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2012-10-08 13:50:56
September 17 2009| Filed Under Bonds, Budgeting, Economics
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 public
(official) and 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