Current Account Deficits: Government Investment Or Irresponsibility?

 

Current Account Deficits: Government Investment Or Irresponsibility?

by Reem Heakal

The current account is a section in a country's balance of payments (BOP) that records its current transactions. The account is divided into four sections:

• goods,
• services,
• income (such as salaries and investment income) and
• unilateral transfers (for example, workers' remittances).

 

A current account deficit occurs when a country has an excess of one or more of the four factors making up the account.

• When a current transaction enters the account, it is recorded as a credit; when a value leaves the account, it is marked as a debit.
• Basically, a current account deficit occurs when more money is being paid out than brought into a country.

 

What a Deficit Implies

When a current account is in deficit, it usually means that a country is investing more abroad than it is saving at home. Often, the logic dictating a country's investment decisions is that it takes money to make money.

• In order to try and boost its gross domestic production (GDP) and future growth, a country may go into debt, taking on liabilities to other countries. It then becomes what is termed as a "net debtor" to the world.
• However, a problematic deficit can result if a government has not planned out a sound economic policy and used its debts for consumption purposes, not future growth. (For more insight, see What Fuels The National Debt?)

 

A current account deficit implies that a country's economy is functioning on borrowed means.
In other words, other countries are essentially financing the economy, and hence sustaining the deficit.

When determining the economic health of a nation, it is important to understand

• where the deficit stems from,
• how it's being financed and
• what possible solutions exist for its alleviation.

To do so, we need to look at not only the current account, but also the other two sections of the BOP,

• the capital account and
• the financial account.

 

The Capital and Financial Accounts
Foreign funds entering a country from the sale or purchase of tangible assets - as opposed to non-physical assets such as stocks or bonds - are recorded in the capital account of the BOP. (Again, money entering the account is noted as a credit, and money leaving the account is a debit.)

Financial transactions such as money leaving the country for investment abroad are recorded in the financial account.

Together, these two accounts provide financing for a current account deficit.


Why Is There a Deficit?
Is a current account deficit simply a matter of a government's bad planning and/or uncontrollable spending and consumption?

• Well, sometimes.
• But more often than not, a deficit is planned for the purpose of helping an economy's development and growth.
• It can also be a sign of a strong economy that is a safe haven for foreign funds (we'll explain this below).
• When an economy is in a state of transition or reform, or is pursuing an active strategy of growth, running a deficit today can provide funding for domestic consumption and investment tomorrow.

Here are some of the types of deficits, both planned and unplanned, that countries experience.

 

Balance of Trade Deficit
With the long-term in mind, a country may run a deficit by importing more than it's exporting, with the ultimate goal of producing finished goods for export. In this scenario, the country will plan to pay off the temporary excess of imports at a later time with proceeds made from future export sales. The proceeds made from these sales would then become a current account credit. (To Learn more, read In Praise Of Trade Deficits.)

 

Investing for the Future
Instead of saving money now, a country could also choose to invest abroad in order to reap the rewards in the future. The outing funds would be recorded as a debit in the financial account, while the corresponding incoming investment income would eventually be earmarked as a credit in the current account. Often, a current account deficit coincides with depletion in a country's foreign reserves (limited resources of foreign currency available to invest abroad).

 

Foreign Investors
When foreign investors send money into the domestic economy, the latter must eventually pay out the returns due to the foreign investors. As such, a deficit may be a result of the claims foreigners have on the local economy (recorded as a debit in the current account).

 

This kind of deficit could also be a sign of a strong, efficient and transparent local economy, in which foreign money finds a safe place for investment. The United States capital market, for example, was seen as such when "quality assets" were sought out by investors burned in the Asian crisis. The U.S. experienced a surge of foreign investment into its capital markets. And while the U.S. received money that could help increase domestic productivity and hence expand its economy, all of those investments would have to be paid off in the form of returns (dividends, capital gains), which are debits in the current account. So a deficit could be the result of increased claims by foreign investors, whose money is used to increase local productivity and stimulate the economy.

 

Overspending Without Enough Income
Sometimes governments spend more than they earn, simply due to ill-advised economic planning. Money may be spent on costly imports while local productivity lags behind. Or, it may be deemed a priority for the government to spend on the military rather than economic production. Whatever the reason, a deficit will ensue if credits and debits do not balance.

 

Financing the Deficit

 

Public and Private Foreign Funds
Funding channeled into the capital and financial accounts (remember, these accounts finance the deficits in the current account) can come from both (1) public (official) and (2) private sources.

• Governments, which account for official capital flows, often buy and sell foreign currencies. Credit from these sales is recorded in the financial account.
• Private sources, whether institutions or individuals, may be receiving money from some sort of foreign direct investment (FDI) scheme, which appears as a debit in the income section of the current account but, when investment income is finally received, becomes a credit.

 

Balanced Financing
To avoid unnecessary extra risks associated with investing money abroad, the financing of the deficit should ideally rely on a combination of long-term and short-term funds rather than one or the other.

• If, for example, a foreign capital market suddenly collapses, it can no longer provide another country with investment income.
• The same would be true if a country borrows money and political differences cut the credit line.
• However, by planning to receive recurrent investment income over the years, such as by means of an FDI project, a country could intelligently finance its current account deficit.

 

Capital Flight
In times of global recession, the financing of a deficit can sometimes be traced to capital flight, that is, private individuals and corporations sending their money into "safe" economies.

• This money is recorded as a credit in the current account but, in reality, it is not a reliable source of financing.
• In fact, it is a strong indication that the world economy is slowing and may not be able to provide financing in the near future.

 

Conclusion

• In order to determine whether a country's economy is weak, it is important to know why there is a deficit and how it is being financed.
• A deficit can be a sign of economic trouble for some countries, and a sign of economic health for others.
• To support the current account deficits of countries around the world, the global economy must be strong enough so that exports can be bought and investment income repaid.
• Often, however, a current account deficit cannot be sustained for too long - it is widely debated whether the consumption of today will result in chronic debt for future generations.

by Reem Heakal, (Contact Author | Biography)

 

 

http://www.investopedia.com/articles/04/012804.asp