Tuesday, October 2, 2012

Does a Current Account Deficit Matter?

A current account deficit measures the balance of trade in:
  • goods
  • services
  • net investment incomes and transfers
A deficit on the current account means a country is importing more than we are exporting. This will have to be matched by a surplus on the financial and / or capital account.

The financial account comprises of 2 main features:
  • a) Short Term Capital flows e.g. hot money flows and purchase of securities
  • b) Long Term Capital flows e.g. investment in building new factories

current-account-deficit-world

Some economists argue we need not worry about a current account deficit. This is because:
  1. If a current account deficit is financed from long term capital inflows then this can be beneficial for the economy. Inward investment can increase the productive capacity of the economy.
  2. In an era of globalisation it is much easier to attract sufficient capital flows to finance the deficit.
  3. If the deficit gets too large it will cause a devaluation which helps to reduce the deficit. Also when there is a slowdown in consumer spending the deficit will fall.
  4. A current account deficit provides an outlet for domestic demand and prevents inflation.


Reasons to Worry about a Current Account Deficit.

1. There could be problems financing the deficit in the long term. A short term deficit is not a problem, but if you have a deficit of over 6% of GDP then it is a problem if you rely on Capital flows. A significant part of the current account deficit in US is financed by Chinese investors buying US securities, at relatively low interest rates.

2. Most countries would not be able to borrow such large amounts at low interest rates. The US currently can because the US is seen as the World’s reserve currency. However if attitudes to the US economy change and investors lose their confidence in the US economy, they will stop buying US debt. This will cause 2 problems.

  • US interest rates will need to rise to attract enough people to buy the debt. These higher interest rates will reduce demand in the economy. Higher interest rates will particularly hurt American consumers who have large amounts of debt at the moment.
  • If capital flows can’t be attracted then the dollar will continue to devalue further. This could cause inflationary pressures, interest rates may need to rise to stabilise the dollar.
Basically to correct the deficit would be a painful experience for the US economy and result in a slowdown or possibly recession

3. In the US the current account deficit is to a large extent caused by excess spending in the economy. It is partly caused by government borrowing which increases Aggregate Demand in the economy and hence growing demand for imports. A large current account deficit is often a sign of an unbalanced economy. It could be a sign of structural weakness and an uncompetitive manufacturing sector. This is particularly a problem in the Eurozone where the exchange rates are permanently fixed.

4. A deficit on the current account increases foreign liabilities. In the beginning a current account deficit could be just a deficit on buying goods. However over time the deficit will be increased by the interest payments on the capital surplus. Foreigners invest in the US. On these investments they receive interest payments or dividends. These dividends count as a debit on the current account. Therefore the longer the deficit goes on the higher the level of investment income debits will be accrued. This means that in the future the economy will need to attract capital flows just to pay off the investment income. As well as the deficit on goods and services.

US current account deficit reached 6% of GDP in 2006. This reflected strong domestic demand and a decline in competitiveness. The credit crunch caused a reduction in US current account deficit.

Example of Iceland's Current Account Deficit




Iceland is an example of a country with a large current deficit which later imploded.
In the years leading up to 2008, there was a sharp inflow of capital to Icelandic banks. This enabled Iceland to run a record current account deficit. Iceland was spending more than they were earning. When capital flows dried up, banks lost money and there was a rapid deterioration in the current account.

Current Account Deficits in the Eurozone

In the Eurozone, current account deficits are a bigger cause for concern because countries have a permanently fixed exchange rate (common currency). Therefore they can't devalue to restore competitiveness. Therefore countries may have to pursue internal devaluation (deflation) to restore competitiveness.

Conclusion


It depends on the size of the current account as a % of GDP. Clearly in Iceland's case, over 20% of GDP was unsustainable. But, in US case 6% of GDP later shrank to a more manageable 3% of GDP.
A current account deficit is often a signal of another underlying problem. For example, a banking boom (in Iceland's case). A boom in domestic demand or a lack of competitiveness in Eurozone.


See also:

External links

8 comments:

http:www.figurewizard.com said...

This is a fascinating article. I see that it was published in March of 2007. Since then we have seen the Northern Rock fiasco here on the back of a worldwide tightening of credit.

The problem for our present woeful current account deficit is that medium and long term inward capital flows have been largely for mergers and acquisitions, not for long term manufacturing as was the case in the 1980's with the likes of Nissan and Honda. As Harold Macmillan once famously said; this is akin to selling the family silver. Since the credit crunch margers and acquisition activity will be severely curtailed. As a result we are now more reliant on hot money flows to balance the books.

It is for this reason that the decision by the Bank of England to reduce interest rates by a quarter point on the 6th December 2007 may come to be seen as a mistake. The fall in Sterling that followed the announcement of this must serve as a warning.

Anonymous said...

Totally agree.At this stage of the economic cycle to be also running a Budget Deficit of 3% GDP is a sure sign that monetary and fiscal
policy is too lax.Further easing of interest rates without severe control of public expenditure will create temporary relief at the cost of medium term crisis and longer term decline.We need another
Margaret Thatcher to shake things up!

Richard said...

Thanks anonymous. I'm not so sure Mrs Thatcher is the one for us to avoid boom and busts, her record was pretty dismal in this regards

wyclefguy2007 said...

Your works are highly rewarded. In view of your points, I believe money flows can also be generated through investment in building the factories that will promotes employment opportunities thereby alleviate anti-social beheviours, jobseekers allowance given to working class unemploy citizen and foreigner, generates more interest to reduce the deficit and thereby prevent the country's economy to incure more debts into the deficit. In addition, many countries in the developing economy at times budget more than their GDP of the previous budget year. Despite having a deficit economic situation at hand, they will still continue to borrow into the economy that is already unstabilised. Moreso, Investors money do helps in reducing country's current account deficit through the purchases of country's securities, but at times causes more damages on the country's local produce. For instance, during 80s, a locally owned company in United States was known as the major manufacturer of standard electronics, but a company in one of the developing nation started to produce the similar products. when a situation of capitalism arise, the said company came to buy about 60% of electronic manufacturing companies in the U.S at that time thereby promotes its countries Trade Mark. So, I will suggest that countries can prevent fall into deficit by promoting locally produce, preveting borrowing, generates more revenue and budget for less expenditure.

wyclefguy2007 said...

Your points are great. Whenever expenditures are more than revenue, it will definetely create deficit and thereby increase country's debt and promotes borrowing from other sources to creates a standardized economy. Sometimes too much money in circulation causes damages into economy by virtue of loans without collateral which is rampered in the U.K economy. A current account deficit with a reasonable plans on available resources does matter.

Lisa said...

True facts shared on Current Account Deficit.thanks so much and appreciated. Bank jobs requirements

Gary Hulbert said...

As we all know that our economy is having some hard time working into its different section to make their role or work. Just like they have said Economic cycle is running down with a 3% GDP budget deficit. Thanks for showing us something important like this.

Capital Accounts Collection

Muriel T. Roseberry said...

A deficit in an agreed account as per tradable assets will hamper a bilateral agreement between two parties. That means a suspension between import and export is agreed until the deficit is either settled or reconciled with flexible means.