Deficits & Balance of Payments

Types of Deficits

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Every day in newspapers we keep reading about various government deficits going up/down or international agencies commenting on India’s high fiscal deficit or India relying too much on foreign funding. In order to understand these statements, let us discuss various types of deficits which are important to understand and track.

Current Account Deficit: Suppose there is a small village called Farmville. Most of the people in Farmville are farmers and they all grow wheat. All other items that villagers need will have to be bought in from other villages and cities. Shopkeepers in Farmville go to other cities/villages and buy items that can be sold in Farmville. Similarly Farmville’s farmers also travel to other cities/villages to sell the wheat that they have grown. Let us call all goods bought from other places into Farmville’s boundaries as imports. All wheat that crossed Farmville’s boundary and got sold in other places will be regarded as exports. Current account deficit is the difference between value of imports and exports. If total goods bought by residents of Farmville are worth Rs 10,000 and wheat sold outside of Farmville is worth Rs 8,000, then current account deficit of Farmville is Rs 2,000. If imports are greater than exports, the difference is referred to as current account deficit of a country. On the other hand, if exports are greater than imports, the difference is referred to as current account surplus.

Capital Account Deficit: Let’s consider a similar example. Suppose there is a city called Capitalia. It’s a fast growing city and all the companies are opening their offices in this city. It represents a very good investment opportunity and many people who are not living in the city, might want to invest in things like housing, restaurants, small business etc in the city. Thus, a lot of money will pour in from other cities. At the same time, people working in the city might send money back to their hometowns or some residents of Capitalia might invest in other cities. If the total money going out of the city is more than total money coming in, the difference is called capital account deficit. On the other hand, if total money coming in is more than total money going out, the difference is called capital account surplus.

Fiscal Deficit: It is very easy to understand this concept, if we take the example of Prateek. Prateek earns Rs 10,000 on a monthly basis, but has a habit of spending much more. Every night he goes out to party and on an average spends around Rs 30,000 a month. He can do this, only if he borrows Rs 20,000 every month from someone else. Thus, Prateek’s expenditure is more than his income and difference is called as fiscal deficit. Now replace Prateek with the government of a country. Government gets its income in the form of taxes from citizens and spends this money on various public projects and schemes. If Government’s expenditure is more than its income, it also needs to borrow in order to fill the gap. This difference between expenditure and income is called fiscal deficit and it represents the Government’s borrowing requirement.

Foreign Currency Reserves

A dollar is what I need

We strongly recommend reading our articles on Forex, before starting with this one. Here, we will try to explain what are foreign currency reserves and how are they accumulated.

Let’s start with an example. Suppose there are two countries: Dorne and Vale. Dorne’s currency is D$ and Vale’s currency is V$. Currently the exchange rate is 1D$ = 2V$. So for every D$ desired by the citizens of Vale, they will have to pay 2 V$. Dorne announces some new economic policy and the country suddenly becomes a hot investment destination. After these new changes lots of people from Vale want to invest in Dorne. This will increase the supply of V$ in the forex market, and demand for D$ will increase. We know that when demand for a product increases, its price rises. So the price of D$ will increase. Let’s say the exchange rate moves upto 1D$=4V$. Again as we learnt in our article on FX, this appreciation of D$ will make Dorne’s exports costly, as Vale’s citizens will now have to pay more V$ to buy the same amount of D$.

In our article on Central bank, we learnt that managing volatility in forex market and printing money are among the important functions of a central bank. In the above example, appreciation of D$ occurred because supply of V$ increased against D$. Let’s say Dorne’s central bank doesn’t like this and starts printing more D$ to pump into forex market in order to buy and absorb increased supply of V$. As the central bank starts buying V$, with the newly printed D$, it will start accumulating V$. This accumulated pie of V$ is called foreign currency reserves.

Now let’s understand why these foreign currency reserves are very important. Suppose suddenly the situation in Dorne turns bad due to collapse of the Central Government and now all the citizens of Vale, who had earlier invested in Dorne, want to pull out their investments. All of them will start selling D$ to convert it into V$, which they can take back to Vale. This will increase the supply of D$ in the forex market. Again as the supply increases we know that price of D$ will go down and it will depreciate against V$. Dorne’s central bank doesn’t want that to happen. So it starts selling V$ from its foreign currency reserves to buy D$ and increase the demand to match supply. In this way it will be able to control excessive depreciation of its currency.

