Current account deficit and Unfavorable balance of payment

Current account deficit and Unfavorable balance of payment

Current Account Deficit

The current account deficit is a measurement of a country’s trade where the value of the goods and services it imports exceeds the value of the products it exports. The current account includes net income, such as interest and dividends, and transfers, such as foreign aid, although these components make up only a small percentage of the total current account. The current account represents a country’s foreign transactions and, like the capital account, is a component of a country’s balance of payments (BOP).

The current account balance seems to be an abstruse economic concept. But in countries that are spending a lot more abroad than they are taking in, the current account is the point at which international economics collides with political reality. When countries run large deficits, businesses, trade unions, and parliamentarians are often quick to point accusing fingers at trading partners and make charges about unfair practices. Tension between the United States and China about which country is primarily responsible for the trade imbalance between the two has thrown the spotlight on the broader consequences for the international financial system when some countries run large and persistent current account deficits and others accumulate big surpluses.

A current account deficit indicates that a country is importing more than it is exporting.
Emerging economies often run surpluses, and developed countries tend to run deficits.
A current account deficit is not always detrimental to a nation’s economy—external debt may be used to finance lucrative investments.

Managing a Current Account Deficit

A country can reduce its existing debt by increasing the value of its exports relative to the value of imports. It can place restrictions on imports, such as tariffs or quotas, or it can emphasize policies that promote export, such as import substitution, industrialization, or policies that improve domestic companies’ global competitiveness. The country can also use monetary policy to improve the domestic currency’s valuation relative to other currencies through devaluation, which reduces the country’s export costs.

While an existing deficit can imply that a country is spending beyond its means, having a current account deficit is not inherently disadvantageous. If a country uses external debt to finance investments that have higher returns than the interest rate on the debt, the country can remain solvent while running a current account deficit. If a country is unlikely to cover current debt levels with future revenue streams, however, it may become insolvent.

Factors which cause a current account deficit

A current account deficit occurs when the value of imports (of goods, services and investment income) is greater than the value of exports.

There are various factors which could cause a current account deficit:

Overvalued exchange rate

If the currency is overvalued, imports will be cheaper, and therefore there will be a higher quantity of imports. Exports will become uncompetitive, and therefore there will be a fall in the quantity of exports. Countries in the Eurozone (e.g. Greece, Portugal and Spain) experienced an overvalued exchange rate (and they couldn’t devalue). In 2007, these three countries had a current account deficit equal to 10% of GDP.

Economic growth

If there is an increase in national income, people will tend to have more disposable income to consume goods. If domestic producers cannot meet the domestic demand, consumers will have to import goods from abroad. In the UK we have a high marginal propensity to imports (mpm) because we do not have a comparative advantage in the production of manufactured goods. Therefore if there is fast economic growth there tends to be a significant increase in the quantity of imports and a deterioration in the current account.

Decline in competitiveness/export sector

In the UK, there has been a decline in the exporting manufacturing sector because it has struggled to compete with developing countries in the far east. This has led to a persistent deficit in the balance of trade.

Higher inflation

If UK inflation rises faster than our main competitors then it will make UK exports less competitive and imports more competitive. This will lead to deterioration in the current account. However, inflation may also lead to a depreciation in the currency to offset this decline in competitiveness.

Recession in other countries

If the UK’s main trading partners experience negative economic growth, then they will buy less of our exports, worsening the UK current account.

Borrowing money

If countries are borrowing money to invest e.g. third world countries, then this will lead to deterioration in current account position.

Financial flows to finance current account deficit.

If a country can attract more financial flows (either short-term portfolio investment or long-term direct investment), then these flows on the financial account will enable the country to run a larger current account deficit. For example, the UK has run a persistent current account deficit since the 1980s; this reflects the fact the UK has attracted capital flows to finance this current account deficit. Without financial flows, the currency would depreciate until equilibrium is restored.

Balance of Payment

Balance of Payment (BOP) of a country can be defined as a systematic statement of all economic transactions of a country with the rest of the world during a specific period usually one year.

The systematic accounting is done on the basis of double entry book keeping (both sides of transactions credit and debit are included). Economic transaction includes all such transactions that involve the transfer of title or ownership of goods and services, money and assets.

The Balance of Payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country.

If a country has received money, this is known as a credit, and, if a country has paid or given money, the transaction is counted as a debit. Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance. But in practice this is rarely the case and, thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.

Balance of Payments Problem in India!

What measures can be adopted to tackle the problem of disequilibrium in the balance of payments will also be discussed: About 15 years ago in 1991 India had to experience a severe balance of payments crisis.

A default on payments, which would have a disastrous consequent for the Indian economy, had become for the first time in our history a serious possibility in June 1991. It was at this time that new Congress Government with Dr. Manmohan Singh as our Finance Minister took several short-term and long-term measures to overcome the balance of payments crisis.

Apart from undertaking various measures of domestic liberalisation, he took several for-reaching measures relating to balance of payments problem. Rupee was devalued in July 1991 and later in two years’ time, foreign exchange rate of rupee was made market-determined and also convertible into foreign currencies.

Anti-export basis in our economic strategy was removed and accordingly tariffs on imports were reduced, so as to promote competition. In this way costly import-substitution strategy of industrialisation was abandoned. These measures bore fruits and India was successful in solving the balance of payments problem. Our exports started growing at a relatively rapid rate than before. Capital flows and remittances by NRIs increased manifold. Of course for a short time, we got special assistance from IMF and World Bank to fulfill our obligations regarding balance of payments.

Balance of Trade and Balance of Payments:

Balance of trade and balance of payments are two related terms but they should be carefully distinguished from each other because they do not have exactly the same meaning. Balance of trade refers to the difference in value of imports and exports of goods only, i.e., visible items only. Movement of goods between countries is known as visible trade because the movement is open and can be verified by the customs officials.

During a given period of time, the exports and imports of goods or merchandise may be exactly equal, in which case, the balance of payments of trade is said to be balanced. But this is not necessary, for those who export and import are not necessarily the same persons. If the value of exports exceeds the value of imports, the country is said to experience an export surplus or a favourable balance of trade. If the value of its imports exceeds the value of its exports, the country is said to have a deficit or an adverse balance of trade.

The terms “favourable” and “unfavourable” are derived from the mercantilist writers of the 18th century. In those days, settlements of the foreign transactions were made in gold. If India had exported Rs. 1000 crore worth of goods but had imported Rs.800 crore worth of goods, India would receive Rs. 200 crores worth of gold from the foreign countries. As gold was regarded as wealth and as the receipts of gold made a country wealthy, the mercantilist writers regarded exports surplus as being favourable to the country.

On the other hand, if India had exported Rs. 1000 crores worth of goods, but imported Rs. 1500 crores worth of goods, it had to pay Rs. 500 crores in gold to the foreigners. India would be losing gold and would be poorer to that extent. Therefore, an import surplus was regarded by the mercantilist writers as adverse balance. But in these days, the international transactions are not settled in terms of gold. Even then, the terms “favourable” and “unfavourable” balance of trades has continued to be used till today.

Effects

Initially, a trade deficit is not necessarily a bad thing. It can raise a country’s standard of living because its residents gain access to a wider variety of goods and services for a more competitive price. It can also reduce the threat of inflation since it creates lower prices. A trade deficit may also indicate that the country’s residents are feeling confident and wealthy enough to buy more than the country produces.

Over time, however, a trade deficit can cause more outsourcing of jobs to other countries. As a country imports more goods than it buys domestically, then the home country may create fewer jobs in certain industries. At the same time, foreign companies will likely hire new workers to keep up with the demand for their exports.

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