A nation creates a current account deficit when it relies on foreigners for the capital to invest and spend. Depending on why the country is running the deficit, it could be a positive sign of growth. It could also be a negative sign that the country is a credit risk.
Components
According to the Bureau of Economic Analysis, there are four components of the current account. The largest is trade in goods and services. The other three are much smaller. Net income is earned by residents by overseas investments or work. Second are direct remittances from workers to their home country, foreign aid, and foreign direct investments. The third is increases or decreases in assets like banks deposits, securities, and real estate. The largest component of a current account deficit is the trade deficit. That’s when the country imports more goods and services than it exports. The current U.S. trade deficit reveals that the United States imports a lot more than it exports. Many think that America is becoming less competitive in the global market. The second largest component is a deficit in net income. That occurs when foreigners earn more from the country than residents earn on foreign work and investments. The other two components, direct remittances, and investment income aren’t large enough to materially affect the current account deficit.
Causes
Countries with current account deficits are big spenders that foreign investors consider creditworthy. These countries’ businesses can’t borrow from their own residents. They simply haven’t saved enough in local banks. Businesses in a country like this can’t expand unless they borrow from foreigners. That’s where the credit-worthiness comes into the picture. If a country has a lot of spendthrifts, it won’t find any other country to lend to it. That’s what happened during the Greek debt crisis. Why would another country lend to such a spender, even if it is credit-worthy? The lender country also exports a lot of goods and even some services to the borrower. The lender country benefits. It can manufacture more goods, thus giving more jobs to its people. That explains the relationship between China and America. China is among the largest foreign holder of U.S. debt. It’s happy to do so because it’s also the largest exporter to the United States. Japan, however, has become the largest holder of U.S. sovereign debt, standing at around $1.3 trillion as of September, 2020.
Consequences
In the short-run, a current account deficit is helpful to the borrowing nation. Foreigners are willing to pump capital into it. That drives economic growth beyond what the country could manage on its own. In the long run, a current account deficit saps economic vitality. Domestic businesses don’t develop because the market is dominated by foreign competition. Many domestic companies outsource jobs because it’s cheaper for them. Foreign investors may start to question whether the country’s economic growth will provide enough return on their investment. Demand weakens for the country’s assets, including the country’s government bonds. As foreign investors withdraw funds, bond yields rise. The national currency loses value relative to other currencies. That lowers the value of the assets in the foreign investors’ strengthening currency. It further depresses investor demand for the country’s assets. This can lead to a tipping point where investors will dump the assets at any price. The only saving grace is that the country’s holdings of foreign assets are denominated in foreign currency. As the value of its currency declines, the value of the foreign assets rise. That further reduces the current account deficit. In addition, a lower currency value increases exports as they become more competitively priced. The demand for imports falls once prices rise as inflation sets in. These trends stabilize any current account deficit. Regardless of whether the current account deficit unwound via a disastrous currency crash or a slow, controlled decline, the consequences would be the same. That’s a lower standard of living for the country’s residents.
How To Correct a Current Account Deficit
A country with a current account deficit should invest the foreign capital it receives wisely. It should build roads and ports, and educate its workforce, to boost international trade. The country’s leaders should create a current account surplus as soon as possible. They should improve domestic productivity and the competitiveness of its local businesses. It should also seek to reduce imports of basic necessities, such as oil and food, by boosting that ability at home.
The Current Account Deficit and the Balance of Payments
Balance of Payments
