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IDFC AMC

Current Account Deficit

By: Punam Sharma

What is Current Account Deficit and its cause?
 

  • Current account records transactions of merchandise trade and invisibles (services+ transfers+ net income) of India with rest of the world.
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  • Merchandise Trade refers to trade of goods only.
  •  

  • Invisible component is subdivided into services, transfers and net income.
  •  

  • Services refers to trade in services like transportation, tourism etc.
  •  

  • Transfers are receipts or payments without any intention of
    receiving anything in return like workers’ remittances, donations,
    aids and grants etc.
  •  

  • Net Income refers to income paid or received on investments like
    dividends, rents, interest etc.
  •  

  • Current account deficit is when payments exceed receipts from trade of
    goods & services, transfers and net income.
  •  

  • It indicates India is borrowing and is net debtor to rest of the world.
  •  

  • Increasing trade deficit on account of higher imports is the major component
    leading to increase of current account deficit.
  •  

  • Chart below shows the trade balance in absolute term.
  •  

Trade Balance

 

  • Over the years, it’s seen the trade deficit has been widening on back of higher imports
    and slower growth of exports.
  •  

  • Till first half of 2013, exports and imports stand at $146.549bn and $237.221bn
    respectively resulting in trade deficit of $90.672bn.
  •  

  • Increasing oil and gold imports are major contributors to the increase of imports.
  •  

  • Chart below shows overall import and oil and gold in absolute terms.
  •  

 
Imports

 

  • From the chart above, it’s seen oil and gold import has been continuously rising.
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  • Till first half of 2013, oil and gold imports stand at $80.28bn and $20.25bn respectively.
  •  

  • Current account deficit is generally funded by Capital account which records all inflows
    and outflows of capital of the country.
  •  

  • Both current and capital account are components of balance of payment which records
    all monetary tractions of a country with rest of the world.
  •  

 

  • Positive balance of payment means country is receiving monetary inflows which
    increase the foreign currency assets.
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Impact of Current Account Deficit?
 

  • Deficit leads to depletion of foreign currency assets as these assets are used as a
    source to fund deficit which forms part of capital account.
  •  

  • Depletion of foreign currency assets reduces money supply1 which in turn results to liquidity issues.
  •  

  • High imports results in higher demand for dollar causing rupee to weaken (rupee depreciation) which in turn impacts liquidity.
  •  

  • Chart below shows trend in current and capital account and overall balance of payment in absolute term.
  •  

Balance of Payment

 

  • From above chart, it’s seen India has been in current account deficit since 2005 and it’s
    just being widening.
  •  

  • During 2002 to 2004, India did have current account surplus but this was not due to trade surplus but increase in trade in services which recorded a growth of almost 100% in 2002.
  •  

  • From 2005 to 2008, higher capital account growth has off set the current account deficit leading to positive balance of payment.
  •  

  • However from 2009 due to slower growth in capital account in proportion to higher current account deficit, overall balance of payment has been declining.
  •  

  • Current account deficit till H1FY13 is at $38.97bn and Q2FY13 is 5.4% of GDP.
  •  

Foreign Currency Assets

 

  • As mentioned, foreign currency assets are used to fund the current account deficit and
    growth in balance of payment increases foreign currency assets.
  •  

  • It’s seen from 2002 when India had current account surplus, foreign currency assets have been increasing.
  •  

  • During 2007-2008, although country faced deficits, foreign currency assets increased on account of growth in balance of payment led by growth in capital account.
  •  

  • However, 2009 onwards with continuously increasing deficit and declining balance of payment, foreign currency assets have been on a declining trend.

 

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IDFC AMC

What is Deposits of banks?
 

  • Deposits of banks are its liability and consist of deposits of public and other
    banks.
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  • Deposits of public form largest part of deposits and include demand and time
    deposits.
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  • Demand deposits include all liabilities which are payable on demand and
    includes current deposits, demand liabilities portion of savings bank deposits,
    demand drafts, balances in overdue fixed deposits etc.
  •  

  • Time deposits are those which are payable otherwise on demand and
    includes fixed deposits, staff security deposits, time liabilities portion of savings bank
    deposits etc.
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  • Net Demand and Time Liabilities (NDTL) is sum of demand and time liabilities
    (deposits) of banks with public and other banks wherein assets with other banks is
    subtracted to get net liability of other banks.
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  • Banks allocate deposits it receives towards cash reserves, SLR requirement
    (investment in Government and other securities) and credits (loans) to corporate and
    individuals which are assets for banks.

