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1. Devaluation

This involves reducing the value of the currency against others. (e.g. selling pounds would cause thevalue of the Pound to falll)

If there is a devaluation in the currency, the price of importing goods increases and therefore the quantity

demanded of imports falls. Exports will be become cheaper and there will be an increase in the quantity of exports

Therefore, assuming demand is relatively price elastic, we would expect a devaluation to lead to animprovement in the current account.

However it does depend upon the elasticity of demand for exports and imports.

The Marshall Learner Condition

This states that a devaluation will improve the balance on the current account,on the condition that the combined elasticitys of demand for imports and exports is greater than one.

If (PED x + PED m > 1) then a devaluation will improve the current account.

If (PED x + PED m > 1) then an appreciation will worsen the current account.

This is because the effect on the current account depends on the total value and not just the quantity ofexports.

The J Curve effect

In the short term, demand for imports and exports tends to be inelastic. Therefore, after a devaluation, thecurrent account tends to get worse before it gets better. However, vver time, demand becomes moreprice elastic and the current account improves.

Another problem with devaluation is that it can lead to imported inflation. Basically imports will be moreexpensive. Higher inflation can reduce the countries competitiveness. Therefore the improvement in thecurrent account might only be temporary.

2. Deflation

If a government reduces aggregate demand by raising interest rates or increasing taxes then people willhave less money to spend so they reduce consumption of imports.

The UK has a high marginal propensity to import therefore a reduction in AD improves the currentaccount significantly.

Deflationary policies will also put pressure on manufacturers to reduce costs and this will lead to morecompetitive exports and so exports will increase

However this policy will conflict with other macroeconomic objectives With lower Aggregate Demand,growth is likely to fall causing higher unemployment. A government is unlikely to want to risk higherunemployment just to reduce a current account deficit.

3. Supply Side Policies

Supply side policies can improve the competitiveness of the economy and help make exports moreattractive. This can improve the current account position, but it may take considerable time to have effect.See:supply side policies

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4. Protectionism

Increased tariffs of quotas will reduce imports and improve the current account

However :

1) Protectionism leads to retaliation so exports will decrease 2) Domestic industries may become uncompetitive, because there is no incentive.

How does a Government Reduce a Current Account Deficit?Revise quicker now!

Expenditure switching and expenditure reducing policies

Before we get started, it should be noted that the current government, and recent governments, in the UK do not

actually care about the current account deficit. They believe that it will be financed more or less indefinitely. They aremuch more concerned about the control of inflation. Examiners are keen that you understand how deficits can be

reduced, but the following policy measures are not at the forefront of the Chancellors mind at the moment!

These polices were relevant in the 50s and 60s, especially when the UK was part of the Bretton Wood fixed

exchange rate system. They are also relevant to any country that cannot finance current account deficits over the

long run as easily as the UK seems to be able to do.

Expenditure switching policies

These are policies that a government may use to switch consumers' expenditure away from imports and towards

home produced goods. There are two main types - using import controls like tariffs and devaluing the exchange rate.Let's look at these two in turn.

Import controls

Of course, this policy is not as relevant as it was in the past. Nowadays, the World Trade Organisation

(WTO)would not let a country get away with tariffs just because it wasn't very happy with its current account deficit.

If a country levies tariffs (a tax on imports) on various imports, then their prices will rise relative to the home

produced goods and so the demand for imports should fall and switch to domestically produced goods. This will be

good for domestic producers as well as helping the current account deficit to fall. The foreign firm could absorb the

cost of the tariff, take a cut in profits and not raise their price, but this is not a long term solution for them. Tariffsgenerally cause import prices to rise.

Apart from the fact that this is difficult to implement nowadays, the resulting trade war that is likely if a policy of

import controls did get past the WTO would be disastrous.

A devaluation of the exchange rate

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Of course, in a world of floating exchange rates, a currency should automatically change in response to a current

account surplus or deficit. The change should also automatically correct the balance of payments disequilibria.

A current account deficit in the UK, for example, will mean that the demand for pounds to buy UK exports is lower

than the UK consumers' demand for foreign currency to buy imports. The value of the pound will fall, making exports

relatively cheap and imports relatively more expensive. UK consumers will switch their purchases from imports to

home produced goods, and consumers from other countries will switch their purchases from their home produced

goods to UK exports. The UK's current account deficit should reduce back to equilibrium.

A very nice story, which should work in theory, but in the real world life is never that simple!

In the days of the Bretton Woods fixed exchange rate system, the UK would often find itself in a deficit situation. The

governments of the time tended to try all other policies to reduce the deficit. Devaluation was the last resort. It

was a sign that you had failed. When a country is a member of an exchange rate system, it is the foundation stone

around which the rest of government macroeconomic policy is built.

And why do governments avoid devaluation at all costs, even though it makes industry more competitive? The

resulting higher import prices lead to higher inflation. Since the Second World War, the inflation rate of the UK has

been higher, on average, than all developed countries. It is not a coincidence that the UK has seen the value of the

pound fall dramatically over the same period. Devaluation is the easy way out for exporters but is a poor long term

option. See the topic called 'Exchange rates' for more discussion on these issues.

