example, the UK has run a persistent current account deficit since the 1980s; this reflects the fact the UK has attracted capital flows to finance this current account deficit. Without financial flows, the currency would depreciate until equilibrium is restored.
Balance of Payment
Balance of Payment (BOP) of a country can be defined as a systematic statement of all economic transactions of a country with the rest of the world during a specific period usually one year.
The systematic accounting is done on the basis of double entry book keeping (both sides of transactions credit and debit are included). Economic transaction includes all such transactions that involve the transfer of title or ownership of goods and services, money and assets.
The Balance of Payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country.
If a country has received money, this is known as a credit, and, if a country has paid or given money, the transaction is counted as a debit. Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance. But in practice this is rarely the case and, thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.
Balance of Payments Problem in India!
What measures can be adopted to tackle the problem of disequilibrium in the balance of payments will also be discussed: About 15 years ago in 1991 India had to experience a severe balance of payments crisis.
A default on payments, which would have a disastrous consequent for the Indian economy, had become for the first time in our history a serious possibility in June 1991. It was at this time that new Congress Government with Dr. Manmohan Singh as our Finance Minister took several short-term and long-term measures to overcome the balance of payments crisis.
Apart from undertaking various measures of domestic liberalisation, he took several for-reaching measures relating to balance of payments problem. Rupee was devalued in July 1991 and later in two years’ time, foreign exchange rate of rupee was made market-determined and also convertible into foreign currencies.
Anti-export basis in our economic strategy was removed and accordingly tariffs on imports were reduced, so as to promote competition. In this way costly import-substitution strategy of industrialisation was abandoned. These measures bore fruits and India was successful in solving the balance of payments problem. Our exports started growing at a relatively rapid rate than before. Capital flows and remittances by NRIs increased manifold. Of course for a short time, we got special assistance from IMF and World Bank to fulfill our obligations regarding balance of payments.
Balance of Trade and Balance of Payments:
Balance of trade and balance of payments are two related terms but they should be carefully distinguished from each other because they do not have exactly the same meaning. Balance of trade refers to the difference in value of imports and exports of goods only, i.e., visible items only. Movement of goods between countries is known as visible trade because the movement is open and can be verified by the customs officials.
During a given period of time, the exports and imports of goods or merchandise may be exactly equal, in which case, the balance of payments of trade is said to be balanced. But this is not necessary, for those who export and import are not necessarily the same persons. If the value of exports exceeds the value of imports, the country is said to experience an export surplus or a favourable balance of trade. If the value of its imports exceeds the value of its exports, the country is said to have a deficit or an adverse balance of trade.
The terms “favourable” and “unfavourable” are derived from the mercantilist writers of the 18th century. In those days, settlements of the foreign transactions were made in gold. If India had exported Rs. 1000 crore worth of goods but had imported Rs.800 crore worth of goods, India would receive Rs. 200 crores worth of gold from the foreign countries. As gold was regarded as wealth and as the receipts of gold made a country wealthy, the mercantilist writers regarded exports surplus as being favourable to the country.
On the other hand, if India had exported Rs. 1000 crores worth of goods, but imported Rs. 1500 crores worth of goods, it had to pay Rs. 500 crores in gold to the foreigners. India would be losing gold and would be poorer to that extent. Therefore, an import surplus was regarded by the mercantilist writers as adverse balance. But in these days, the international transactions are not settled in terms of gold. Even then, the terms “favourable” and “unfavourable” balance of trades has continued to be used till today.
Effects
Initially, a trade deficit is not necessarily a bad thing. It can raise a country’s standard of living because its residents gain access to a wider variety of goods and services for a more competitive price. It can also reduce the threat of inflation since it creates lower prices. A trade deficit may also indicate that the country’s residents are feeling confident and wealthy enough to buy more than the country produces.
Over time, however, a trade deficit can cause more outsourcing of jobs to other countries. As a country imports more goods than it buys domestically, then the home country may create fewer jobs in certain industries. At the same time, foreign companies will likely hire new workers to keep up with the demand for their exports.
