Consequences of Current Account Deficit
In the previous article, we have seen what is current account deficit (CAD), components of CAD and how to calculate it. In this article, we are going to discuss the 7 major causes of current account deficit in detail. Also, what are the consequences of current account deficit.
7 Causes of 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. Major causes of current account deficit are explained below :
1.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.
2. 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.
- 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.
3. Decline in Competitiveness/Export Sector
There might be a decline in the competitiveness/export sector in a country because it has to struggle to compete with the other developing countries. This has led to a persistent deficit in the balance of trade.
4. Higher Inflation
- If India’s inflation rises faster than our main competitors then it will make India’s 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.
5. Recession in other countries
If India’s main trading partners experience negative economic growth, then they will buy less of our exports, worsening the India’s current account.
6. Borrowing Money
If countries are borrowing money to invest e.g. third world countries, then this will lead to deterioration in current account position.
7. 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 India has run a persistent current account deficit since 2005; this reflects the fact the India has attracted capital flows to finance this current account deficit. Without financial flows, the currency would depreciate until equilibrium is restored.
Effects / Consequences of CURRENT ACCOUNT DEFICIT
- Economic growth : In the short-run, a current account deficit is helpful to the debtor nation. Foreigners are willing to pump capital into it. That drives economic growth beyond what then country could manage on its own.
- Weakening of demand : In the long run, a current account deficit saps economic vitality. Foreign investors question whether economic growth will provide enough return on their investment. Demand weakens for the country’s assets, including the country’s government bonds.
- Rise in bond yields : As foreign investors withdraw funds, bond yields rise. The national currency loses value relative to other currencies. That lowers the value of the assets in the foreign investors’ strengthening currency. It further depresses investor demand for the country’s assets. This can lead to a tipping point where investors will dump the assets at any price.
- Rise in value of foreign assets : The only saving grace is that the country’s holdings of foreign assets are denominated in foreign currency. As the value of its currency declines, the value of the foreign assets rise. That further reduces the current account deficit.
- Setting in of Inflation : In addition, a lower currency value increases exports as they become more competitively priced. The demand for imports falls once prices rise as inflation sets in. These trends stabilize any current account deficit.
- Lower Standard of Living : Regardless of whether the current account deficit unwound via a disastrous currency crash or a slow, controlled decline, the consequences would be the same. That’s a lower standard of living for the country’s residents.