20 April 2021

BOP, CAD and Fiscal Deficit

Analysis
Task - 5

SUBMITTED BY
Shubham Naik
21WM60 B2
I : Balance of Payment (BOP) Analysis

The balance of payments is the record of all international trade and financial transactions made
by a country's residents.

The balance of payments has three components—the current account, the financial account,
and the capital account. Current accounts measure international trade, net income on
investments, and direct payments. The financial account describes the change in international
ownership of assets. The capital account includes any other financial transactions that don't
affect the nation's economic output.

Trend of bop for the last 10 years

Trend of BOP (Amt in Rs billion)

Year Current A/C Capital A/C BOP
2010 -2196.5 2911.7 715.2
2011 -3759.7 3190.3 -569.4
2012 -4796.1 4857.3 61.2
2013 -1871.4 2898.2 1026.8
2014 -1633.1 5475.5 3842.4
2015 -1437.6 2663.4 1225.8
2016 -969.2 2443.4 1474.2
2017 -3141.3 5891.2 2749.9
2018 -4002.3 3834 -168.3
2019 -1724.3 5885.8 4161.5

BOP follows the double entry system of accounting i.e. every debit has a corresponding credit.
Ideally, when all the components are rightly accounted for, the net sum would be ‘zero’. India
has a deficit current account with the value of the imports exceeding the value of exports for
most of the years. This negative current account is covered up by the positive capital account
(funded by foreign Investments, loans etc.).

However, as per the data provided by RBI, for 2018-19, the positive capital account could not
cover up for the current account deficit and hence the overall deficit in BOP was to the tune of
₹ 202 billion. This amount is balanced out through foreign exchange reserves. Over the last
decade (barring one year), the capital account was able to balance out the negative current
account.
Comparative analysis on BOP of India, USA, Brazil, Russia and China

Current situation of BOP in India

India’s current account surplus moderated to US$ 15.5 billion (2.4 per cent of GDP) in Q2 of
2020-21 from US$ 19.2 billion (3.8 per cent of GDP) in Q1 of 2020-21; a deficit of US$ 7.6
billion (1.1 per cent of GDP) was recorded a year ago [i.e. Q2 of 2019-20]. A balance of
payments surplus means the country exports more than it imports. It provides enough capital
to pay for all domestic production. The country might even lend outside its borders. A surplus
boosts economic growth in the short term. Owing to the Atmanirbhar movement to ramp up
the domestic production had a positive impact on the Indian economy.

• The narrowing of the current account surplus in Q2 of 2020-21 was on account of a rise
in the merchandise trade deficit to US$ 14.8 billion from US$ 10.8 billion in the
preceding quarter.
• Net services receipts increased both sequentially and on a year-on-year basis, primarily
on the back of higher net earnings from computer services.
• Private transfer receipts, mainly representing remittances by Indians employed
overseas, declined on a y-o-y basis but improved sequentially by 12 per cent to US$
20.4 billion in Q2 2020-21.
• Net outgo from the primary income account, primarily reflecting net overseas
investment income payments, increased to US$ 9.3 billion from US$ 8.8 billion a year
ago.

Current situation of BOP in USA

The trade deficit in the US widened for the second month to USD 71.1 billion in February of
2021 from a revised USD 67.8 billion in the previous month, slightly above market
expectations of a USD 70.5 billion gap. It is the biggest trade deficit on record as imports fell
less than exports, in another sign the American economy recovers faster than its trading
partners from the pandemic hit.

• The U.S. Census Bureau and the U.S. Bureau of Economic Analysis announced today
that the goods and services deficit was $68.2 billion in January, up $1.2 billion from
$67.0 billion in December, revised.
• January exports were $191.9 billion, $1.8 billion more than December exports. January
imports were $260.2 billion, $3.1 billion more than December imports.
 • The January increase in the goods and services deficit reflected an increase in the goods
deficit of $1.3 billion to $85.4 billion and an increase in the services surplus of $0.1
billion to $17.2 billion.
• Year-over-year, the goods and services deficit increased $23.8 billion, or 53.7 percent,
from January 2020. Exports decreased $15.7 billion or 7.6 percent. Imports increased
$8.1 billion or 3.2 percent.

