Sunday, July 20, 2008

Do We Have To Worry About Current Account Deficit? (Unit 3/ 6)

Student’s Question: Current account deficit may not necessarily bad right?

It may & it may not

Current account consists of 4 main components:
(i) Trade in goods (manufactured goods, capital goods, durable & non-durable goods etc)
(ii) Trade in services (financial, banking, tourism, education etc)
(iii) Income & profits (Britons working abroad sending money back to England etc)
(iv) Current transfers (Aid or subsidies given by EU government, bilateral aid etc)

In UK, the current account under the Balance of Payments (BOP) has been under persistent deficit for 19 years. The large deficit in current account is mainly driven by trade deficit in goods & it seems that the growing surplus in trade in services is still insufficient to offset it

However, the deficit accounts only about 2.5% of UK’s GDP. For US which has the world’s largest trade deficit, it accounts for nearly 6% of its GDP

Financial/ Capital account records:
(i) Short term money flows (speculative/ hot-money)
(ii) Long term investment e.g. Japanese pension fund may wants to broaden its international portfolio to UK, Malaysian firms setting up companies in Malaysia, so send money from Malaysia to UK to finance its building & operation, etc)

General arguments
Reasons to worry for current account deficit:
1. May lead to depreciation of home currency. When a country borrows from international organisation such as IMF to finance the deficit, it may raise market concern that the Central Bank may not have sufficient foreign exchange reserves say, dollar to meet the obligations. The expectation of dollar shortage leads to the expectation of depreciation of home currency. This will fuel the concern that the external debt burden would increase & thereby intensifies the demand for dollar by speculators. This eventually leads to depreciation of home currency (self-fulfilling, due to market EXPECTATION)

2. Burden of debt repayment. Borrowing to finance the deficit is not sustainable in long term. Excessive borrowings & failure to repay on schedule had put many countries into greater debt due to high interest payments. Countries such as Russia, Brasil, African countries & many other developing countries faced similar situation

3. Fall in the standards of living. As home currency faces rapid depreciation, it means fall in the purchasing power & imported goods are now more expensive. This will ultimately lead to fall in the standard of living as people get to consume lesser goods of better quality

4. Sign of structural weakness in economy. For UK, the deficit in current account is largely fuelled by the weak export in goods which has strong relation with the sluggish manufacturing sector in UK. 3 reasons accounted for this. UK’s goods are not price competitive due to low productivity in the manufacturing sector which raises the costs. Second, pound has been appreciating against many major currencies since 1996, which means relatively more expensive to buy from UK. Finally UK has lost its comparative advantage in manufacturing sector to China

5. Foreigners have increasing claim on UK assets. To finance the deficit, other than borrowing UK can also attract inflow of foreign investments (causing a surplus in capital/ financial account). However this means increasing foreign ownership of domestic assets. Shall there is an economic crisis, UK will be in a very vulnerable position when foreigners withdraw their investments, causing a rapid depreciation of sterling especially against Yen

6. Capital flows may dry up 1 day. Country like US has been able to finance its deficit by attracting capital flows from Asian countries, particularly Japan and China (similar to Point 5). Both countries are willing to buy dollar assets because they don't want their currency's to appreciate and therefore reduce their competitiveness when trading with US. How long will this continue is uncertain

Reasons not to worry about current account deficit:
1. The deficit has not triggered any crisis thus far. UK has sustained current account deficits of much larger proportions in the past and this has not provoked a major crisis of confidence in the international financial markets. UK has one of the most open capital markets in the world. Thus far the country has proved to be a favoured venue for overseas investment & financing a trade deficit in goods and services has not triggered a sharp collapse in the value of sterling

2. Great knock-on effects from foreign investment. Increase in the number of foreign firms setting up operations in UK has many advantages. These include the increase in job opportunities, technology transfer & better management practices. For e.g. Japanese firms may bring over their management practices which greatly benefit the Britons as it helps increase their productivity

3. Economy is growing faster than the others. Increase in import relative to export may mean that the country is growing relatively faster compared to its trading partner. Higher economic growth means people have higher tendency to consume imported goods. Also increase in import could be due to greater imports of raw materials to fuel the awakening manufacturing sector. However since other countries are growing at slower pace, this explains why the demand for exported goods is rather low

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