Understanding Macro Economy - Why are current and capital account flows important for markets?

What are current and capital account flows? What is the difference between them? How do they impact the economy? How do they impact markets? What is India's position on these important economic parameters? Read on as We attempt to address these questions and throw some light on why every investor , advisor and business owner need to track these key economic variables.

Broadly speaking, all forms of money flows in and out of a country fall into the bracket of external current and capital account flows. Money that moves entirely within a country is not part of this. For example, when a software company sells its services to a US based company, the money it receives is a current account inflow into the country. Whereas when the same software company sells software to an Indian client and receives payment locally in rupees, that's not a part of our external flows. All transactions between the residents of a country with the residents of other countries are recorded in the balance of payments of an economy. It basically represents the sources and uses of foreign exchange of the country. The balance of payments can be primarily grouped into current account and capital account flows. Current and capital account flows directly impact the value of the currency of any country. Current account flows The current account represents the trade aspect of the economy with the other economies and the world. This comprises of merchandise exports and imports as well as providing and receiving services. Exports and imports can be of tangible goods - those which you can touch and feel, as well as "invisibles". The invisibles comprise of services like travel, transportation, insurance and other miscellaneous services such as professional services. Current account flows also include official and private transfers. Official transfers include contributions made or received by the government of the country to international institutions, government grants, gifts etc. If the Indian Government sends say US$ 10 million as aid to an earthquake stricken poor country, it would be a current account outflow from the Indian economy. Private transfers may be in the form of gifts, family maintenance, education fees etc. When Gulf based NRIs remit money back home for family maintenance, that's an example of current account inflows into India. On the other hand, when affluent families send their children overseas for education, the fees they pay in dollars represents current account outflows for India. Investment income earned through financial or non financial sources also forms part of the current account flows. For instance, incomes received from a financial security or property. All remittances received by the residents of the country from other countries are recorded as inflows while all remittances made by the residents to other countries are recorded as outflows. What is trade balance? Usually, the largest component of current account flows is the level of imports and exports of goods and services. Trade balance represents the difference between the merchandise exports and imports. It is an indicator of efficiency of a country in producing goods. A country that imports more goods than it exports, will have a negative trade balance. Most countries try to incentivise exports in a bid to have a more favourable trade balance. Trade deficits occur when the value of merchandise imports exceed the value of mechandise exports. What is a current account deficit Countries like India tend to try and balance out a negative trade balance or a trade deficit (which is caused by our large oil and gold imports) with more focus on invisibles - export of services like software etc and encouraging foreign travels to visit India and spend their foreign currency in India. A current account deficit would exist if the current account inflows are less than its outflows. For example, if India is running a trade deficit, but manages to receive significant amount of inflows from invisibles (software exports, travel and tourism etc) as well as significant inward remittances from NRIs towards family maintenance, we could still end up with a current account surplus though we have a trade deficit. This is what we saw in the country in the middle of the last decade. That was also the time that our currency appreciated strongly. Sadly today, the situation is quite different. Our imports of oil and gold make the trade deficit so high that all the invisibles are unable to neutralise this and as a result we are running high levels of current account deficit. Why is this important? A current account deficit implies we need more foreign currency to pay for our imports than we earn by way of export of goods and services. As with any law of demand and supply, when demand is high and supply is limited, prices rise. So is the case with the dollar - rupee rate : when our demand for dollars far exceeds the supply of dollars that we generate, the dollar becomes costlier against the rupee. In other words, our currency depreciates. A depreciating currency makes imports even more costly, although it makes exports more attractive. If, after one round of depreciation, exports haven't picked up sufficiently to counter the rising import bill, the current account deficit can widen - and thus compound the problem. A depreciating currency for a stock market like India which Is so heavily dependent on FII inflows - is bad news as FII's returns get negatively impacted when the local currency depreciates. Typically, when a country falls short on current account flows, it turns to capital flows to try and restore the balance of payments and provide stability to the local currency. What are capital account flows? Transactions that create assets or liabilities are capital account transactions. Movement of money into and out of the country which create assets or liabilities are capital account flows. For example, when an NRI sends money back home for family maintenance, that's a current account inflow into India. When the same NRI invests in an NRE deposit, that's a capital account inflow into the country. He has created an asset for himself and a liability for the Indian bank with this transaction. He can pull this money out at any time - it's his asset. Whereas, the money he sent home for family maintenance gets spent in India - it doesn't go back. All forms of foreign investments into the country represent inflows on capital account. Foreign investment can be in the form of foreign direct investment or portfolio investment. When the residents of other countries invest to acquire physical assets in our country, it is known as foreign direct investment (FDI). When foreign retail giants bring in money into India to set up local operations, that's FDI. FDI is usually encouraged as it is money that comes in to stay in. If foreign residents invest in financial securities in Indian markets, it is portfolio investment (FII flows). India has been receiving significant FII inflows - and this is the single biggest reason why our overall balance of payments hasn't snowballed into a crisis - yet. We have a current account deficit and FDI inflows are very muted. The Government is looking at policy measures to boost FDI inflows to reduce its dependence on FII inflows - which can exit the country as easily as they came, should the foreign portfolio investors take a negative view on their Indian portfolio investments. Similarly, residents of India can invest in physical or financial assets abroad - within a limit which currently stands at US$ 200,000 per annum per investor. This would be treated as capital outflows. Indian companies can also make overseas acquisitions - with necessary approvals - like Tata Motors did when they acquired Jaguar. That's an example of FDI outflows. Commercial borrowings which may be long, medium and short term credits in the form of loans, bonds etc may be extended to or received by Indian entities from abroad. These are part of capital flows. Capital account deficit and surplus Capital account deficit means that the inflows received from capital transactions are less than the capital account outflows. A capital account surplus means that the foreign inflows from abroad exceed the outflows from the residents. As mentioned, India is running a high level of current account deficit, which is not fully balanced out by a capital account surplus - which is why our currency remains under pressure. In any case, capital account inflows in the form of borrowings and portfolio inflows are not a sustainable way of maintaining a healthy balance of payments - as these are "hot flows" - inflows which can easily turn into outflows if the lender / investor senses trouble. To have a healthy balance of payments, the first priority will be to boost current account inflows (exports of goods and services) and then fall back on FDI inflows and then on FII inflows and lastly on external commercial borrowings (ECB). Impact on markets A country that is funding its current account deficit through only FII inflows and external commercial borrowings will be looked upon unfavourably by foreign portfolio investors - who will worry about any sharp depreciation in the country's currency which can negatively impact returns on their own portfolio investments. Countries is such situations would want to reassure portfolio investors that they are taking all steps necessary to increase higher quality flows - such as exports and FDI. The Asian crisis of the mid 1990s was an example of a poor balance of payments situation. Our own situation in 1990-91 was no different - and it was that crisis that sowed the seeds for the liberalisation wave that we saw in the 1990s. Markets are always forward looking - and projections of weakness or instability in balance of payments is enough to get foreign investors and lenders edgy - which can accelerate into a crisis very quickly. In our present context, we would do well to track how our situation evolves - as we are not in a very comfortable situation, where FII inflows are to some extent mitigating a very weak current account deficit situation and weak FDI flows.