Current situation of BOP in Brazil

Brazil's current account deficit narrowed to USD 2.3 billion in February of 2021 from USD 4.7
billion in the same month of the previous year and below market expectations of a USD 2.4
billion gap. The services deficit shrank to USD 1.4 billion, from USD 2.3 billion a year earlier,
while the goods surplus narrowed to USD 0.4 billion from USD 1.8 billion in January of 2020,
due to a 14.5 percent jump in imports while exports rose 4.3 percent. Meantime, the primary
income deficit went down to USD 1.7 billion from USD 4.3 billion and the secondary income
surplus rose to USD 0.3 billion from 0.2 billion in the same period of 2020.

• In February, Brazil’s current account posted a smaller deficit of USD 2.3 billion,
compared to the USD 4.7 billion shortfall logged in the same month last year, while
also narrowing from the USD 7.1 deficit in January.
• Accordingly, the 12-month sum of the current account balance narrowed to a USD 6.9
billion deficit from the USD 9.2 billion shortfall recorded in January, which was
equivalent to approximately 0.5% of GDP

Current Situation of BOP in Russia

According to the Bank of Russia's preliminary estimates of January balance of payments, the
current account surplus came in at US$6.8 bn, while net private capital outflow reached US$8.0
billion, making it the primary reason for the trouble weakness last month. The decline in the
January current account surplus from US$10.6bn in 2020 to US$6.8bn in 2021 is largely
attributable to the deterioration of the commodity market conditions (Urals price drop from
US$63/bbl in January 2020 to US$55/bbl and the cut in physical output as per OPEC+
requirements), but still, it is slightly lower than our US$8-10bn expectations, which may
suggest deterioration of non-oil components.

The positive balance of financial transactions of private sector, according to the Bank of
Russia’s preliminary estimate, in the first quarter of 2021 totaled $11.8 billion compared to
$18.1 billion in the corresponding period of the previous year. During the reporting period
banks and other sectors increased foreign assets leaving liabilities to non-residents unchanged,
what was different from the first quarter of 2020, when the main form of net lending to the rest
of the world by the private sector was a reduction in external liabilities. Current account surplus
will rise by 50%+ in 2021. Analysts forecast that the state of Russia’s external accounts will
see significant improvements in 2021 as Russian and global economies return to growth from
2Q21, which is likely to be accompanied by stronger demand and more stable commodity
prices.

Current Situation of BOP in China

China's trade surplus widened to USD 75.42 billion in November 2020 from USD 37.18 billion
in the same month the previous year, and far above market expectations of USD 53.5 billion.
This was the largest trade surplus since at least 1981, as exports jumped to an all-time high
amid improving global demand.

China reported a trade surplus of USD 103.25 billion in January-February 2021 combined,
rebounding sharply from a USD 7.21 billion deficit in the same period a year earlier, and easily
beating market consensus of a USD 60 billion surplus, as the economy recovered from the
disruption caused by COVID-19, with more factories resuming their production. Exports
surged 60.6 percent year-on-year, the eighth straight month of increase; while imports rose at
a softer 22.2 percent, the fifth consecutive month of growth. China's trade surplus with the US
for the first two months of the year stood at USD 51.26 billion, much larger than a surplus of
USD 25.37 billion in the corresponding period a year earlier. To smooth distortions due to the
Lunar New Year festival, Chinese customs combine January and February trade data

Current Account vs Capital account

The current and capital accounts represent two halves of a nation's balance of payments. The
current account represents a country's net income over a period of time, while the capital
account records the net change of assets and liabilities during a particular year.

Current Account: The current account deals with a country's short-term transactions or the
difference between its savings and investments. These are also referred to as actual transactions
(as they have a real impact on income), output and employment levels through the movement
of goods and services in the economy.
The current account consists of visible trade (export and import of goods), invisible trade
(export and import of services), unilateral transfers, and investment income (income from
factors such as land or foreign shares). The credit and debit of foreign exchange from these
transactions are also recorded in the balance of the current account. The resulting balance of
the current account is approximated as the sum total of the balance of trade.

Capital Account: The capital account is a record of the inflows and outflows of capital that
directly affect a nation’s foreign assets and liabilities. It is concerned with all international trade
transactions between citizens of one country and those in other countries.

