A lot of people nowadays wonder what is credit score and why this term has been gaining so much importance in the banking industry and hence our financial life. But amidst the quest to focus on credit score and the importance of credit monitoring, first, it is important to know two key economic terms that impact and reflect about our economy a lot.
Let’s deep dive a bit and understand them.
The first important economic term is current account deficit (CAD).
A common yet crucial financial term often heard about when reading or searching about the economy is the current account deficit. Similar to how knowing what is credit score
is important for your credit health, the current account deficit is a partial reflector of the credit monitoring process of the country’s economy.
CAD is a condition wherein the country’s trade wherein the expenses in the form of imported goods and services’ value exceeds the revenue generated in the form of exported products and services’ value.
How is the Current Account Deficit calculated?
The country’s Current account is the net revenue on exports minus the payments for imports of goods and services.
Total exports comprise the country’s income via selling to the rest of the world. Total imports comprise the country’s expenditure via buying from the rest of the world.
A positive current account balance value implies that the country is exporting more and earning more than it’s spending. At the same time, a negative balance shows that the country is buying more from the rest of the world than the amount it is earning by selling to them. So, CAD is a way of credit monitoring for economists to know how the nation’s finances are going on.
How to balance out the Current Account Deficit?
When you get to know about what is credit score and what your current score is, you take all measures to improve it if required.
So, the nation’s finance ministry, too, takes measures to balance out CAD.
The current account deficit can be lowered in numerous ways. Firstly, the country can increase the value of exports vis-a-vis the value of imports from the rest of the world. To work towards the same, steps like placing restrictions on imports or emphasizing policies that promote exports can be taken.
Secondly, the country can even work internally and develop or tweak policies so that the domestic companies’ global competitiveness improves. During monetary policy decisions, steps can be taken to improve the domestic currency’s valuation vis-a-vis foreign currencies via devaluation. This would, in turn, assist in reducing the country’s export costs, hence pulling down the fiscal deficit as well.
How is the Current Account Deficit important?
In the real short term, a current account deficit is usually helpful to the borrowing nation, as the country’s economic growth drives u since foreigners are keen to pump capital into it.
However, in the long run, a current account deficit weakens the economic vitality. Foreign investors may, in such cases, question the ability of a country’s economic growth to provide enough return on their investments. Consequently, as foreign investors begin to withdraw funds, bond yields begin to rise. The country’s national currency tends to lose its value relative to other currencies, which lowers the value of the net assets in the foreign investors’ strengthening currency.
Is the Current Account Deficit good or bad?
After understanding what is credit score, you get to know that a low credit score is bad for your financial health and credit approval chances, right?
But the answer to whether CAD is good or bad is not that simple.
The answer to this depends upon the reason behind the deficit. If the deficit is because the country has been using external debt to finance investments which in the end result in higher returns than debt’s interest rate, it’s a good deficit. In such a scenario, the country can simultaneously carry a current account deficit yet remain solvent. Whereas if the fiscal deficit is reflective of low savings instead of high investment, it could be an indication of either consumption binge or even a reckless fiscal policy framework.
Next term to know about, fiscal deficit.
One of the most commonly heard financial terms which we often come across when it comes to a country’s economic condition and policies is the Fiscal Deficit. A fiscal deficit is a condition wherein there is a shortfall in the government’s income compared to its spending. Simply put, a country’s government that carries a fiscal deficit is spending beyond its means, implying that their expenditure for that year exceeds their revenue.
How is the fiscal deficit calculated?
This is another parameter that assists in the process of economic check and credit monitoring of a nation.
The fiscal deficit is calculated both in absolute terms as well as a percentage of the country’s GDP (gross domestic product). This means that it is calculated as a percentage (%) of its GDP or simply as the total money spent by the Indian government in excess of that year’s income.
What is included in the calculation of the fiscal deficit?
The calculation of fiscal deficit is mainly based on two vital components, namely, income and expenditure. Let’s deep dive a bit to understand both components.
-The income component is basically comprised of two variables. The first is the revenue generated from taxes levied by the central government—secondly, the income generated from non-tax variables. As far as the taxable income is concerned, it includes revenue from GST, excise duty, corporation tax, customs duty, income tax, etc. Whereas in the case of non-taxable income, components like interest receipts, external grants, dividends, receipts from union territories (UTs), profits, etc., are included in the calculation.
-On the other hand, the expenditure component comprises funds allocated by the government (usually during Union Budget every year) for the completion of numerous tasks such as pension and salary payments, funds for infrastructure, emoluments, creation of assets, etc.
How can Fiscal Deficit be balanced out?
A country whose government is carrying a fiscal deficit tends to balance it out, at least for the short-term, via market borrowings. Government issues bonds and sells them to banks, who purchase these bonds and later sell them to investors. Given that government bonds are undoubtedly considered an extremely safe investment instrument, the interest rate paid on loans to the government, therefore, represent a risk-free investment for investors.
Additionally, even the government also tends to view the fiscal deficit situation indeed as an opportunity to extend various schemes and policies without having to take extreme steps such as increasing taxes or lowering the spending in the annual budget announcement.
Why is Fiscal Deficit important, and how does it impacts us?
Fiscal deficits, especially the long-running ones, can often turn out to be detrimental to both economic growth and stability. When the government goes on a borrowing spree to repeatedly try balancing the deficit, this action tends to crowd out private borrowers such as companies, manipulates interest rates, and also reduces net exports, resulting in either higher taxes, higher inflation, or even both.
The practice of excessive money printing by the government to fund such deficits can lead to the devaluation of paper money, thereby reducing consumers’ purchasing power as well. A significantly high fiscal deficit could also result in derailment of macro stability, hence leading to delays or even removal of investment decisions by businesses, which would affect employment prospects and hiring in the economy. All this can even be a signal during credit monitoring that the economy needs some urgent corrective measures so that more trouble doesn’t pile up for the nation and citizens.