Monday, December 20, 2010

Mythbusting: Current account deficit edition

The question


In recent months, the current account deficit has risen. The latest data shows:

Sep 2009 -3.03
Dec 2009 -3.64
Mar 2010 -3.68
Jun 2010 -3.84

This has started making many people worried. Is such a `large' current account deficit a cause for concern?

The right answer

How long should a man's legs be? Long enough to touch the ground.

The old intuition


Under a fixed exchange rate, where the central bank holds the rate fixed by trading on the market:
  • Net capital inflow is an autonomous variable
  • All the capital that comes into the country is bought by the central bank (and vice versa), and this has consequences for sterilisation or monetary distortions.
  • You can then ask yourself whether the amount of capital coming into the country is "too much" or "too little".

The new intuition

But all this changes under a floating exchange rate!




As the graph above shows, RBI's trading on the currency market has been at near-zero values in recent months: we have something that is essentially a floating exchange rate. The rupee is now a fairly big market, and small scale trading by RBI has zero impact on the price: i.e. what we're seeing is a true market price. Under a floating exchange rate:
  • Net capital inflows = Current account deficit, as an accounting identity
  • If there is a sudden increase in capital inflows, this yields a rupee appreciation, which tends to increase the current account deficit. Conversely, if there is a sudden capital outflow, this yields a rupee depreciation, which tends to decrease the current account deficit. Through this, there are constant equilibriating forces which bring the two together.
With a floating exchange rate, you curiously look at the current account deficit and wonder that if there is some sudden international crisis (e.g. Lehman's death) whether there would be a short-run dislocation. For the rest, there is no policy involvement in either the current account deficit or in net capital inflows, both of which are purely market phenomena.

A new angle


In the very short run (e.g. a day), changes in the exchange rate can have little impact upon imports or exports. So if $10 billion suddenly leaves the country in a day, when the rupee depreciates, there can't be a response from import or exports immediately. The only response that can come about immediately is: from capital flows.

When $10 billion leaves the country, the rupee depreciates, and some investors think that they will score some nice returns by buying short-dated rupee securities. They step in in the breach, thus yielding an equilibrium.

So I will conjecture: A country that has capital controls against short-dated debt flows will have more volatility on the currency market.

Also see


Viewing the current account deficit as a capital inflow by Matthew Higgins and Thomas Klitgaard, FRBNY, December 1998.

Previous editions of `Mythbusting'


Mythbusting: Reserves edition, 18 October 2008.

5 comments:

  1. Slightly off track query here. Why the sudden rise in rupee trading by intl investors?

    ReplyDelete
  2. Hi Ajay,

    Just below the graph you write "...and small scale trading by RBI has zero impact on the price: i.e. what we're seeing is a true market price..."

    Well this still is not true price of rupee unless off course full convertibility is introduced. Would you agree with that ?

    Thanks,
    Neeraj.

    ReplyDelete
  3. Some queries I had:
    1. With the frequent RBI interventions; is our exchange rate policy closer to the fixed or flexible type?
    2. The bid-ask spreads on Rupee is not as narrow as the international currencies; would not that be a hindrance to the equilibrium condition you were talking about?

    ReplyDelete
  4. The intuition on the floating rate is accurate I believe, but is there any level where the deficit actually becomes dangerous? An interesting survey would be to see if the deficit is funding an investment (novel enough if the rate of return of higher than the rate of borrowing) or being used for consumption (hence destabilizing). More accurate reflections would actually emerge from the Revenue deficit and primary deficit. These are figures which actually appear very rarely on most deficit arguments......but the revenue deficit is a more accurate description of the adverse effects of a deficit. If investors were also made aware of such facts, I think both the financial and goods markets would benefit the Economy.

    ReplyDelete
  5. It also depends on political situation, image of the country(example-corruption and rule of law,tax policy) willingness of government to put budget deficit in order, financial market's price level and interest rate-inflation outlook. As in Calvo's term, when "sudden stop" happens all the developing-emerging nations are put in the same box and country with liability in nonnative currency face the max problems. CAD is a slippery slop, when government sees it is not a problem today it tends to allow it to go unchecked(example-US) until they realize otherwise when crisis hits.

    ReplyDelete

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