 
Deposits of Bank
 

What is Bank Credits?
 

  • Bank credits (loans) comprises of food and non food credit.
  •  

  • Food credit (2.2% of total bank credit1) is provided by banks to Food Corporation of
    India, State Government and State cooperative agencies for purchase of food.
  •  

  • Non food credit (97.8% of total bank credit) comprises of credit given to agriculture,
    industries, retail (personal loans) and service sector.
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  • Chart below shows sectoral breakup as % of Non food Credit.
  •  

Non food credit breakup

 

  • Chart below shows industry sector breakup.
  •  

 

industry break up
 
Credit-Deposit Ratio (C/D Ratio)
 

  • Credit-Deposit ratio is proportion of loan created by banks from deposits it receives. In
    other words its capacity of banks to lend.
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  • High ratio indicates banks are generating more credit from its deposits.
    C/D Ratio is impacted by certain factors like credit-deposit growth, cash reserves and
    investments (SLR) made by banks.
  •  

  • Banks gives credit after allocating its deposits to cash reserves and SLR. Therefore
    increase in cash reserves or investment deposit ratio2 will reduce banks capacity to lend,
    thereby lowering C/D ratio.
  •  

  • Chart below shows C/D ratio and investment ratio trend of banks.
  •  

 
investment deposit ratio trend
 

  • From the above chart, we can observe that when banks increase their investments, their
    credits decline and vice versa.
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  • Post 2005, investment-deposit ratio has declined and C/D ratio has increased indicating
    banks are investing less in government and other securities and giving more credit to
    public.
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  • Low deposit growth (means public are holding cash or investing in gold or real estate
    rather than depositing in banks) will result in lower amount to lend out and fall in C/D
    Ratio.
  •  

  • Credit growth depends on economy. When economy is booming, companies for
    expansion borrow more and personal loans increase as purchasing power increases
    thereby increasing bank credits. This in turn will result in higher C/D ratio.
    Chart below shows movement of credit growth with GDP growth.
  •  

 
trend of credit growth with GDP
 

  • From above chart, it’s evident that there is correlation between GDP and credit growth.
  •  

  • Deposit and Bank credit currently3 stand at 64339bn and 49626bn respectively.
  •  

  • Chart below shows credit and deposit growth.
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credit & deposit growth
 

  • Chart below shows allotment of deposits to bank credits, cash reserves and investments
    as % of deposits and in absolute terms.
  •  

 

 

 

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IDFC AMC

Money Multiplier

By: Punam Sharma

What is Money Multiplier?
 

  • RBI creates money in banks via reserve money (M0). As mandated by RBI,
    banks keeps aside some money as part of reserve requirement (CRR1) and lends out
    the excess reserves (excess money in form of deposits in banks).
  •  

  • Money multiplier is the process through which banks create more money
    through its excess reserves, thereby expanding money supply.
  •  

  • In other words, its process of creating more money by banks from reserve
    money.
  •  

  • Chart below shows how banks create more money through excess reserves.
  •  

 

How Money Multiplier impacts Money Supply?
 

  • Money supply2 is a function of money multiplier and reserve money.
  •  

  • Changes in money multiplier will have impact on the money supply.
  •  

  • Factors determining money multiplier are reserve ratio, currency to deposit ratio, credit deposit ratio.
  •  

  • Low reserve ratio, would require banks to keep aside less reserves as CRR, thereby
    increasing its excess reserves to lend out which increases money supply. Higher reserve
    ratio will have reverse effect on money supply.
  • Currency to deposit ratio (currency leakage) tells how much public is holding as cash
    and not re depositing in banks. More cash held by public means lesser deposits thereby
    reducing the amount bank can lend out resulting in lower money supply. Reverse holds
    true when less cash is held by public.
  • Credit-deposit ratio indicates how much banks are lending out rather than keeping with
    themselves. High ratio means banks are lending out more money which in turn would
    increase money supply.
  • Chart below gives a snap shot of the money supply.
  •  