Budgetary Deficit is the difference between all receipts and expenditure of the government, both revenue and capital. This difference is met by the net addition of the treasury bills issued by the RBI and drawing down of cash balances kept with the RBI. The budgetary deficit was called deficit financing by the government of India. This deficit adds to money supply in the economy and, therefore, it can be a major cause of inflationary rise in prices.
Budgetary Deficit of central government of India was Rs. 2,576 crores in 1980-81, it went up to Rs. 11,347 crores in 1990-91 to Rs. 13,184 crores in 1996-97.
The concept of budgetary deficit has lost its significance after the presentation of the 1997-98 Budget. In this budget, the practice of ad hoc treasury bills as source of finance for government was discontinued. Ad hoc treasury bills are issued by the government and held only by the RBI. They carry a low rate of interest and fund monetized deficit. These bills were replaced by ways and means advance. Budgetary deficit has not figured in union budgets since 1997-98. Since 1997-98, instead of budgetary deficit, Gross Fiscal Deficit (GFD) became the key indicator.
- The difference between total revenue and total expenditure of the government is termed as fiscal deficit. It is an indication of the total borrowings needed by the government and thus amounts to all the borrowings of the government . While calculating the total revenue, borrowings are not included.
- The gross fiscal deficit (GFD) is the excess of total expenditure including loans net of recovery over revenue receipts (including external grants) and non-debt capital receipts. The net fiscal deficit is the gross fiscal deficit less net lending of the Central government.
- Generally fiscal deficit takes place either due to revenue deficit or a major hike in capital expenditure. Capital expenditure is incurred to create long-term assets such as factories, buildings and other development.
- A deficit is usually financed through borrowing from either the central bank of the country or raising money from capital markets by issuing different instruments like treasury bills and bonds.
- Revenue deficit is concerned with the revenue expenditures and revenue receipts of the government. It refers to excess of revenue expenditure over revenue receipts during the given fiscal year.
- Revenue Deficit = Revenue Expenditure – Revenue Receipts
- Revenue deficit signifies that government’s own revenue is insufficient to meet the expenditures on normal functioning of government departments and provisions for various services.
- In India social expenditure like MNREGA is a revenue expenditure though a part of Plan expenditure.
- Its targeted to be 2.9% of GPD in the year 2014-15, though the fiscal revenue and budget management act specifies it to be zero by 2008-09
Subsidies- Cash Transfer of Subsidy Issue.
A subsidy is a benefit given by the government to groups or individuals usually in the form of a cash payment or tax reduction. The subsidy is usually given to remove some type of burden and is often considered to be in the interest of the public.
Direct Cash Transfer Scheme is a poverty reduction measure in which government subsidies and other benefits are given directly to the poor in cash rather than in the form of subsidies.
It can help the government reach out to identified beneficiaries and can plug leakages. Currently, ration shop owners divert subsidised PDS grains or kerosene to open market and make fast buck. Such Leakages could stop. The scheme will also enhance efficiency of welfare schemes.
The money is directly transferred into bank accounts of beneficiaries. LPG and kerosene subsidies, pension payments, scholarships and employment guarantee scheme payments as well as benefits under other government welfare programmes will be made directly to beneficiaries. The money can then be used to buy services from the market. For eg. if subsidy on LPG or kerosene is abolished and the government still wants to give the subsidy to the poor, the subsidy portion will be transferred as cash into the banks of the intended beneficiaries.
It is feared that the money may not be used for the intended purpose and men may squander it.
Electronic Benefit Transfer (EBT) has already begun on a pilot basis in Andhra Pradesh, Chhattisgarh, Punjab, Rajasthan, Tamil Nadu, West Bengal, Karnataka, Pondicherry and Sikkim. The government claims the results are encouraging.
Only Aadhar card holders will get cash transfer. As of today, only 21 crore of the 120 crore people have Aadhar cards. Two other drawbacks are that most BPL families don’t have bank accounts and several villages don’t have any bank branches. These factors can limit the reach of cash transfer.
