The following is an excerpt from Chapter 22 - “Balance of Payments” of my soon to be published textbook “Pearson Baccalaureate Economics”
If the total spending by a nation's residents on goods and services imported from the rest of the world exceeds the revenues earned by the nation's producers from the sale of exports to the rest of the world, the nation is likely experiencing a current account deficit. The situation is not at all uncommon among many of the world's trading nations. The map belowmap represents nations by their cumulative current account balances over the years 1980-2008. The red countries all accumulated current account deficits over the three decades, with the largest by far being the United States with a cumulative deficit of $7.3 trillion. The green countries are ones which have had a cumulative surplus in their current accounts, the largest surplus belonging to Japan at $2.7 trillion, followed by China at $1.5 trillion.
The top ten current account deficit nations are represented below. It is obvious from this chart that the United States alone accounts for a larger current account deficit then the next nine countries combined. At $7.3 trillion dollars in deficits over 28 years, the US deficit surpasses Spain's (at number 2) by 1,000 percent.
The consequences of a nation having a current account deficit are not immediately clear. It should be pointed out that it is debatable whether a trade deficit is necessarily a bad thing, in fact. Below we will examine some of the facts about current account deficits, and we will conclude by evaluating the pros and cons for countries that run deficits in the short-run and in the long-run.
Implications of persistent current account deficits: When a country like like those above experience deficits in the current account for year after year, there are some predictable consequences that may have adverse effects on the nation's macroeconomy. These include currency depreciation, foreign ownership of domestic assets, higher interest rates and foreign indebtedness.
The effect of a current account deficit on the exchange rate: In the previous chapter you learned about the determinants of the exchange rate of a nation's currency relative to another currency. One of the primary determinants of a currency's exchange rate is the demand for the nation's exports relative to the demand for imports from other countries. With this in mind, we can examine the likely effects of a current account deficit on a nation's currency's exchange rate. Additionally, we will see that under a floating exchange rate system, deficits in the current account should be automatically corrected due to adjustments in exchange rates.
When households and firms in one nation demand more of other countries' output than the rest of the world demands of theirs, there is upward pressure on the value of trading partners' currencies and downward pressure on the importing nation's currency. In this way, a movement towards a current account deficit should cause the deficit country's currency to weaken.
As an illustration, say that New Zealand's imports from Japan begin to rise due to rising incomes in New Zealand and the corresponding increase in demand for imports. Assuming Japan's demand for New Zealand's output does not change, New Zealand will move towards a deficit in its current account and Japan towards a surplus. In the foreign exchange market, demand for Japanese yen will rise while the supply of NZ$ in Japan increases, as seen above, depreciating the NZ$.
The downward pressure on exchange rates resulting from an increase in a nation's current account deficit should have a self-correcting effect on the trade imbalance. As the NZ$ weakens relative to its trading partners' currencies, consumers in New Zealand will start to find imports more and more expensive, while consumers abroad will, over time, begin to find products from New Zealand cheaper. In this way, a flexible exchange rate system should, in the long-run, eliminate surpluses and deficits between nations in the current account. The persistence of global trade imbalances illustrated in the map above is evidence that in reality, the ability of flexible exchange rates to maintain balance in nations' current accounts is quite limited.
Foreign ownership of domestic assets: By definition, the balance of payments must always equal zero. For this reason, a deficit in the current account must be offset by a surplus in the capital and financial accounts. If the money spent by a deficit country on goods from abroad ends up in the does not end up returning to the deficit country for the purchase of goods and services, it will be re-invested into the county through foreign acquisition of domestic real and financial assets, or held in reserve by surplus nations' central banks.
Essentially, a country with a large current account deficit, since it cannot export enough goods and services to make up for its spending on imports, instead ends up “exporting ownership” of its financial and real assets. This could take the form of foreign direct investment in domestic firms, increased portfolio investment by foreigners in the domestic economy, and foreign ownership of domestic government debt, or the build up of foreign reserves of the deficit nation's currency.
The effect on interest rates: A persistent deficit in the current account can have adverse effects on the interest rates and investment in the deficit country. As explained above, a current account deficit can put downward pressure on a nation's exchange rate, which causes inflation in the deficit country as imported goods, services and raw materials become more expensive. In order to prevent massive currency depreciation, the country's central bank may be forced to tighten the money supply and raise domestic interest rates to attract foreign investors and keep demand for the currency and the exchange rate stable. Additionally, since a current account deficit must be offset by a financial account surplus, the deficit country's government may need to offer higher interest rates on government bonds to attract foreign investors. Higher borrowing rates for the government and the private sector can slow domestic investment and economic growth in the deficit nation.
Side note: While the interest rate effect of a large current account deficit should be negative (i.e. causing interest rates to rise in the deficit country), in recent years the country with the largest trade deficit, the United States, has actually experienced record low interest rates even while maintaining persistent current account deficits. This can be understood by examining by the macroeconomic conditions of the US and global economies, in which deflation posed a greater threat than inflation over the years 2008-2010. The fear of deflation combined with low confidence in the private sector among international investors has kept demand for US government bonds high even as the US trade deficit has grown, allowing the US government and central bank to keep interest rates low and continue to attract foreign investors.
Whereas under “normal” macroeconomic conditions a build up of US dollars among America's trading partners would require the US to raise interest rates to create an incentive for foreign investors to re-invest that money into the US economy, in the environment of uncertainty and low confidence in the private sector that has prevailed over the last several years, America's trading partners have been willing to finance its current account deficit at record low interest rates.
The effect on indebtedness: A large current account deficit is synonymous with a large financial account surplus. One source of credits in the financial account is foreign ownership of domestic government bonds (i.e. debt). When a central bank from another nation buys government bonds from a nation with which it has a large current account surplus, the deficit nation is essentially going into debt to the surplus nation. For instance, as of August 2010, the Chinese central bank held $868 billion of United States Treasury Securities (government bonds) on its balance sheet. In total, the amount of US debt owned by foreign nations in 2010 was $4.2 trillion, or around 50% of the country's total national debt and 30% of its GDP.source: http://www.ustreas.gov/tic/mfh.txt
On the one hand, foreign lending to a deficit nation is beneficial because it keeps demand for government bonds high and interest rates low, which allows the deficit country's government to finance its budget without raising taxes on domestic households and firms. On the other hand, every dollar borrowed from a foreigner has to be repaid with interest. Interest payments on the national debt cost US taxpayers over $400 billion in 2010, making up around 10% of the federal budget. Nearly half of this went to foreign holders of US debt, meaning almost $200 billion of US taxpayer money was handed over to foreign interests, without adding a single dollar to aggregate demand in the US.
The opportunity cost of foreign owned national debt is the public goods and services that could have been provided with the money that instead is owed in interest to foreign creditors. If the US current account were more balanced, foreign countries like China would not have the massive reserves of US dollars to invest in government debt in the first place, and the taxpayer money going to pay interest on this debt could instead be invested in the domestic economy to promote economic growth and development.
- Why would a large current account deficit cause a nation's currency to depreciate? How could a weaker currency automatically reduce a nation's current account deficit?
- Why should governments be concerned about a large trade deficit? What is one policy a government could implement to reduce a deficit in the current account?
- Would a nation with a large trade deficit be better off without trade at all? Why or why not?
- Discuss the validity of the following claim: “Americans buy tons of Chinese imports, but the Chinese don't buy anything from America, this is why the US has such a huge trade deficit with China”. To what extent is this claim true or false?