Money Supply

 

Statistics
 

  • Chart below shows Money supply growth as a function of Reserve money growth and
    Money Multiplier
  •  

Reserve Money Growth

 

  • From the above chart, we can see Money supply growth has been supported by
    increase in money multiplier.
  • Post 2008, creation of reserve money has reduced and increase in money supply has
    predominantly let to growth in money supply.
  • Since 2011, RBI has reduced CRR, which has led to money multiplier increase thereby
    increasing money supply.
  • Table below shows data on money supply, reserve money and money multiplier.
  •  

Reserve Money & Money Multiplier

 

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IDFC AMC

What is Reserve Money?
 

  • Reserve Money is sum of a country’s currency in circulation and banks deposits
    with the RBI.
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  • Currency in circulation includes notes in circulation, rupee coins and small coins.
    Bank’s deposits are reserves maintained as cash reserve ratio by banks in the
    current account with the RBI.
  •  

  • It forms the basis on which money supply builds and circulates in the system.
  •  

  • When RBI creates reserve money either via currency or bank reserves, it provides
    liquidity into the banking system which thereby supplies money to the economy.
  •  

  • RBI infuses liquidity by increasing reserve money.
  •  

  • Reserve money is also known as high powered money, monetary base, base
    money and is represented as M0.
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How RBI Creates Reserve Money?
 

  • Reserve Money is liability of the RBI. Two liability components are currency in
    circulation and bank deposits.
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  • Currency in circulation involves creating reserve money by printing currency and
    bank deposits creates reserve money by crediting bank reserves which are
    maintained as part of cash reserve ratio.
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  • To increase its liability, RBI needs to correspondingly increase its assets as
    well.RBI assets are forex assets (foreign currency asset), gold, rupee securities
    (domestic assets).
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  • RBI prints currency by buying foreign currency assets, gold or domestic assets.
    When there is dollar inflows from foreign investors, RBI buys dollars and sells
    rupee to the market, thereby creating reserve money by growing its foreign
    currency assets.(forex intervention)
  •  

  • RBI creates reserve money by buying domestic assets via OMOs, Liquidity
    Adjustment Facility operations.
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  • RBI creates reserve money via bank reserves by increasing Cash Reserve Ratios.
  •  

 
how RBI creates reserve money
 
What is the Impact of Reserve Money?
 

  • Reserve money reflects the liquidity operations of the RBI.
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  • Broad money (M3) which is currency in circulation+ Demand and Time deposits with the
    banks is a multiple of reserve money.
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  • Increase in reserve money, increases broad money (money supply) thereby creating
    liquidity in the economy.
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Statistics
 

  • Below charts show the liability components as % of its contribution in creating Reserve
    money and assets (as % of Reserve Money) bought by RBI against which reserve
    money is created.
  •  

 
Assets & Liabilities of RBI
 

  • From the above charts, we can see, Currency in circulation forms around 70% of reserve
    money and RBI mainly depends on buying foreign currency assets to increase currency
    in circulation.
  • Prior to the 2008 crisis, RBI created reserve money by purchasing foreign currency
    assets and relied less on domestic assets. This is observed between 2005-2007 foreign
    currency assets contributed more than 100%.
  • However post 2008 crisis when foreign inflows reduced, RBI started purchasing
    domestic assets for creation of reserve money.2008 onwards foreign currency assets
    contribution has fallen and domestic assets purchase to back issuance of currency to
    create reserve money has been rising.
  • Banks deposits as % of reserve money has been around 20% as it depends on CRR
    ratio.
  • Post 2008 crisis RBI has lowered CRR to manage liquidity which reduces banks
    contribution to bank deposits with the RBI.
  • Chart below shows growth of reserve money in absolute term via growth in currency in
    circulation and bank deposit.
  •  

 
Reserve Money Absolute Growth
 

  • From the above chart, reserve money has grown around 4.4 times from 2002 till date.

 

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