The components of the capital account include foreign investment and loans, banking and other
forms of capital, as well as monetary movements or changes in the foreign exchange reserve.
The capital account flow reflects factors such as commercial borrowings, banking, investments,
loans, and capital.

Relationship between Current and Capital account

As we already know, both current account vs capital account are the key components of the
Balance of payments, and both current account vs capital account differ in nature. Let us
discuss some key difference between Current Account vs Capital Account.

• The current account consists of the flow of ‘goods & services’ in an economy, whereas
Capital account represents the flow of ‘capital’ in the economy.
• A current account is a measure of Trade of any country and helps in evaluating the
inflow and outflow of visible goods and invisible services in the economy. On the other
hand, the current account is a measure of capital investments made in the economy and
helps in evaluating sources and uses of capital.
• The key components of the current account are Merchandise trade, services, income
receipts, and unilateral transfers. Whereas Capital account consists of foreign direct
investment, foreign portfolio investment and loans and advances made by a country to
another country.
• The current account depicts the Net income position of the country, whereas Capital
account represents changes in ownership of assets of a country.
• A country is said to be a net lender if its current account balance is a positive and net
borrower if its current account balance is negative. Similarly, under the capital account,
 if the country’s claims on the rest of the world are positive, it is termed as a net creditor
and net debtor for vice versa.

Both the difference between a current account vs capital account helps in evaluating the
Macroeconomic picture of a country, its monetary & fiscal policies, and future growth
potential. While the Current account measures the Inflow of goods and services in an economy,
on the other hand, Capital account gauges the inflow and outflow of capital in the economy.

The current and capital accounts represent two halves of a nation's balance of payments. The
current account represents a country's net income over a period of time, while the capital
account records the net change of assets and liabilities during a particular year. In economic
terms, the current account deals with the receipt and payment in cash as well as non-capital
items, while the capital account reflects sources and utilization of capital. The sum of the
current account and capital account reflected in the balance of payments will always be zero.
Any surplus or deficit in the current account is matched and cancelled out by an equal surplus
or deficit in the capital account.

The current account gives economists and other analysts an idea of how the
country is faring economically. The difference between exports and imports will determine
whether a country's current balance is positive or negative. When it is positive, the current
account has a surplus, making the country a "net lender" to the rest of the world. A deficit
means the current account balance is negative. In this case, that country is considered a net
borrower. If imports decline and exports increase to stronger economies during a recession, the
country's current account deficit drops. But if exports stagnate as imports grow when the
economy grows, the current account deficit grows. A surplus in the capital account means there
is an inflow of money into the country, while a deficit indicates money moving out of the
country. In this case, the country may be increasing its foreign holdings.
II : Current Account Deficit (CAD)

Current Account Deficit or CAD is the shortfall between the money flowing in on exports, and
the money flowing out on imports. Current Account Deficit (or Surplus) measures the gap
between the money received into and sent out of the country on the trade of goods and services
and also the transfer of money from domestically-owned factors of production abroad.

CAD Formula

Current account deficit = (Export – Import) + Net income from abroad + Net transfers

Factors affecting CAD calculations

Current account deficit/surplus is affected by several factors including:

• Exchange rate (overvalued exchange rate would cause large deficit) – A

depreciation in the exchange rate makes the currency relatively more competitive. After
a depreciation, exports will be more competitive and imports more expensive. This
should improve the current account. However, it requires the demand for exports and
imports to be relatively price elastic. If demand is inelastic, then cheaper exports will
only cause a small rise in demand and the actual value of exports can decrease.
• Level of consumer spending (economic growth) and hence import spending – A
period of consumer-led economic growth will cause a deterioration in the current
account. Higher consumer spending will lead to higher spending on imports. At the end
of the 1980s, the UK economy was booming with rising consumer spending and
inflation. This led to a widening deficit on the current account.
• Capital flows to finance deficit in long-term – To some extent, the size of a
sustainable current account deficit depends on how the level of capital flows a country
can attract. For example, in the past, the US was able to run a persistent current account
deficit of 3% of GDP or more because foreign investors wanted to buy dollar assets.
Without this demand for dollar assets (such as Treasury Bills), there would have been
a decline in the value of the dollar which would have reduced the size of the current
account deficit.
• Saving rates, influencing level of import spending – A country with a low savings
rate and high % of consumption will typically have a higher current account deficit.
This is because a higher percentage of national income is going on consumption (which
approx. 1/3 may be imports). Countries with higher savings and higher levels of
 investment tend to have an economy more geared towards production, exports and a
lower share of income goes on imports.
• Relative inflation/competitiveness – In the long term, the current account will be
influenced by the relative competitiveness of an economies export industries.If a
country becomes uncompetitive, then exports will decline relative to imports. For
example, in the 1950s and 1960s, the UK didn’t have a large current account deficit.
However, starting in the 1970s and 1980s, we have seen a steady increase in the
underlying current account deficit. In particular, the deficit in goods (manufactured
goods) has increased. This suggests that UK industry has become relatively less
competitive

