Introduction
In the intricate web of international economics, Current Account Deficit (CAD) and Capital Account Convertibility (CAC) play a central role in a country’s balance of payments and economic stability. Understanding how these two elements interact is essential for managing growth, exchange rate stability, and investment flows. While CAD reflects the excess of imports over exports, CAC indicates the extent to which capital can move freely across borders.
Understanding the Current Account Deficit (CAD)
The current account comprises trade in goods and services, net income from abroad, and net transfers. A Current Account Deficit arises when imports and outflows exceed exports and inflows, requiring external financing through borrowing or capital inflows.
Causes of CAD:
• High import demand due to weak domestic production.
• Heavy import dependence on energy, especially oil.
• Low export competitiveness.
• An overvalued currency.
• Rising consumer income driving luxury imports.
Implications of CAD:
• Downward pressure on the domestic currency.
• Imported inflation due to a weaker currency.
• Increased foreign debt.
• Risk of credit‑rating downgrades and rising borrowing costs.
What Is Capital Account Convertibility (CAC)?
Capital Account Convertibility is the ability to freely convert local currency into foreign exchange for capital transactions, such as investments and loans. Full convertibility allows both residents and non‑residents to move capital in and out without restrictions.
Benefits of CAC:
• Attracts foreign direct and portfolio investment.
• Enhances market efficiency and asset pricing.
• Encourages better governance and financial discipline.
• Expands access to global capital markets.
Risks of CAC:
• Volatile capital flows can create instability.
• Exchange rate volatility complicates monetary management.
• Economic vulnerability in weak financial systems.
• Exposure to speculative attacks.
India’s Experience with CAD and CAC
India often runs a moderate CAD due to import demand for oil and gold, partly offset by remittances and IT services exports. Financing this deficit relies on FDI, portfolio flows, and loans.
India has adopted a partial convertibility model: most current account transactions are liberalized, while capital account transactions are carefully allowed (FDI, FPI), but full CAC remains distant, pending stronger institutions and macro‑stability. The Tarapore Committee laid key groundwork for a phased approach.
Recent Trends and Challenges
Have a look at the latest developments and key hurdles facing CAD and CAC:
Recent Trends
• Elevated CAD Levels: Post‑pandemic recovery combined with global oil price spikes pushed many emerging markets—including India—into a wider current account deficit in 2024–25, despite resilient services exports and remittances.
• Shifting Capital Flows: Global investors are rotating between emerging market equity, bonds, and safe‑haven investments amid rising U.S. interest rates. This has led to episodic inflows and outflows into India’s capital account.
• Rising FDI and FPI: India continues to attract strong FDI across sectors like green energy and technology, while FPI remains sensitive—flowing in when global sentiment is positive, and reversing during risk‑off episodes.
• Macroprudential Interventions by RBI: To manage volatility, the Reserve Bank of India has tightened norms—such as raising LTV limits, prescribing minimum residual maturity, and revising unhedged forex exposure rules for banks.
• Digital Cross‑Border Trends: Rise in digital asset trading and fintech remittances is gradually influencing capital account dynamics, though currently constrained by regulation.
Challenges
• Volatility Risk: Sudden reversals in portfolio flows can cause sharp currency swings, raising import costs and inflation.
• Currency Vulnerability: Persistent CAD plus global headwinds (tight policy abroad, geopolitical risk) can weaken the rupee and force central bank intervention.
• Fiscal Stress: High CAD financed through short‑term debt can aggravate sovereign risk, especially when global rates rise.
• Regulatory Gaps: Capital account liberalization requires a robust legal, compliance, and supervisory framework—areas where developing economies still have gaps.
• Global Policy Uncertainty: Changes in U.S. Fed policy, China's economic slowdown, or geopolitical tensions can rapidly shift investor sentiment, impacting capital availability.
The Interrelation Between CAD and CAC
A current account deficit must be funded. Capital account convertibility facilitates funding by allowing inflows. But if most funding comes via short‑term, volatile flows, the economy becomes fragile—prone to abrupt withdrawals, currency depreciation, and financial stress.
This makes it critical to liberalize capital flows gradually and couple that with strong domestic macro safeguards: stable inflation, fiscal prudence, deep financial markets, and regulatory oversight.
Conclusion
Current Account Deficit and Capital Account Convertibility are twin pillars of a nation’s external sector strategy. While CAD reflects the gap between a country’s foreign currency outflow and inflow, CAC determines how easily capital can cross borders to bridge that gap.
In the current global context—where emerging markets face volatile capital flows, shifting monetary stances, and geopolitical headwinds—it is more important than ever to strike the right balance. A moderate, well‑financed current account deficit can support growth, but over‑reliance on unstable capital flow is risky.
Capital account liberalization can boost investment and economic efficiency, yet it requires a calibrated, phased approach and strong institutional backstops. India’s experience exemplifies the need to liberalize only as domestic financial markets mature, reserve buffers build, and regulatory systems strengthen.
By understanding recent trends and addressing ongoing challenges, policymakers can better navigate the complexities of CAD and CAC—aiming for sustainable growth, stable exchange rates, and resilient economies in a rapidly changing global landscape.