Consequences of current account deficits and surpluses

Overview

Why a current account deficit is not necessarily a problem, benefits a current account deficit brings to domestic consumers and consequences of a current account deficit for future generations.

What you need to know

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Questions from this subtopic

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1. 1

   Explain why a current account deficit is not necessarily a problem.

   Model answer

   A deficit may reflect a country importing capital equipment to build productive capacity, financed by foreign investors who expect a return, in which case the borrowing pays for itself through higher future output. It may reflect an economy growing faster than its trading partners, so its import demand is rising more quickly than its export markets, which is a symptom of strength rather than weakness. Where the deficit is financed by long-term direct investment attracted by good prospects rather than by short-term borrowing, it is sustainable. The size, the cause and above all the method of financing determine whether it matters.

2. 2

   Under what circumstances does a current account deficit become a serious problem?

   Model answer

   It becomes serious when it is large relative to national output, persistent, and reflects consumption rather than investment, so that it is building up liabilities without building the capacity to service them. It is dangerous when financed by short-term borrowing or volatile portfolio flows that can be withdrawn at short notice, and when the underlying cause is a loss of competitiveness that shows no sign of correcting. In those conditions the country is vulnerable to a sudden stop in which foreign lenders refuse to roll over the financing, forcing an abrupt depreciation, sharp interest rate rises and a severe contraction.

3. 3

   Analyse the consequences of a persistent current account deficit for a country's external liabilities.

   Model answer

   Each year's deficit must be financed by selling assets or borrowing, so the stock of foreign claims on the country grows. Servicing those claims requires ever-larger payments of interest, profits and dividends abroad, which appear as primary income debits and therefore widen the current account deficit further. This can become self-reinforcing, so that a deficit originally caused by trade becomes increasingly a deficit caused by income payments. Ownership of the country's productive assets and property also shifts abroad, which has political as well as economic implications.

4. 4

   Analyse the effect of a persistent current account deficit on the exchange rate.

   Model answer

   A current account deficit means that, from trade and income transactions alone, more of the country's currency is being supplied to buy foreign currency than is being demanded, which puts downward pressure on the exchange rate. Whether the currency actually falls depends on the capital account: strong inflows of foreign investment can create enough demand for the currency to hold it up, and this is how large deficits persist for years without depreciation. If confidence weakens and those inflows stop or reverse, the correction can be sudden and large rather than gradual.

5. 5

   Analyse the consequences of a current account deficit for domestic employment and output.

   Model answer

   A deficit means domestic residents are spending on foreign output rather than domestic output, so demand and employment in tradeable sectors are lower than they would otherwise be, and the effect is concentrated in manufacturing and other import-competing industries. This can produce structural unemployment in particular regions. Working the other way, the imports include capital equipment and inputs that support domestic production, and the capital inflows financing the deficit fund domestic investment that creates jobs. The net effect depends on whether the deficit reflects strong domestic demand, which raises employment overall, or weak competitiveness, which lowers it.

6. 6

   Explain why a country running a large current account deficit may face pressure to raise interest rates.

   Model answer

   The deficit must be financed by attracting foreign capital, and foreign investors must be persuaded to hold the country's assets rather than someone else's. If confidence weakens, a higher return is required to keep those funds coming in and to stop existing holders leaving, so the authorities may have to raise interest rates. Higher rates then depress domestic investment and consumption and raise the cost of servicing government and household debt, so the external position begins to dictate domestic monetary policy, which is a real loss of policy freedom.

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