Question

Consider the following actions which the Government can take:

1. Devaluing the domestic currency.

2. Reduction in the export subsidy.

3. Adopting suitable policies which attract greater FDI and more funds from FIIs. 

Which of the action/actions can help in reducing the current account deficit?

1. 1 and 2
2. 2 and 3
3. 3 only
4. 1 and 3

Answer 1

Correct Answer - Option 4 : 1 and 3

The correct answer is 1 and 3.

• How do you deal with a Current Account Deficit?
  • CAD exists due to a host of factors including existing exchange rate, consumer spending level, capital inflow, inflation level, and prevailing interest rate.
  • For the Current Account Deficit in India, crude oil and gold imports are the primary reasons behind high CAD.
  • The Current Account Deficit could be reduced by boosting exports and curbing non-essential imports such as gold, mobiles, and electronics. Hence, statement 3 is correct.
  • Currency hedging and bringing easier rules for manufacturing entities to raise foreign funds could also help.
  • The government and RBI could also look to review debt investment limits for FPIs, among other measures.
• Devaluing the domestic currency makes the export of a country competitive in the international market, which eventually helps to increase export and to earn foreign currency. This can help to reduce CAD. Hence, statement 1 is correct.
• Reduction in the export subsidy will discourage export and export from India will become expensive at the international market vis-a-vis other countries. Thus, CAD will increase. Hence, statement 2 is not correct.

• The current account deficit (CAD):
  • It is a measurement of a country’s trade where the value of the goods and services it imports exceeds the value of the products it exports.
  • To understand CAD in detail, it is essential to learn about the Current Account.
    • A nation’s Current Account maintains a record of the country’s transactions with other nations, in terms of trade of goods and services, net earnings on overseas investments and net transfer of payments over a period of time, such as remittances.
    • This account goes into a deficit when money sent outward exceeds that coming inward.
  • Current Account Deficit is slightly different from Balance of Trade, which measures only the gap in earnings and expenditure on exports and imports of goods and services.
    • Whereas, the current account also factors in the payments from domestic capital deployed overseas.
    • For example, rental income from an Indian owning a house in the UK would be computed in the Current Account, but not in the Balance of Trade.
• How do you calculate the Current Account Deficit?
  • The current account constitutes net income, interest and dividends and transfers such as foreign aid, remittances, donations among others. It is measured as a percentage of GDP.
  • Trade gap = Exports – Imports
  • Current Account = Trade gap + Net current transfers + Net income abroad
• Is the Current Account Deficit something to worry about?
  • Current Account Deficit may be a positive or negative indicator for an economy depending upon why it is running a deficit.
  • Foreign capital is seen to have been used to finance investments in many economies.
  • Current Account Deficit may help a debtor nation in the short-term, but it may worry in the long-term as investors begin raising concerns over adequate return on their investments.