Impact of unauthorized exports and imports on CAD

Unauthorised exports and imports do influence the variations in CAD. CAD consists of Trade
Deficit which is exports – imports. Therefore, exports and imports form part of CAD and
current account is deficit when, the country’s imports are more than its exports. When the
exports and imports are unauthorized that means they are not recorded in the government
records which will hence not form part of BOP calculation. So, unauthorized exports and
imports will not form part of calculations for CAD.

We cannot conclude whether it is a positive or negative impact as it depends on the values of

the unauthorized exports and imports. Suppose if the value of unauthorized exports is more
than imports then there are chances that the country might have current account surplus
depending on the values of accounted exports and imports. In the same manner, if the value of
unauthorized imports exceeds the exports, then the country might have current account deficit
depending on the authorized values of imports and exports. Therefore, unauthorised exports
and imports does impact the variations in CAD but we cannot conclude whether it is a positive
impact or negative.

Relationship between CAD and Retail consumer spending

There is a direct relationship between CAD and consumer retail spending. Increased consumer
retail spending implies that economy is improving since the consumers are having more
disposable income in their hand. Increased spending means there is more demand and increased
sales in products. If the manufacturers and suppliers are not able to meet the increased domestic
market demand, then they have to import them from foreign market. In comparison to increased
imports there will be lesser exports resulting in trade deficit which will in turn increase the
CAD.

Improvement in economy and GDP does not really mean good, sometimes it can be bad for the
Balance of Payments (BOP). Increased imports will negatively affect the reserves of the
country which in long run will deteriorate the country’s economy as then there will not be any
reserves left. This will also increase in inflation as there will be increased demand in the market.

Urban Perspective

Urban people have more expenses as compared to rural people. They also have interest
payments and tax payments; thus they are left with lesser disposable income. This implies that
they will be spending less for the products and hence the demand will be comparatively lower,
hence there might not be much burden on the suppliers regarding less availability of goods in
the market. This will not have a direct impact on the current account deficit. As per reports
there are only 33% people living in urban India, rest all live-in rural India. Less population in
urban India does not mean there is less retail spending as compared to rural India. Urban people
have higher income and have more demands as compared to rural people; urban people do
contribute much to negative balance of CAD. Rural people spend only on essentials but urban
people spend not only on essentials but also on different retail items which are not necessary.
Therefore, to meet the urban demand the suppliers must import resulting in increase in the
import level of the country thus having negative impact on the current account deficit (CAD).

Rural Perspective

One of the reasons for CAD is excess spending of the consumers, and this usually happens
when the saving rate of the consumers is less as compared to expenses. Rural people do not
have enough income to save for future, they usually spend their entire income on their
livelihood. Their excess spending leads to more demand in the market and to cover the demand
suppliers get the products from the urban market. This leads to shortage of goods in the urban
market and suppliers there then have to import goods to fulfil the urban demand. This leads to
excess imports over exports resulting in more current account deficit (CAD).
III : Fiscal Deficit

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. While
calculating the total revenue, borrowings are not included. 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.

