Sunday, July 03, 2011

New BOP data -- a reminder of the paradigm shift that is required in our heads

Recently, India released BOP data. Many people, writing about this new data, wrote text such as:
The current account deficit (CAD) moderated to 1.1% of GDP in Q1 from 2.2% in Q4 2010, due to an improvement in the trade deficit and a sharp rise in the invisibles surplus.

Net capital inflows moderated sharply to 1.7% of GDP in Q1 from 2.9% in Q4, due to a steep fall in equity inflows and a moderation in debt capital inflows.
This is wrong.

Under a floating rate, the current account deficit is the same as net capital flows. Net capital flows finance the current account deficit. The exchange rate is moving constantly so that the two are equalised. It's no longer the case that each of these have a distinct and unrelated causal story.

Under a fixed exchange rate, such decoupled thinking was okay! You would look at the trade side and talk about why the CAD moved. You would look at capital flows and talk about why the net capital inflow moved. The two stories would take place on their own without a tight connection. That intuition has to be jettisoned once a country grows up into a market determined (i.e. floating) exchange rate, where there is a new macroeconomics which shapes both pieces.

On this theme, see Mythbusting: Current account deficit edition, on this blog, 20 December 2010.

Most of what we knew about Indian macroeconomics in 1993 has become obsolete. The good news is that standard undergraduate textbooks in macroeconomics, which are used internationally, are now much more useful in understanding India when compared with the way things used to be. And, you might like to read this integrated kit of four papers -- one, two, three, four -- which will give you a modern framework for thinking about Indian macroeconomics. If I had to teach a class in macroeconomics in India, I would teach these four papers (along with some other material).

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