Persistent Current Account Deficits (DP IB Economics)

Factor

Implications of a Persistent Current Account Deficit

Depreciating Exchange Rates

• A persistent current account deficit can put downward pressure (depreciate) on a country's currency as the economy is constantly supplying its currency onto world markets

Increasing Interest Rates

• With downward pressure on the currency, the Central Bank may raise interest rates in order to attract foreign/portfolio investment

  • The raised rates will encourage demand for the currency which will help it to stop depreciating

Increasing Foreign Ownership of Domestic Assets

• A persistent current account deficit may result in increased foreign ownership of domestic assets

  • It can be driven by the need to finance the deficit through foreign capital inflows, potentially leading to a larger share of ownership by foreign entities

Increasing National Debt

• A chronic current account deficit can contribute to the accumulation of external debt as financing is required to fund the deficit 

Worsening International Credit Ratings

• If the deficit is viewed as unsustainable or indicates weak economic fundamentals, credit rating agencies may downgrade the country's creditworthiness, potentially raising borrowing costs

  • Investors can lose confidence in a country's ability to repay any future borrowing

Demand Management Conflicts

• A persistent current account deficit may necessitate adjustments in demand management policies and in the process create trade offs

  • E.g. It may require measures to curb domestic consumption or stimulate exports to reduce the deficit and rebalance the economy

Impact on Long term Economic Growth

• A chronic current account deficit can have implications for economic growth

  • It may signal an imbalance in the economy, relying on external financing rather than domestic productivity and competitiveness

Policy Option

Benefits

Costs

Do nothing

• Floating exchange rates act as a self-correcting mechanism. Over time a higher level of imports will end up depreciating the currency causing imports to decrease (they are now more expensive) and exports to increase (they are now cheaper). This improves the deficit 

• There may be other external factors that prevent the currency from depreciating. It may take a long time for self-correction to happen and many domestic industries may go out of business in the interim. The longer it takes to self-correct, the more firms will delay investment in the economy

Expenditure Switching

• This is often successful in changing the buying habits of consumers, switching consumption on imports to consumption on domestically produced goods/services. This helps improve a deficit

• Any protectionist policy often leads to retaliation by trading partners. This may consist of reverse tariffs/quotas which will decrease the level of exports. This may offset any improvement to the deficit caused by the policy

Expenditure Reducing

• Deflationary fiscal policy invariably reduces discretionary income which leads to a fall in the demand for imported goods & improves a deficit

• Deflationary fiscal policy also dampens domestic demand which can cause output to fall. When output falls, GDP growth slows & unemployment may increase

Supply-side

• Improves the quality of products and lowers the costs of production. Both of these factors help the level of exports to increase thus reducing the deficit
  

• These policies tend to be long term policies so the benefits may not be seen for some time. They usually involve government spending in the form of subsidies and this always carries an opportunity cost