Topics on the balance of payments

Consequences of persistent current account deficits and financial account surpluses

 Most countries run a deficit in their current account, but this isn’t a major problem for short periods of time, or if there are also times when the country runs a surplus in its financial account.  The real problems may appear if a country maintains a deficit in its current account for an extended period.

So what’s the problem?  Countries that maintain a long-term current account deficit have to pay for their addiction to imported goods somehow. The two ways to pay for this deficit are either to take loans from abroad or to sell its physical or financial assets to foreign buyers. But both of these strategies can be dangerous

The danger of taking loans from abroad  We said earlier that developing countries occasionally overvalue their currency so they can purchase capital goods from foreign sellers. This allows them to import more than they export, resulting in a financial account surplus, that is financed by taking loans from foreign countries. But this can lead to problems such as….

The danger of taking loans from abroad  If a country takes a loan from another country to finance its current account deficit, it must pay interest to the lending country in that country’s currency. This can lead to the depletion of the borrowing country’s foreign exchange reserves

The danger of taking loans from abroad  Interest on loans can be expensive. The country that is indebted to lending countries must pay interest to the lending countries, and this is money that might have been spent on consumption or investment, thus a sacrifice of future economic growth is made.

The danger of taking loans from abroad  The interest payments made by the borrowing country could have been spent on needed imports of capital goods necessary for the production process. Interest payments may prevent the country from furthering their production possibilities and their future ability to export. Sacrifices to economic growth are also made therefore.

The danger of taking loans from abroad  Loans must be paid back in the future. If a country is spending more presently than than it is earning from borrowing, eventually sacrifices will have to be made, The time will come when people will have to reduce their standard of living in order for the country to pay back its loans

The danger of taking loans from abroad  A country with a current account deficit will need to attract financial investments to pay for its current account deficit. They may achieve this by raising interest rates, but that is likely to lead to reduced AD which in turn may lead to recession, which make it even more difficult to pay back loans

The danger of taking loans from abroad  A country that has excessive loans which it may not be able to repay, runs the risk of defaulting on these loans. Depreciation of its currency may result, the country may not be able to secure loans in the future and it may be forced to pursue a policy of achieving a current account surplus, which can be harsh for its citizens to endure.

This sounds bleak, but….  It doesn’t have to be so grave. If the borrowing country is taking loans in order to achieve economic growth, it may be able to pay back its loans while at the same time allowing citizens to improve their standard of living. If the loans are not leading to economic growth, then significant problems are on the horizon.

The danger of selling domestic assets  Rather than financing its current account deficit with loans from abroad, some countries (like the U.S.A.) choose to sell domestic assets to foreigners. This allows U.S. citizens to enjoy high levels of consumption, but comes with problems as well…

The danger of selling domestic assets  Future sacrifices will have to be made by citizens of a country that is currently selling its domestic assets. If in the future, citizens wish to reacquire these assets, they will have to make sacrifices in order to regain ownership of these assets.

The danger of selling domestic assets  The country with a high current account deficit may need to raise interest rates in order to attract foreign investment, which is needed to finance the current account deficit. Recessionary pressures may result from these higher interest rates.

The danger of selling domestic assets  If foreign investors lose confidence in the country with the current account deficit, and fear that its currency may depreciate, foreigners may stop investing in the country. The borrowing country may not be able to finance its current account deficit and its currency may very well depreciate in value.

This also sounds bleak, but….  A country may be able to achieve economic growth while it has gone through the process of selling domestic assets. If it can eventually buy back some of these assets and correct the imbalance in their current and financial accounts, confidence may be restored and its currency value can be maintained

And now the other side of the coin….

Consequences of persistent current account surpluses and financial account deficits

 Low domestic consumption is characteristic of countries with current account surpluses and financial account deficits. This corresponds to lower standards of living compared with countries in the opposite situation

Consequences of persistent current account surpluses and financial account deficits  The deficit in the financial account means that investment money is leaving the country and going abroad as either loans or purchases of foreign assets. Either way, this is funding that could be directed towards the domestic economy.

Consequences of persistent current account surpluses and financial account deficits  Lending to foreign countries may be inherently risky. The borrowing country may default, their currency may depreciate and the borrowing country could end up with significant financial losses.

Solving a persistent current account deficit situation  Countries with a persistent current account deficit problem have several tools they may implement to deal with this situation. All they need to do is figure out how to import less and export more.

Solution 1—Reduction of AD and expenditure-reducing policies  Contractionary fiscal and monetary policy can reduce AD and lower incomes and reduce imports. These policies can also lower inflation rates, make domestic goods more competitive and increase exports. But what’s the downside to this…?

Solution 2—Protectionism/expenditure switching  A country with a persistent current account deficit could resort to protectionism to reduce the amount of imports. However, as you know, these policies also carry lots of negative side-effects….

Solution 3—Depreciation/expenditure switching  A country with a persistent current account deficit could allow its currency to depreciate in order to reduce the amount of imports. The negatives of this include higher import prices (cost-push inflation), and the shifting of SRAS to the left could have recessionary effects.

Anyone still listening?

Solution 4—Exchange Controls  Countries with persistent current account deficits could impose exchange controls, thus limiting the amount of foreign currency available to consumers. These policies have similar negative side-effects to those of protectionist policies.

Solution 5—Supply-side policies?  Supply-side policies might shift SRAS and LRAS to the right, thus reducing domestic firms costs of production and making these firms more competitive abroad. Or they might not…..

The End!