Today, the UK has a floating exchange rate. In theory (as explained above) current account deficits should

automatically cause the pound to fall in value to help reduce the deficit. But the pound has been strong for the last

four years regardless of the trade position of the UK.

As we said earlier, currency transactions as a result of exports and imports account for less than 10% of dailyturnover. The key to the value of the pound nowadays is speculation. The 'markets' think the UK economy is doing

pretty well, so investors buy the pound instead of other currencies. These investors obviously don't think the current

account deficits are a problem otherwise they would take fright and sell their holdings of sterling.

So even if the government wanted to pursue the 'devaluation' policy option to reduce a current account deficit,

nowadays, it simply doesn't have the clout in the currency markets to affect the value of the pound. Look what

happened on Black Wednesday!

Expenditure reducing policies

Any government policy designed to reduce demand in the economy and so reduce consumer spending in the

economy (and on imports in particular) falls into this category. On the fiscal policy side the government could

increase taxes or reduce public spending. On the monetary policy side, interest rates could be raised (although this

is now the job of the MPC).

If consumer spending falls in an economy, then spending on all goods and services, including imports, will fall. This

will reduce a current account deficit.

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The big problem with this policy is that the deflation in the economy is likely to cause, at the very least, a slowdown

and possibly a recession. In the 50s and 60s UK governments used to announce deflationary measures in almost

immediate response to bad trade figures (a rise in interest rates, a tax on luxury goods or a clampdown on bank

lending). Nowadays, governments wouldn't dare to announce excessive cuts in government spending or large rises in

taxes. Gordon Brown may well sneakily raise taxes on less visible things (like dividends on shares bought to build a

pension), but to announce an increase in income tax is considered to be electoral suicide!

Anyone can cure a current account deficit by having a recession (or cure high inflation for that matter - see the last

two recessions!). This is why this 'expenditure reducing' policy of deflation was often used in conjunction with

something like a devaluation. The deflation would create the spare capacity in the economy and the devaluation

would increase aggregate demand again back up to the full employment level. Both policies should, at the same

time, reduce the current account deficit.

Policies to improve competitiveness

So, import controls are difficult to impose in today's world of free trade and the WTO. The value of the pound may

well fall, but only if the currency markets allow it. Deflation is completely out of the question given the risk of

recession and its political difficulties. How else can a government try to reduce a current account deficit?

For most manufacturing firms, it seems the only way to sell more goods abroad and to persuade UK consumers to

buy more home produced goods rather than imports is to become more competitive, particularly in terms of 'non-

price' factors. In terms of the most worrying 'price' factor, there is not much that they can do about the strong

pound.

Governments can help in this field by providing tax relief for capital investment and for research and development.

They can provide training to improve the skills of the workforce and invest money into education generally so that

the quality of all school leavers improves.

The J-curve and the Marshall Lerner condition

The success or otherwise of a devaluation in terms of reducing a current account deficit depends on the Marshall

Lerner condition. This condition said that, for a devaluation to be successful in terms of a reduced current account

deficit, the sum of the elasticity of demand for UK exports and the elasticity of demand in the UK for imports must

be greater than one.

The J-curve simply shows that, following a devaluation, a country's current account deficit may actually increase in

the short run before in falls and disappears.

RBI cited the market perception of the US Federal Reserve (Fed) tapering off its QE

(Quantative Easing) programme as the reason for FIIs pulling out over $7.5 billion out of

Indian Debt and Equity markets over the last couple of months. The central bank then went

on to tighten liquidity to give strength to the Indian Rupee (INR) that had depreciated by

over 11 percent to all time lows.

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RBIs liquidity tightening measures are now threatening Indias economic growth and

economists are busy lowering growth forecasts to levels of even below decade low 5%

growth seen in fiscal 2012-13.

The fact that RBI tightened liquidity after a meeting of the P prime minister, finance

minister and RBI Governor did not escape markets as RBIs measures were announced late

in the evening on the same day of the meeting on 15 July 2013. The PM and the FM would

have definitely impressed on the RBI that the Fed is responsible for the INR weakening and

the central bank must act in haste.is being questioned here and will the country always move on the actions

of the Fed?

The point here is that basing a monetary policy response to an action of the Fed gives rise to

the question of whether the Fed is to be held responsible for the woes of the INR? Indias

economic independence is being questioned here and will the country always move on the

actions of the Fed?

The Fed is an American Institution and its sole concern is for the US. The Feds monetary

policy is dependent on its perception of the US economy. Fed will never look into the

repercussions of its actions to economies across the world. Fed will throw money into the

system and will pull it out based on US economy outlook. Feds actions do affect the rest of

the world but as far as the Fed is concerned it is up to individual economies to adapt to the

world economic environment. The Fed will never make excuses for its actions and its effects

on the rest of the world.

