Impact of current account deficit and Balance of Payments (BOP) on the economy
Balance of payments (BOP) is an important concept in international economics. It is a record of all the economic transactions between a country and the rest of the world. It is divided into two main accounts: the current account and the capital account (Haekal, 2022). In this article, the concepts of balance of payment (BOP) and current account deficit are reviewed, with emphasis on the determinants of the latter.
The current account is a record of all transactions related to trade in goods and services, income, and current transfers. It includes exports and imports of goods and services, as well as money received or paid out in the form of rent, dividends, interest, and other forms of income. The capital account is a record of all transactions related to investments and other financial transactions. It includes foreign direct investment, portfolio investment, and other financial flows.
A country’s overall BOP can be in surplus (more money coming into the country) or deficit (more money leaving the country). A deficit in the BOP can lead to a devaluation of the country’s currency and a decrease in the country’s international reserves (Lioudis, 2022).
BOP = Current account + capital account + financial account + balancing item Where; Current Account = Balance in trade + Balance in services + Net income flows + Net current transfers Capital account = Surpluses or Deficits of Net Non-Produced + Non-Financial assets + Net Capital Transfers Financial account = Net direct investment + net portfolio investment + assets funding + errors and omissions Balancing items = Actual Change in International Reserves - (Current Account + Capital Account)
Calculating the balance of payments (Haekal, 2022)
Why is it important to study the Balance of Payments (BOP)?
The balance of payments (BOP) is an important indicator of a country’s economic health and its level of integration with the global economy. It provides a snapshot of a country’s economic transactions with the rest of the world, which can help policymakers and investors make informed decisions. It is important to study BOP for the following reasons (Melvin and Norrbin, 2017):
- It provides insight into a country’s trade and investment flows: The BOP shows, how much a country is exporting and importing. It can reveal trends in trade and investment flows. This information can be used to identify opportunities for trade and investment and to assess the competitiveness of a country’s economy.
- It can indicate a country’s ability to pay for imports: A BOP deficit means that a country is spending more on imports than it is earning from exports and other sources. This can lead to a decline in the country’s international reserves and a devaluation of its currency.
- It can indicate a country’s financial stability: A country with a large BOP deficit or surplus may be at risk of a financial crisis. A balance of payments (BOP) surplus can indicate a healthy economy and a strong currency, while a BOP deficit can indicate a weak economy and a vulnerable currency.
- It can indicate a country’s dependence on external sources of finance: A country that is dependent on external sources of finance, such as foreign investment or borrowing, may be more vulnerable to external economic shocks.
Impact of current account deficit on an economy
Evidence on the impact of the current account deficit on a country’s economic performance reveals contradicting findings. For instance, Freund and Warnock (2007), discovered in their study that increases in the current account deficit have a negative effect on economic growth. However, Telatar and Terzi, (2009), and Kostakglu and Dibo (2011), while examining developing countries found that the current account deficit is an indicator of strong economic growth.
On the other hand, Sharma and Pasricha (2020) who studied the economic trends up to 2017 found that in the case of India, the current account deficit has been detrimental to the exchange rate. Based on these findings, we can summarise the following effects of current account deficit for an economy:
- Dependence on foreign borrowing: A country with a negative current account balance may need to borrow money from other countries to finance its imports and pay for its trade deficit. This can increase the country’s dependence on foreign borrowing and make it more vulnerable to external economic shocks.
- A decline in international reserves: A negative current account balance can lead to a decline in the country’s international reserves, as it is spending more money on imports than it is earning from exports and other sources.
- Devaluation of the currency: A negative current account balance can put pressure on a country’s currency to devalue, as it increases the demand for foreign currency and decreases the demand for the country’s own currency.
- Increased inflation: An increase in imports can lead to an increase in domestic prices, as it increases the supply of goods and services in the domestic market, leading to inflation.
- Economic growth: A negative current account balance can reduce economic growth, as it reduces the amount of money available for domestic investment and consumption. However, it can also be a sign of economic growth, as more imports indicate increased consumption and demand for goods and services.
The determinants of current account deficit for India
The determinants of current account deficit vary from country to country. For instance, the international real interest rate, real exchange rate, per capita GDP, and level of exports were found to have an impact on the current account deficit of 44 developing countries Loayza and Chong, Alberto and Calderon, (1999). On the other hand, Sadiku et al., (2015) found that in the case of North Macedonia, there is a strong relationship between the current account, fiscal balance, financial development, terms of trade, and trade openness. In the case of India, there are few studies that explore the determinants of the current account deficit. Behera and Yadav (2019), point to fiscal deficit, terms of trade growth, inflation, real deposit rate, trade openness, relative income growth, and the age dependency factor as determinants of current account deficit. While Fayaz and Bhatia (2016), found increasing imports, restrictions on Foreign Direct Investment (FDI), Gross Domestic Product (GDP), Net Foreign Assets (NFA), Trade Openness, Real Effective Exchange Rate (REER), and Wholesale Price Index (WPI) as determinants of the current account deficit.
Overall, there are no recent studies dedicated to exploring the determinants of the current account deficit in India. In India, the current account deficit is one of the major macroeconomic problems due to the country’s dependence on imports, especially oil. The prevalence of the current account deficit results in decreasing the efficiency of the economy in attaining competitive advantage and supporting domestic businesses. Thus, for managing the issue there is a need to understand the factors contributing to rising in the current account deficit and the economic status of India so that suitable policies for improvement can be suggested.
- Behera, H. K. and Yadav, I. S. (2019) ‘Explaining India’s current account deficit: a time series perspective’, Journal of Asian Business and Economic Studies, 26(1).
- Fayaz, M. and Bhatia, S. K. (2016) ‘Trends, patterns and determinants of Indian current account deficit’, Applied Econometrics and International Development, 16(1).
- Freund, C. and Warnock, F. (2007) ‘Current Account Deficits in Industrial Countries: The Bigger They Are, The Harder They Fall?’, NBER Chapters, in: G7 Current Account Imbalances: Sustainability and Adjustment, pp. 133–168.
- Haekal, R. (2022) Balance of payments, Investopedia.
- Kostakglu, F. and Dibo, M. (2011) ‘Türkiye’de Cari Açık ve Ekonomik Büyüme İlişkisinin VAR Yöntemi ile Analizi’, in Anadolu International Conference in Economics II. Eski ş ehir.
- Lioudis, N. (2022) How Does the Balance of Payments Impact Currency Exchange Rates?, Investopedia.
- Loayza, N. and Chong, Alberto and Calderon, C. A. (1999) ‘Determinants of Current Account Deficits in Developing Countries’. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=630771.
- Melvin, M. and Norrbin, S. (2017) ‘Chapter 3 – The Balance of Payments’, in International Money and Finance (Ninth Edition). 9TH edn. Science Direct, pp. 59–83.
- Sadiku, L. et al. (2015) ‘The Persistence and Determinants of Current Account Deficit of FYROM: An Empirical Analysis’, in 7th International Conference, The Economies of Balkan and Eastern Europe Countries in the changed world. Procedia Economics and Finance.
- Sharma, P. and Pasricha, S. (2020) ‘A Trend Analysis of Current Account Deficit and Its Determinants in India’, International Journal of Scientific Research in Engineering and Management, 4(4).
- Telatar, O. M. and Terzi, A. (2009) ‘Turkey in the Economic Growth and Current Account Balance Relationship’, Ataturk University Faculty of Economics and Administrative Sciences School Journal, 23, pp. 119–134.