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