Indian policy makers cannot expect the Feds actions to be positive for the country always.Loose Fed monetary policy leads to flows of liquidity into the country leading to growth,

inflation and asset bubbles. Government is happy with growth and asset bubbles but cannot

handle inflation and that is left to the RBI to handle. INR strengthening due to liquidity

flows is fine with the government as it takes credit for that but INR weakening due to

liquidity outflows is not fine and the government blames the Fed for that. RBI should let the

INR strengthen but should not let the INR weaken is the motto of the government.

The FM. P. Chidambaram had issues with Dr. Y.V. Reddy when he tempered INRs rise and

now he is fire fighting a weakening INR that is brought about largely due to domestic

policies rather than the Feds action.

Indias fiscal deficit is due to poor subsidy policies of the government. Indias CAD (Current

Account Deficit) is due to inflation and again poor subsidy policies of the government. Fiscal

deficit and CAD is seen as the biggest contributors to the INR fall. Not Feds policies.

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The government should reflect and hasten measures to control its fiscal and current account

deficit. To a certain extent there is an eye on the deficits and there are conscious efforts to

bring down both the deficits but that will take time.

The INR in the meanwhile will react to growth expectations in the economy and with the

government fire fighting on deficits, growth will take time to bottom out and stabilize. The

sooner that this realization dawns on the government the better as then it can let RBI take

monetary measures based on growth inflation dynamics rather than based on Feds policies

As students of financial management, one needs to understand how the underlying

macroeconomic conditions can potentially affect the capital markets. One such

contemporary issue doing the rounds of financial circuits is that of India's current account

deficit (CAD), and how gold imports need to be curbed to control this deficit.

In this write up, we try and explore India's fascination for buying gold and whether curbing

gold import to curtail CAD is a right step? If not, then what alternatives exist to tackle this

problem. Is India really the world's largest consumer of gold? Have our gold imports

actually become a serious cause of concern for our policymakers?

The answer to both is 'yes'. As per World Gold Council estimates, India is likely to import a

whopping 615 tonnes of gold in the first half of 2013, compared to only 381 tonnes a year

ago. Since India fulfils almost its entire requirement of gold through imports, this trend has

led to worrisome levels of CAD.

India's trade deficit jumped to more than $20 billion in May as gold and silver imports

surged nearly 90% yoy in the month. Consequently, RBI has been taking steps to curb gold

imports, such as hiking the import duty and imposing regulatory restrictions.

While this step may be desirable, it may not be necessarily effective. Alternatives for

curtailing CAD (a consumption-aided disaster) such as reducing government expenditure

exist and might be better. The crucial question is why the government remains hesitant to

adopt these measures.

The finance minister appealed to the citizens to resist the temptation of buying gold. But

why penalise the consumer for situations that have been partially created on account of

government's own actions?

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India's 2012 gold demand was about 11% more than that of China and five times that of the

US. So, curtailing demand will align India's gold consumption with the global players. But

as shown in figure 1, the value of gold imports in India has surged recently, despite the

sharp rise in gold prices, indicating that our gold imports are relatively price inelastic

Efforts should also be made to introduce attractive financial instruments to divert householdsavingsin

non-productive assets like gold, he added.

Current Account Deficit (CAD) touched a record high of 4.8 per cent ofGDPin 2012-13 on risinggoldand

oil imports. It, however, narrowed down to 3.6 per cent of GDP in the January-March quarter.

"The situation demands a complete overhaul of foreign trade and industrial competitiveness strategies

adopted so far. Policy makers must also consider cutting import of non-essential items including second

hand and re-manufactured goods, especially non-competitive goods from China,"Assocham Secretary

GeneralD S Rawat said.

Stating thatthe practiceof financing CAD with short term capital inflows and borrowings makes it

vulnerable to external shocks, industry leaders said the effect of reduction in CAD in Q4 could

helprupeeappreciate.

"It (CAD at 3.6 per cent) will help the rupee rebound to the level of 57 to 58 per dollar in coming months.

India will benefit from this rebound as the actual decline of commodity prices will be felt in coming

months," Executive Director at PHDCCI Saurabh Sanyal said.

The moderation in CAD in Q4 was due to non-oil and non-gold imports falling due to slowing economic

growth.

The current account gap in the March quarter was $ 18.1 billion, or 3.6 per cent of GDP, lower than $

21.7 billion a year earlier.

During 2012-13, CAD stood at $ 87.8 billion (4.8 per cent of GDP) as against $ 78.2 billion (4.2 per cent

of GDP) during 2011-12.

"The high level of CAD puts pressure on rupee and this is very much evident in the recent months where

the rupee is showing a high degree of volatility. In the immediate future all possible measures of financing

the deficit have to be explored, however, the objective should be to ensure that CAD is brought under

control," Banerjee said.

In the immediate term, exports of merchandise need to get improved market access, exporters should get

credit at international rates, Rawat said.

TheFinance Ministry, meanwhile, said "the short-term increase or decrease in CAD should not be a

cause for either optimism or pessimism"

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