Practice Exam Questions

Causes of a Current Account Deficit Exam Answer


Last updated 21 Mar 2021

Economist Ed Huang looks at this question on the balance of payments: " Evaluate the causes of persistent current account deficits for developed or developing countries.

A current account deficit happens when there is a net outflow of currency from a country on the trade, investment income and transfer account. It is an almost inevitable consequence of trade that there will be imbalances in doing so, thus some countries are left in surplus, others in deficit – and many stay in one of these two camps for extended periods of time. It is not difficult to observe that the UK has been subject to one such persistent current account deficit. Having not experienced current account trade surplus for 30 years now, the evidence is clear – despite the best claims the current Conservative party are making about the future. Of course, the UK is far from the only country with a current account deficit, but there are clearly different causes for different nations that lead to an imbalance in trade.

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One potential cause of a persistent current account deficit is that of sustained economic growth. Growth in an economy is indicated by a sustained rise in its real GDP, which in turn must mean that the total income of the nation has increased. If the incomes of at least some of the individuals within the economy are rising, then almost certainly a proportion of this increase will be spent on imported goods and services. In developing economies, this may be especially true as economic growth may coincide with changes in tastes towards luxury and higher-tech goods, which are often imported from developed nations.

Thus economic growth has a direct link to an increase in the value of imports which, ceteris paribus, will lead to an increase in the current account deficit. This is evident in economies such as Ethiopia and Rwanda, who both have current account deficits in excess of 10% of GDP, but are two of the fastest growing nations globally (10.3% and 7.7% respectively).

However, this much depends on the marginal propensity to import of the nation. This concept can be defined as the proportion of an additional unit of income that will be spent on imported goods. If the marginal propensity to import is high, then a rise in income (characterised by economic growth) will have a larger effect on the current account deficit than if it is low, since it implies that the level of imports will vary closely with changes in income.

The UK population has a characteristically high MPM, so the current account deficit is far more sensitive to growth rates than other countries – particularly those with high import tariffs (Djibouti has an average 18% tariff compared to the US’ 1.5%). Furthermore, the marginal propensity to import also varies between individuals in a nation. Some classes (especially those reliant on commodity imports, such as the steel processing or energy generation industries) are more likely to spend a greater proportion of additional income on imported goods than others. Thus if the economic growth is concentrated in sectors with high MPMs, then the changes in the current account deficit will be magnified compared to if the rise in output and income is located in sectors with low MPMs.

Furthermore, it could be argued that high current account deficits caused by high growth rates are unsustainable, and therefore perhaps not persistent (depending on one’s interpretation of the word). In the case of Rwanda and Ethiopia, such a large deficit will drain foreign reserves and – given that at least part of the deficit is caused by an inflow of borrowed money used to close the savings gap between investment and savings – accumulate debt. Extended periods of high current account deficits are therefore unsustainable in the long term, although if the deficit is used to build critical infrastructure that can later serve a self-sustaining economy, then there need not be one indefinitely.

Extended periods of high inflation can also lead to persistent deficits in the current account. High inflation indicates that the prices of domestic goods and services are rising rapidly, and this can mean that domestic production becomes less competitive compared to imported goods and services, since it is becoming comparatively more expensive relative to abroad. One such example would be Turkey, where inflation was 9% in 2013 and the current account deficit was a sizeable 5% of GDP.

However, this can be entirely offset if inflation is similarly high – or even higher – in the countries where the imported goods originate from. If prices are rising not just domestically, but also abroad, then there is no change in competitiveness and thus no effect on the balance of payments. In the case of Turkey, were inflation to be equally high within the EU (where over 50% of its imported goods originate from), then this would offset its high inflation as there would be no significant change in price competitiveness between foreign and domestic goods, ceteris paribus.

Finally, economies can also be subject to persistent current account deficits if their levels of investment are too low to allow for exports of high (or even moderate) value items. For instance, economies with low levels of investment may have to rely on exports of raw, unprocessed commodities that have the potential to be greatly increased in value if they were processed on site. Examples would include oil exports in Angola (where 80% is exported as unrefined crude oil), and coffee plantations in Ethiopia (where many of the beans are left unprocessed on site, to be roasted once they are exported). This results in price-uncompetitive exports, lowering the country’s export capabilities and thus worsening the balance of payments. This may also include too little investment in human capital (i.e. insufficient spending on education), which translates into low productivity (so high unit labour costs and therefore uncompetitive goods and services), as well as a lack of the skills necessary for higher skill jobs.

Countries such as Romania (where there has been a sharp growth in the IT sector in the last couple of decades) can benefit from higher-value goods and services being exported per worker compared to other economies where human capital levels are lower, and thus where the value of goods produced per worker is also less. Insufficient levels of investment will therefore lead to the inability to export high-value goods and services, and thus may mean a diminished total value of exports and thus a worse current account deficit.

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