What happens when CAD rises

UPSC Syllabus: Gs Paper 3- Indian economy

Introduction

Even with 7.4% growth, contained inflation, Current Account Deficit (CAD) at ~0.8% of GDP, and $701.4 billion reserves, the rupee fell over 5% last year and equity markets turned volatile. This reflects a disconnect between strong macro fundamentals and external outcomes. When oil prices rise, import bills increase and CAD widens. A stronger dollar and weak capital flows reduce financing support, so short-term pressures dominate currency movement despite stable fundamentals.

Oil Shock as the Starting Point of CAD Pressures

1. War-driven oil price rise increases import bill: Higher crude prices raise the import bill before demand adjusts, widening the trade deficit and increasing CAD.
2. India’s oil dependence raises dollar demand: As a major oil importer, dollar demand jumps sharply, putting direct pressure on the rupee.
3. Corporate margins get squeezed: Higher import costs reduce corporate profitability, adding to economic stress.
4. Short-term imbalance rises before adjustment: Import costs increase immediately, while demand adjusts slowly, worsening short-term CAD.
5. Quantified long-term impact on CAD: A 1% oil price rise worsens CAB by up to 0.08pp of GDP over five years; 10% → ~0.8pp, 20% → ~1.6pp, and 5% → ~0.4pp, showing cumulative pressure.

Impacts of CAD Pressures on the Economy

1. Currency weakens despite strong fundamentals: The rupee fell over 5% and stayed near record lows, showing CAD pressure dominates short-term outcomes.
2. Equity markets become volatile: Rising external imbalance leads to increased volatility in equity markets.
3. Mismatch between fundamentals and outcomes: Strong indicators like growth and reserves fail to stabilize currency in the short run.
4. Buffers partially absorb shocks: Services exports and remittances reduce pressure but cannot fully offset CAD rise.
5. Policy tools delay pass-through: Hedging and pricing policies slow the impact but do not eliminate it.

From CAD to Currency Pressure: Role of Capital Flows

1. CAD requires stable financing: Even a moderate CAD (~0.8% of GDP) needs consistent capital inflows for balance.
2. Decline in portfolio investment flows: In 2025, foreign portfolio investors pulled back, reducing financing support.
3. Weakening of FDI inflows: Net FDI softened due to profit repatriation and outbound investment, weakening stability.
4. Shift in market risk perception: Reduced inflows changed risk calculus, increasing currency sensitivity.
5. Flow dynamics overpower stock strength: Strong reserves ($701.4 billion) and growth cannot offset thin and volatile inflows.
6. Reduced patient capital increases vulnerability: Lower stable inflows make the rupee more sensitive to risk appetite shifts.

Role of Global Dollar Strength and Risk Aversion

1. Stronger dollar tightens financial conditions: A strong dollar leads to tighter global liquidity, reducing capital flows to India.
2. Risk-off sentiment reduces inflows: Investors shift to safer assets, increasing risk premium and lowering inflows.
3. Simultaneous pressure on currency: Higher oil-related dollar demand and lower capital inflows hit the rupee together.
4. Short-term pricing driven by premia: Currency movement is driven by oil and risk premia in the short run, not fundamentals.

Why the Pressure Persists Despite Strong Fundamentals

1. Long-term anchor exists but does not act quickly: The rupee is ~18% below PPP equilibrium, showing strength in the long run but not immediate relief.
2. Based on long-term real exchange rate behaviour: Estimates use monthly RER data over more than three decades, showing mean-reverting trends over time.
3. Very slow pace of adjustment: Only 13% correction happens in one year, 25% in three years, and 44% in five years, showing gradual adjustment.
4. Long half-life delays correction: It takes more than five years to correct half of the misalignment, slowing recovery.
5. Adjustment is uneven and shock-driven: Corrections often occur during risk-off episodes and capital outflows, not smoothly.
6. India adjusts slower than peers: Countries like Brazil and Indonesia adjust faster, highlighting India’s slower response.
7. Short-term shocks dominate fundamentals: Oil shocks and capital flow volatility overpower fundamentals, keeping pressure on the rupee.

Conclusion

Rising CAD reflects dependence on oil imports and volatile capital flows. Stability needs fuel tax adjustments, FX reserve use, hedging, diversified sourcing, and stable greenfield FDI through predictable policy and local-currency markets. Long-term strength requires export scale, energy diversification, strategic reserves, renewables, and efficiency to reduce vulnerability.

Question for practice:

Discuss how a rise in the Current Account Deficit (CAD) affects the rupee despite strong macroeconomic fundamentals, and examine the role of oil prices, capital flows, and global factors in this process.

Source: Businessline