Current Account Deficit: Causes and Effects

Current Account Deficit: Causes and Effects

A current account deficit is a situation in which the value of the goods and services a particular country imports exceeds the value of the goods and services it exports.

The current account is one of the two components of the balance of payments of a particular country. It represents the value of all exports and imports, as well as the international outflow and inflow of capital. It includes the balance of trade, net primary income or factor income on foreign investments minus payments made to foreign investors, and currency transfers.

Fundamentally, the current account is a measurement of the earnings and expenditures of a country abroad. Hence, a surplus or a deficit is an indicator of economic health.

Causes of Current Account Deficit

A deficit in the current account may be an indicator of emerging or existing problems in the economy or the shortcomings of a particular government. However, there are different factors and causes of this deficit.

Below are the specific causes and their respective overview:

1. Economic Growth: The expansion and peak stages of the business cycle often bring in improved consumer spending powers due to an increase in the national income and an increase in demand for goods and services. However, if domestic producers are not able to meet the domestic demand, consumers will have to resort to purchasing goods and services abroad. Furthermore, demand for imported products also increases whenever people have more disposable income.

2. Overvalued Currency: Currency overvaluation often results when a local currency is highly demanded by foreigners or if a central bank raises internal interest rates and demand in the foreign exchange markets increases. Nevertheless, an overvalued currency makes imports artificially cheaper and exports more expensive. The demand for imported products increases because they are cheaper than their counterpart domestic products. In addition, exports become more unattractive in the international market.

3. High Inflation Rate: Rising inflation rate can be another cause of current account deficit. High inflation can affect how domestic firms operate, especially the cost of doing business. Furthermore, it also reflects the domestic price of their goods and services compared with the prices of counterparts and substitutes from abroad. Hence, if the inflation rate in a particular country rises faster than in other countries, it will make exports less competitive and imports more competitive.

4. Trade Policies: Another important factor that affects the current account of a particular country is its trade policies. Protectionist policies can result in lower imports and higher exports, thus potentially resulting in a current account surplus. However, ill-planned trade agreements with other countries can affect local industries and sectors by lowering trade and entry barriers, especially if counterpart and even substitute goods and services from other countries are cheaper and have better quality.

5. Uncompetitive Exports: Another key cause of current account deficit is the decline in the competitiveness of domestic manufacturing or quality of export goods and services and the declining comparative advantage of a country. For example, it makes sense to import products if it is more expensive to manufacture them at home. Furthermore, if export products have lower quality than their foreign counterparts, then they will not be attractive both in the domestic and international markets.

6. Recession Elsewhere: The economic health of other countries can affect the economic health of a particular country. For example, with regard to trade balance, if the major trading partners of a particular country experience economic contraction, then it will affect its exports. These trading partners undergoing low to negative economic growth would be importing less due to a decline in domestic spending power and a decrease in the domestic demand for imported goods and services.

7. Excessive Borrowing: Countries that run on budget deficit resort to borrowing from foreign creditors to finance the normal operations of their governments or fund their major public projects. However, foreign borrowing eventually leads to debt and interest repayments and thus, an outflow of capital. Remember that the current account includes not only trade but also payments made to foreign investors. In some cases, excessive borrowing can lead to default and reduced capital inflow.

The aforementioned are some of the most common factors or causes of current account deficit. However, in general, these causes, including those that are not mentioned above, can also be categorized into two: structural causes and cyclical causes.

Structural causes include under-investment of the government and firms in the local economy, lack of innovation in relevant industries and sectors, relatively low productivity of the firms due to low economic activity, prolonged high inflation, emergence of competitors with cost leadership and strong differentiation, and shortcomings of the government.

On the other hand, cyclical causes are somewhat natural occurrences stemming from the business cycle. These include temporary currency overvaluation, economic growth leading to a boom in domestic demand, and recession in other countries, among others

Effects of Current Account Deficit

A current account deficit does not directly indicate an existing economic problem. In fact, some countries have been in deficit for so long but their economies remain relatively afloat. Note that the United States has been in twin deficits—budget and current account deficits.

The deficit can be sustainable if its underlying causes have positive effects on future economic growth. However, it is considered unsustainable if it is caused by macroeconomic imbalances that would result in disruptive adjustments in the future.

Below are the specific effects and their respective overview:

1. Economic Imbalance: Persistent or prolonged periods of high imports and low exports can be an indicator that the economy has become imbalanced, especially in the aspect of consumer spending and long-term investments in domestic production. The general population seems to be more dependent on imports rather than the capabilities of domestic firms. Furthermore, the country has also become less self-sufficient because of its dependence on imported goods and services, including commodities.

2. Capital Flight: Foreign investors may refrain from investing in countries with a very high current account deficit, especially if it is accompanied by a budget deficit. Existing investors may also pull out their existing investments to mitigate risks, particularly if the economic trajectory of the particular country is heading toward recession. Note that this phenomenon was observed during the Asian Financial Crisis of 1997 which saw capital flight from Asian countries running large current account deficits.

3. Reserve Depletion: It is also important to highlight the impact of current account deficit on foreign exchange reserves. To illustrate, large and prolonged deficits that have left a country less self-sufficient would result in the depletion of its foreign reserves. This comes from the fact that foreign currencies, especially the United States dollars, are used when it comes to importation. Of course, it is important to note that low exports can also decrease the value of the local currency in the foreign exchange market.

4. Currency Devaluation: Some cases require the use of the local currency of the exporting country to purchase its exported products. This is true for large and established countries such as the United States and China. Low exports mean that there the local currency has less use and importance in international trade. However, as part of a market correction, this devaluation of the local currency can somewhat offset the deficit. Remember that an overvalued currency is one of the causes of current account deficit.

5. Employment and Income: Another effect of current account deficit is the specific consequences on the local labor market and national income. The declining competitiveness of exports would eventually lead to downsizing in firms involved in the production of export products. Others might be forced to close down due to the intensity of the competition against imported products. Hence, running large and prolonged deficits can increase the unemployment rate and decrease national income.

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