Gross fiscal deficit in relation to gross domestic product across India

Year 2016 2017 2018 2019 2020

FD to GDP -3.48% -3.46% -3.42% -3.77% -9.5%

With concerns over gradually slowing economic growth, the government increased its fiscal
spending in early 2019. With the onset of the coronavirus (COVID-19) and consequent
lockdown, the unprecedented financial stimulus package led to the worsening of the gross fiscal
deficit. This further stressed the tax revenue system across the country. A major impact of the
pandemic was the projection of negative quarterly growth of GDP in June 2020 across India.
The fiscal deficit, as of May 2020, was estimated to be approximately two trillion Indian rupees.
Government funding was raised terribly due to lockdown and standstill economy with people
not having enough income to sustain their living. During this period government was not
getting enough revenues as the taxes were reduced and also debt from other countries was not
recoverable as every country was facing the same issue.
Current Fiscal position of India

The Union Budget’s focus on higher capital expenditure, financial sector reforms and asset
sales would help to stimulate growth and supply broad-based credit support, but India’s weak
fiscal position would remain a key credit challenge compared with its rating peers. The budget
projects a narrowing of the central government’s fiscal deficit to 6.8% of GDP in fiscal 2022
from an estimated 9.5% in fiscal 2021. The Indian economy is expected to grow 13.7 per cent
in the financial year 2021-22 (FY22), registering a strong rebound from a 7 per cent contraction
this fiscal year, said Moody’s on Thursday, adding the country’s fiscal position would remain
weak in 2021, posing a key credit challenge.

Economic stimulus packages under the Atmanirbhar Bharat Abhiyan and announcement of
comprehensive monetary, liquidity and regulatory measures by the RBI, among other measure
are most likely to push up the fiscal deficit for FY21.

In the Union Budget 2021-22. the economic stimulus is announced not as a macroeconomic
stimulus to revive the demand by providing huge cash transfers or a universal basic income
(UBI). The concern was that if the people’s propensity to save is greater than spending in the
time of a pandemic, dropping “helicopter money” or a UBI in the hands of the people cannot
lead to required demand stimulation. The statistics shows that precautionary savings by the
private sector are on the rise during COVID-19. Instead of massive cash transfers, the Union
Budget has provided targeted economic stimulus, especially to capital infrastructure and the
public health sector. The total size of the budget for FY21 has increased to Rs 34.50 lakh crore.
In FY22, total expenditure is pegged at Rs 35 lakh crore. Still, wide fiscal deficits combined
with lower real and nominal GDP growth over the medium term will constrain the
government's ability to reduce its debt burden.
Current Fiscal position of China

China is on track to set its annual fiscal deficit target beyond 3 percent for 2020, one of the
most-watched economic goals to be unveiled at the forthcoming annual two sessions to pump
more support into its coronavirus-hit economy. The epidemic-induced lockdowns loomed over
China’s economy in the first half of 2020, but with quick emergency response and government-
aided stimulus package, the country’s economy roared back. China emerged in June 2020 as
the first major country to announce a return to economic growth since the outbreak of the
COVID-19 pandemic. product (GDP) growth in the second quarter and 4.9% GDP growth in
the third quarter of 2020.

The IMF estimates that China’s announced fiscal measures and financing plans amounted to
$740 billion, or 4.7% of its GDP, as of November 2020. The government increased its budget
deficit target to a record high of 3.6% of GDP, up from 2.8% in 2019. Key measures included
spending on epidemic control and medical equipment, unemployment insurance, tax relief, and
public investment. Between January and November 2020, China’s fixed asset investment grew
over the same period in 2019 in ecommerce (32%), pharmaceuticals and medical products
(27%), health (26%), computers (20%), and education (14%). China reduced the value-added
tax (VAT) rate and introduced VAT exemptions for certain goods and services. China’s central
bank extended monetary support with interest rate cuts, eased loan terms, and injected liquidity
into banks. Shifting from efforts to reduce debt, the government announced the issuance of
$142.9 billion of special treasury bonds for the first time since 2007; increased the quota for
local government special bonds (a source of infrastructure funding); and fast-tracked the
issuance of corporate bonds to cover pandemic costs but with potential broader uses. The
government says it seeks to control credit risk but the need for additional fiscal and monetary
support to boost growth may undermine this goal.

In the economic race between China and India, China surpasses India on many of the
dimension’s key to growth. It is more open to trade, has better macroeconomic stability, has
developed more widespread education systems, and has achieved higher GDP growth.
However, the long-run population growth of India is projected to result in a population larger
than China’s between 2025 and 2030. It will also result in India’s having a much younger age
distribution than China.