- Subsidy is one of the powerful fiscal instruments, besides taxes and others, by which the objective of growth and social justice may be achieved.
- Subsidies alter relative prices and budget constraints and thereby affect decisions concerning production, consumption and allocation of resources. Like many other countries, subsidies in Indian economy are pervasive. These are explicit or hidden and include the areas such as education, health, environment and variety of economic activities including agriculture and transport. Nearly 66 per cent of the people in India are still dependent on agriculture. The subsidies to agricultural sector provided by the government have recorded phenomenal rise during the past two decades.
- The agricultural subsidies act as an incentive to promote agricultural development. In order to attain the goal of self-sufficiency in food, government adopts short term policies such as support prices of products and input subsidy to stimulate the products to increase the food production. It is expected that subsidies contribute to better cropping pattern, employment and income of the beneficiaries. But in most development programmes, subsidies are one among the many developmental inputs being provided. Thus the observable changes in cropping pattern, employment level and overall incomes are because of the joint effect of all the efforts going on. Therefore, these changes cannot be attributed solely to subsidies.
- The subsidies may be direct or indirect, cash or kind, general or particular, budgetary or non budgetary, etc. But their impact is practically visible on both the production and distribution. The economic rationale of subsidies lies in incentivising the producers to invest in productive activities and increase production leading to high growth in national income and obtaining desirable structure of production.
Subsidies in Indian agriculture are of four types :
Explicit Input Subsidies
- Explicit input subsidies are payments made to the farmers to meet a part of the cost of an input. These are in the nature of explicit payments made to the farmer. For example, subsidy on improved or high yielding variety seeds, plant protection chemicals and equipments, improved agricultural implements and supply of minikits containing seeds, fertilizers and plant protection chemicals for certain crops are the explicit subsidies.
Implicit Input Subsidies
- While there is transparency in explicit input subsidies, implicit input subsidies are hidden in nature. The latter arise on account of the mechanics of pricing of inputs. If inputs whose prices are administratively determined are priced low as compared to their economic cost, it becomes a case of implicit subsidization. As far as the farmer is concerned, he does not receive any direct payment but somebody in the economy accounts for the difference.
Output Subsidies Subsidization of agricultural sector through output pricing means that by a restrictive trade policy, the product prices in the domestic market are maintained at levels higher than those that would have prevailed in the absence of restrictions on trade. On the other hand, if the trade policies have resulted in keeping the domestic prices lower than the corresponding border reference price, the policies have taxed the agricultural sector. The border reference price is the free on board prices in the case of exportables and cost, insurance and freight price in the case of importables.
Food Subsidies This apart, there is an important subsidy linked to the agricultural sector and that is the food subsidy. The twin policy of providing market support to the foodgrains producers and supplying atleast a part of the requirement to consumers at reasonable prices, along with the policy of maintaining a buffer- stock of required quantity for national food security, involved cost in the form of meeting the differences between the economic cost and issue prices of foodgrains.
There are several types of Federal Farm Subsidies:
- Direct payments. ‘‘Direct’’ payments are cash subsidies for producers of selected crops like wheat, corn, sorghum, barley, oats, cotton, rice, soybeans, minor oilseeds, and peanuts. Direct payments are based on a historical measure of a farm’s acreage used for production, but some payments go to owners of land that is no longer even used for farming.
- Marketing loans. The marketing loan program is a price support program that began in the New Deal era. The program encourages overproduction by setting a price floor for crops and by reducing the price variability that would otherwise face producers in the free market. The marketing loan program covers the same crops as the direct subsidy program.
- Insurance. When viewed internationally, the Risk Management Agency runs the USDA’s farm insurance programs, which are available to farmers to protect against adverse weather, pests, and low market prices.
- Disaster aid. In federal system, the government operates various crop insurance and disaster assistance programs for farmers. In addition, Congress frequently declare ‘‘disasters’’ whenever the slightest adverse event occurs, and often distributes special payments to farmers regardless of whether they sustained substantial damage.