When the central bank of a country tries to control excessive currency appreciation, through printing its own currency, in order to buy foreign currency, it ends up building foreign currency reserves. It can use these reserves to control excessive depreciation of its own currency – by selling foreign currency from reserve and buying its own currency. But the important point to note is that there is no limit upto which a Central Bank can print its own currency. However foreign currency reserves held by the bank are limited. So the extent upto which a central bank can protect its currency depreciation depends on the level of foreign currency reserves it holds.

Now, let’s understand the role played by foreign currency reserves in balance of payment.

Balance of Payments

It's a zero sum game

Reading our earlier posts regarding deficits and foreign currency reserve will help you understand this one better. In balance of payment, we are trying to account for all the transactions that take place between a country and the rest of the world. According to balance of payment theory, summation of current account and capital account will always be zero.

From our article on deficit, we know that current account deals with the exchange of goods and services between a country and the rest of the world. If the goods exported by a country to the rest of the world is more than goods imported by the same country from the rest of the world, then their is a current account surplus. On the other hand, if imports are more than exports, there will be a current account deficit situation. Let’s hypothetically assume that India’s current account deficit is INR 500 billion. It means that the value of goods imported by India from rest of the world is INR 500 billion more than goods exported out from India. On a net basis, we can say that India is receiving goods and paying money to the rest of the world. Thus, Rupee is flowing out from India in this case.

We defined capital account surplus as a situation where money coming into the country is more than money going out. This can happen with India if investment by rest of the world in India is more than what India is investing in the rest of the world. These investments can come in the form of foreign portfolio investment (FPI) or foreign direct investment (FDI). We will discuss FPI and FII in the next article. Important point to remember is that if you want to invest in India, you can do that only in rupee. Let’s assume that India’s capital account surplus is INR 550 billion. It means, on a net basis rest of the world is investing INR 550 billion in India.

You must be wondering how more money can came into the country, as only INR 500 billion had gone out via payment for imports and when other countries cannot print Rupee notes. Here foreign currency reserves of other countries come into picture. This extra INR 50 billion is coming in from Rupee reserves of other countries, i.e. total Rupee reserves held by foreign countries would have gone down by INR 50 billion. Keep in mind that total money going out will be equal to total money coming in plus change in foreign currency reserves of other countries. So if the money coming in is more than what is going out, the difference is being funded via foreign currency reserves of other countries.

Similarly if money coming in is less than money is going out, the difference amount is being retained as foreign currency reserves by other countries.

Read on to understand two most commonly used financial terms: FII and FDI.

FDI vs FII

Not all funding is good

First let’s understand each one of them separately and then compare to list the differences.

FDI (Foreign Direct Investment): If a foreign firm opens a manufacturing hub, research centre or any other unit in the form of a subsidiary in India, then the investment is classified as FDI. If a foreign company starts a new company in a joint venture with an Indian firm, it is classified as FDI. If a foreign company invests in a domestic Indian company to inject some fresh capital, again it is considered to be FDI. FDI is stable and long term money getting invested in the country. It helps in building new businesses which results in more jobs, higher GDP leading to increased prosperity. It also brings in product expertise and new technology of foreign company and helps in increasing efficiency.

FII (Foreign Institutional Investment): It consists of foreign money getting invested in the stock/bond markets of a country. A foreign company buying shares of Reliance on NSE, is an example of FII. The money coming in through this route is generally not a long term investment, as the investee company can sell shares anytime and take the money back to its own country. No new businesses are created from this money, as through FII route foreign institutions are buying shares already trading on exchanges and no new investment is flowing directly to the company. Thus FII funds just makes buying and selling shares on exchanges easy by increasing liquidity, however it does not help in creating new jobs by building new business or increasing the GDP. 

Both FDI and FPI are part of the capital account. FDI is a long term investment. For example Maruti Suzuki is a joint venture between Maruti and Suzuki. If tomorrow Suzuki wants to take the money back, it cannot do so by just pressing one button. At the same time, the joint venture has helped in creating so many new jobs and added to the goods produced inside the geographical boundary of India, increasing India’s GDP. On the contrary, let’s consider the example of Morgan Stanley buying shares of TATA Motors on NSE. This transaction does not help in getting access to any new technology, creation of new jobs or access to new funds for business expansion. Overall there is no contribution to the GDP. Thus FDI is always preferred over FPI.