{"id":359928,"date":"2026-04-03T21:36:57","date_gmt":"2026-04-03T16:06:57","guid":{"rendered":"https:\/\/forumias.com\/blog\/?p=359928"},"modified":"2026-04-03T21:36:57","modified_gmt":"2026-04-03T16:06:57","slug":"what-happens-when-cad-rises","status":"publish","type":"post","link":"https:\/\/forumias.com\/blog\/what-happens-when-cad-rises\/","title":{"rendered":"What happens when CAD rises"},"content":{"rendered":"

UPSC Syllabus: Gs Paper 3- <\/strong>Indian economy<\/p>\n

Introduction<\/strong><\/h2>\n

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.<\/p>\n

Oil Shock as the Starting Point of CAD Pressures<\/strong><\/h2>\n
    \n
  1. War-driven oil price rise increases import bill:<\/strong> Higher crude prices raise the import bill before demand adjusts<\/strong>, widening the trade deficit and increasing CAD.<\/li>\n
  2. India\u2019s oil dependence raises dollar demand:<\/strong> As a major oil importer, dollar demand jumps sharply<\/strong>, putting direct pressure on the rupee.<\/li>\n
  3. Corporate margins get squeezed:<\/strong> Higher import costs reduce corporate profitability<\/strong>, adding to economic stress.<\/li>\n
  4. Short-term imbalance rises before adjustment:<\/strong> Import costs increase immediately, while demand adjusts slowly<\/strong>, worsening short-term CAD.<\/li>\n
  5. Quantified long-term impact on CAD:<\/strong> A 1% oil price rise worsens CAB by up to 0.08pp of GDP over five years<\/strong>; 10% \u2192 ~0.8pp<\/strong>, 20% \u2192 ~1.6pp<\/strong>, and 5% \u2192 ~0.4pp<\/strong>, showing cumulative pressure.<\/li>\n<\/ol>\n

    Impacts of CAD Pressures on the Economy<\/strong><\/h2>\n
      \n
    1. Currency weakens despite strong fundamentals:<\/strong> The rupee fell over 5% and stayed near record lows<\/strong>, showing CAD pressure dominates short-term outcomes.<\/li>\n
    2. Equity markets become volatile:<\/strong> Rising external imbalance leads to increased volatility in equity markets<\/strong>.<\/li>\n
    3. Mismatch between fundamentals and outcomes:<\/strong> Strong indicators like growth and reserves fail to stabilize currency in the short run<\/strong>.<\/li>\n
    4. Buffers partially absorb shocks:<\/strong> Services exports and remittances<\/strong> reduce pressure but cannot fully offset CAD rise.<\/li>\n
    5. Policy tools delay pass-through:<\/strong> Hedging and pricing policies<\/strong> slow the impact but do not eliminate it.<\/li>\n<\/ol>\n

      From CAD to Currency Pressure: Role of Capital Flows<\/strong><\/h2>\n
        \n
      1. CAD requires stable financing:<\/strong> Even a moderate CAD (~0.8% of GDP)<\/strong> needs consistent capital inflows for balance.<\/li>\n
      2. Decline in portfolio investment flows:<\/strong> In 2025, foreign portfolio investors pulled back<\/strong>, reducing financing support.<\/li>\n
      3. Weakening of FDI inflows:<\/strong> Net FDI softened<\/strong> due to profit repatriation and outbound investment<\/strong>, weakening stability.<\/li>\n
      4. Shift in market risk perception:<\/strong> Reduced inflows changed risk calculus<\/strong>, increasing currency sensitivity.<\/li>\n
      5. Flow dynamics overpower stock strength:<\/strong> Strong reserves ($701.4 billion<\/strong>) and growth cannot offset thin and volatile inflows<\/strong>.<\/li>\n
      6. Reduced patient capital increases vulnerability:<\/strong> Lower stable inflows make the rupee more sensitive to risk appetite shifts<\/strong>.<\/li>\n<\/ol>\n

        Role of Global Dollar Strength and Risk Aversion<\/strong><\/h2>\n
          \n
        1. Stronger dollar tightens financial conditions:<\/strong> A strong dollar leads to tighter global liquidity<\/strong>, reducing capital flows to India.<\/li>\n
        2. Risk-off sentiment reduces inflows:<\/strong> Investors shift to safer assets, increasing risk premium<\/strong> and lowering inflows.<\/li>\n
        3. Simultaneous pressure on currency:<\/strong> Higher oil-related dollar demand and lower capital inflows<\/strong> hit the rupee together.<\/li>\n
        4. Short-term pricing driven by premia:<\/strong> Currency movement is driven by oil and risk premia in the short run<\/strong>, not fundamentals.<\/li>\n<\/ol>\n

          Why the Pressure Persists Despite Strong Fundamentals<\/strong><\/h2>\n
            \n
          1. Long-term anchor exists but does not act quickly:<\/strong> The rupee is ~18% below PPP equilibrium<\/strong>, showing strength in the long run but not immediate relief.<\/li>\n
          2. Based on long-term real exchange rate behaviour:<\/strong> Estimates use monthly RER data over more than three decades<\/strong>, showing mean-reverting trends over time.<\/li>\n
          3. Very slow pace of adjustment:<\/strong> Only 13% correction happens in one year<\/strong>, 25% in three years<\/strong>, and 44% in five years<\/strong>, showing gradual adjustment.<\/li>\n
          4. Long half-life delays correction:<\/strong> It takes more than five years<\/strong> to correct half of the misalignment, slowing recovery.<\/li>\n
          5. Adjustment is uneven and shock-driven:<\/strong> Corrections often occur during risk-off episodes and capital outflows<\/strong>, not smoothly.<\/li>\n
          6. India adjusts slower than peers:<\/strong> Countries like Brazil and Indonesia adjust faster<\/strong>, highlighting India\u2019s slower response.<\/li>\n
          7. Short-term shocks dominate fundamentals:<\/strong> Oil shocks and capital flow volatility<\/strong> overpower fundamentals, keeping pressure on the rupee.<\/li>\n<\/ol>\n

            Conclusion<\/strong><\/h2>\n

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

            Question for practice:<\/strong><\/p>\n

            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.<\/p>\n

            Source<\/strong>: Businessline <\/a><\/p>\n","protected":false},"excerpt":{"rendered":"

            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… Continue reading What happens when CAD rises<\/span><\/a><\/p>\n","protected":false},"author":10320,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"jetpack_post_was_ever_published":false,"footnotes":""},"categories":[1230],"tags":[12044,216,8184],"class_list":["post-359928","post","type-post","status-publish","format-standard","hentry","category-9-pm-daily-articles","tag-business-line","tag-gs-paper-3","tag-indian-economy","entry"],"jetpack_featured_media_url":"","views":"","jetpack_sharing_enabled":true,"_links":{"self":[{"href":"https:\/\/forumias.com\/blog\/wp-json\/wp\/v2\/posts\/359928","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/forumias.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/forumias.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/forumias.com\/blog\/wp-json\/wp\/v2\/users\/10320"}],"replies":[{"embeddable":true,"href":"https:\/\/forumias.com\/blog\/wp-json\/wp\/v2\/comments?post=359928"}],"version-history":[{"count":0,"href":"https:\/\/forumias.com\/blog\/wp-json\/wp\/v2\/posts\/359928\/revisions"}],"wp:attachment":[{"href":"https:\/\/forumias.com\/blog\/wp-json\/wp\/v2\/media?parent=359928"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/forumias.com\/blog\/wp-json\/wp\/v2\/categories?post=359928"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/forumias.com\/blog\/wp-json\/wp\/v2\/tags?post=359928"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}