- Export subsidies. The USDA operates a range of programs to aid farmers and food companies with their foreign sales.
- Agricultural research and statistics. Most American industries fund their own research and development programs.
- The agricultural sector in India enjoys both input and output subsidies. This chapter provides an overview of agricultural input subsidies in the state, based on secondary data. It is presented in four sections. The first section gives the kinds of subsidies admissible in the year 2000-2001 under different agricultural programmes of State Agricultural Department. The second section gives an account of direct subsidies made available by the Departments of Agriculture, Horticulture, Animal Husbandry and Fisheries. The third section gives details of estimation of the indirect subsidies viz. fertilisers, power and irrigation and in the fourth section the total agricultural subsidies both direct and indirect are analysed.
- Subsidies do not reach the marginalized farmers
The marginalized farmers, the main target audience for the government to come up with subsidies in the first place are found wanting of the same. Effectively, the more well off farmers end up taking more than their fair share.
- The fiscal burden on the government
The government fails to recover its costs because of taxation issues and is thus led to borrow from other sources. Ineffective taxation policies end up taking their toll on the government’s developmental plans.
- The APMC Act
The APMC Act was set up by the government, as a means to improve the efficacy of the process of the farmers getting their rightful price due to them, through the establishment of middlemen acting as links to the chain. Sadly though, their main prerogative was rendered ineffective, due to their own middlemen.
The APMC act established mandis, where farmers auction their produce. The presence of middlemen, effectively multiplied prices at each level which thus led to higher prices and lower profits for the farmers.
Dealing with Harmful Subsidies
Excess subsidisation is not just an unwarranted fiscal cost. It can do significant damage. For example, oversubsidisation of fertilisers, leads to excessive use of fertilisers, pesticides and other agricultural inputs that have environmentally detrimental effects leading to erosion, compaction, and denitrification of top soil. Similarly, excess subsidisation of water causes drying up of rivers, declining water tables and soil erosion. Excess subsidisation of diesel compounds environmental pollution.
- Solution Strategy
A proposed solution strategy to be effective would need to work on three basic levels.
- Customer Base Identification and Selective Targeting
- Effective channelization of subsidies
- Logistics Support.
- Customer Base Identification
- Segmenting farmers into three broad categories based on their economic status, to ensure that the subsidies reach the ones most in need. A proposed model that takes in certain parameters, assigning them different weights through Principal Component Analysis (PCA) and comparing it through a seismic inspired model.
- Logistics From a logistical standpoint the system needs to develop into a more transparent setup. This can be ensured by integrating the UID (Aadhar) system into the fold. This integration would ensure that leaks are prevented and a more transparent and effective system of monetary transfer is established. Cashless and quick transfer of funds could thus become possible, helping weed out the need for middlemen in the system as a whole.
- This proposed model may not be fully effective and has its fallacies, this may not be the best way of coming out with this issue. But, the issue of ineffective agricultural subsidization is one of national importance. This is but a endeavor to think about the same and to come up with something that could help enliven the lives of our farmers.
Current strategy of Government for social sector subsidies
- In its three-year action plan for the economy the government think-tank mooted a reduction in food subsidies as a proportion of GDP by 2019-20 through better targeting and rationalisation measures.
- Within revenue expenditures, subsidies have tended to crowd out the socially more productive expenditures such as those on education and health.
- While in absolute terms, the allocation towards food subsidy, as per the Aayog, will increase marginally to ₹1.57 lakh crore from ₹1.24 lakh crore, as a proportion to GDP, the expenditure will come down to 0.73% from 0.90% in 2015-16.
- The government’s allocations are based on reduction in food subsidy as a proportion to GDP from 0.90% in 2015-16 to 0.73% in 2019-20.
- The efficiency of social expenditure must be improved to deliver better outcomes. This may be done for example through better targeting and the use of direct benefit transfers. Open ended schemes that can absorb rising expenditures and lack clearly identified beneficiaries must be avoided.
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