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What’s current account deficit, and why does it matter?

Sairas Rahman
26 May 2023 00:00:00 | Update: 26 May 2023 17:52:01
What’s current account deficit, and why does it matter?

A current account deficit (CAD) is a situation where a country’s total imports of goods, services, and investments exceed its total exports of goods, services, and investments, resulting in a net outflow of currency to other nations.

Oversimplified, it is the difference between a country’s total payments to other countries and its total receipts – including remittance - from those countries in a given period, usually a year.

The current account includes trade in goods and services, investment income, and transfers such as foreign aid. A current account deficit can be an indicator of a country’s economic headwinds, as it suggests that the country is consuming more than it is producing.

However, it can also indicate that the country is borrowing money from foreign investors to finance its current consumption, which may be necessary for economic growth.

To bring things into perspective, Bangladesh’s CAD reached $3.6 billion during the July-March period of FY23. Compared year-on-year, the country’s CAD has declined, but the deficit grew in terms of the financial account, latest central bank data shows.

This is a direct ripple effect of a nearly 18 per cent decline in net foreign direct investment (FDI), and 24 per cent decline in medium and long-term foreign loans. This ongoing situation has been having a consistent and severe impact on Bangladesh’s foreign reserves.

How does CAD work?

A country can reduce its existing debt by increasing the value of its exports.

It can impose import limitations, such as tariffs or quotas, or it can focus on policies that encourage export, including import substitution, industrialisation, or policies that increase the global competitiveness of indigenous enterprises.

Although having a current account deficit does not necessarily mean a country is spending beyond its means. A country can maintain its financial stability if it uses its external debt to fund investments that provide larger returns than the debt’s interest rate.

A current account deficit occurs when a country imports more goods and services than it exports, meaning that it is spending more money abroad than it is receiving. This results in a negative balance of trade and can lead to a decrease in the value of the country’s currency.

For example, if a country spends $1 billion on imports, but only earns $800 million from its exports, it has a current account deficit of $200 million.

Effects on the economy

A country’s CAD can be calculated by subtracting total value of exports from total value of imports

So, it is the difference between an economy’s net imports and exports. Since the current account includes variables like trade gaps, net current transfers, and net income from abroad, its deficit indicates a negative value.

Unlike balance of payment (BOP), CAD considers domestic capital flows. Hence, they can affect the flow of foreign exchange and can destabilise the economy.

The Keynesian formula for GDP is Y = C + I + G + NIFA. In this equation, the national income or GDP is represented as Y, consumption as C, investments as I, and government expenditure as G. NIFA refers to net income from abroad.

So, it is clear that the deficit in the current account affects a nation’s GDP and eventually affects its exchange rate. This also indicates the inefficiency of fiscal stimulus to incentivise growth with higher debt levels.

Normally, nations with high CAD indicate a fall in competitiveness and an overvaluation of their exchange rate. Countries with floating exchange rates can eventually restore their market competitiveness.

CAD can trigger a myriad of problems for a country’s economy.

A high CAD indicates that investors lose interest owing to a strong devaluation in the currency. Eventually, this situation may lead to a decline in living standards and a lower boost for investments.

A country may face an economic slowdown with greater dependence on imports over exports. Experts believe that while importing raw materials and capital goods indicates rising economic activity, importing commodities like gold and oil slows the economy.

These commodities also cause greater negative externalities, which can cause market failure.

A large CAD can cause a sharp fall in the value of a domestic currency. India has seen a sharp fall in the value of rupees owing to strong capital inflows and foreign direct investments. Unless the RBI intervenes in the foreign exchange market, Rupee may fall too low.

CAD can also indicate a strong depletion in an economy’s foreign reserves. For example, neighbouring India has seen a depletion of $572 billion in 2022 owing to aggressive intervention by the RBI.

International economic and non-economic shocks also add to this fall.

A current account deficit of over 5 per cent is detrimental to a nation’s economic health. A rapid rise in foreign currency demand indicates home currency depreciation. Eventually, this situation may trigger inflation if the deficit is sustainably high.

However, deficits in the current account are not always causes of concern for policymakers, as dependence on foreign capital may indicate an actual need for financing domestic investments.

Therefore, the current account deficit does not harm domestic consumption if the economy is primarily driven by the private sector.

But a huge current account deficit may indicate an unsustainable economy primarily due to a rise in borrowing. Countries such as Russia, Brazil and several African countries have faced massive current account deficits owing to their inability to pay foreign debts.

Nations engaging in capital inflows to finance these deficits have eventually faced currency devaluation and increased mistrust among investors.

Can anything be done?

The current account deficit is a broader measure of a country’s trade balance that includes not only goods but also services, income flows, and transfers.

It measures the balance of trade in physical goods, such as raw materials, finished products, and machinery, all visible goods and services and unilateral transfer.

When exports become cheaper, an economy can automatically reduce the deficit. Although it depends majorly on the elasticity of demand for exports and imports, a rise in aggregate demand can reduce inflation.

There are potential solutions to dealing with CAD, such as currency devaluation and contractionary monetary policy.

When an intervention from a central bank causes devaluation in domestic currency, it raises the price of imported goods. If demand is relatively elastic, this devaluation will cause a positive improvement in the deficit.

The Marshall-Lerner condition states that devaluation will improve the economy if the combined elasticity of demand for exports and imports is higher than 1.

A contractionary monetary policy will increase interest rates, thereby causing a fall in investments. This would eventually lead people to reduce their import consumption, thus improving CAD.

However, it can also reduce economic growth owing to a fall in aggregate demand. It may also cause a rise in long-run exports.

Most budding economies have resorted to protectionist economic policies by imposing tariffs and quotas. But this policy is prone to retaliation by import partners and can also cause domestic industries to become uncompetitive.

The governments can introduce privatisation and deregulation to increase their economy’s efficiency. This implies a gradual fall in production costs and a rise in exports.

Despite the different policies related to switching and reducing the expenditure of a country, CAD poses a potential economic threat. A rise in borrowing implies an outflow of local currency, pressuring its value.

Unless countries adopt a floating exchange rate policy, a large value of the current account deficit can eventually destabilise the economy.