Current Account Deficit: Definition, Components & Example
While every business needs to consider its own goods and services, countries also need to do the same thing. But this happens on a much bigger, global scale. For example, many countries rely on a large volume of exports.
Whereas other countries rely on a large volume of imports. And still, some countries have a balance of both importing and exporting. But how is this all calculated and what is the significance? Keep reading to learn about a current account deficit, what causes it, its benefits, and much more!
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KEY TAKEAWAYS
- The current account deficit relates to the situation where a company ends up importing more goods and services than it is exporting.
- External debt can often be used to help finance investments, so having a current account deficit isn’t always going to be detrimental to the economy of a country.
- Usually, developed countries tend to run deficits, and new, emerging economies can often run surpluses.
What Is a Current Account Deficit?
The current account deficit relates to the measurement of a country’s trade. It breaks down the difference between the value of the goods and services it imports as well as the value of the goods and services it exports.
The current account is going to include a range of areas, such as net income. Net income will often include specifics like interest and dividends. The current account will also include any transfers, which could include foreign aid. However, these components will often only make up a small portion of the total current account.
Essentially, the current account is going to represent the foreign transactions of a country and it’s a part of the country’s balance of payments (BOP), similar to the capital account.
Components of Current Account Deficit
There are four primary components of the current account according to the Bureau of Economic Analysis. The biggest and often most important component is the trade in goods and services a country takes part in, or its trade deficit.
The second component is any net income that is earned by residents who take part in overseas investments or work. The third component includes any direct remittances from workers back to their home country, foreign direct investments, as well as foreign aid.
The fourth component includes any increases or decreases in specific assets, such as real estate, securities, and bank deposits.
That all said, the trade deficit is often the most critical component to be aware of. A trade deficit occurs when a country is importing more goods and services than it’s able to export. For example, the trade deficit of the United States indicates that it imports much more than it exports.
Having a deficit in net income happens when foreigners are earning more from the country compared to residents who earn income from investments and foreign income. The other components, like investment income and direct remittances, don’t typically end up being large enough to have any real effect on the current account deficit.
Causes of Current Account Deficit
Oftentimes, a country that has a current account deficit is usually a regular and big spender. Foreign investors will also consider these countries to be creditworthy. However, these countries aren’t typically able to borrow from their residents to increase their asset position.
So, essentially, the country wouldn’t have enough money saved in its local banks, which means it can’t expand or see significant growth unless it borrows from foreigners. This is why having good creditworthiness is important.
If a country doesn’t have a solid level of creditworthiness, it’s going to be much harder to find another country that would be willing to lend to it. For example, this is exactly what happened during the Greek debt crisis.
It’s very common for a lending country to also export goods and services to the country that’s borrowing. This is since the lending country will see a range of new benefits, such as creating more jobs to manufacture more goods.
Who Benefits from a Current Account Deficit?
Even though a current account deficit isn’t always a good or a bad thing, it can be unsustainable if left unchecked. That said, both consumers and countries as a whole can see some benefits come from a current account deficit.
A country that has a current account deficit can be a strong indicator that it is importing more than it’s exporting. When this happens, the country is able to generate a higher money supply from an increase in foreign borrowings. Ultimately, this can lead to a much higher growth rate and better productivity.
As well, when a country imports more than it exports, it allows for a higher level of domestic consumption. This is since consumers aren’t technically purchasing a domestic product, but one from abroad. Plus, there can be an increase in foreign currencies on exchange markets.
How Current Account Deficit Affects the Economy
When a country has a current account deficit it doesn’t necessarily mean that it’s harmful. It could happen during a period of inward investment which can end up creating new jobs and further investment.
As well, a current account deficit with a floating exchange rate could even cause devaluation. This, in turn, would immediately and automatically reduce the total level of the deficit. Plus, a current account deficit often indicates a strong economy that’s growing at a rapid pace.
However, having a current account deficit isn’t always going to be beneficial. In a lot of ways, and depending on the specific country, it might not be sustainable in the long run. Borrowing for long, extended amounts of time can lead to becoming burdened with higher interest payments. Market forces can cause levels of debt to fluctuate, which can also lead to current account surpluses.
Here are a few other reasons why a current account deficit could be harmful:
- There becomes foreign ownership of assets
- It could indicate an unbalanced economy
- It could indicate an uncompetitive economy
- It could run the risk of depreciation
Example of Current Account Deficit
In India, the current account deficit was 1.5% of the GDP for the 2021-22 financial year. This was a big improvement compared to its recorded third quarter. The major improvement came from the number of Indians living in other countries as well as software exports. As well, interest payouts and dividend outflow dropped.
Another example is the country of Pakistan. In late 2021, the current account deficit was recorded at 7.6%. This was a 0.3% rise from the previous month. The reason for this was a major trade shock throughout the process of economic recovery. The country saw an almost $8 billion increase in overall current account deficit.
Summary
The current account deficit relates to the trade measurement of a country. It happens when the country has a higher value of products or services that it imports compared to the amount it exports. The current account will include components such as net income as well as transfers, which contribute to economic growth.
When a country has a current account deficit it doesn’t always mean that it’s a bad thing. The country can use external debt to help finance a lucrative portfolio investment in the financial markets. However, certain circumstances could lead to a current account deficit being harmful to the country. International trade plays a big role in trade surplus and achieving a current account balance.
FAQs About Current Account Deficit
It all depends on the country. A current account deficit could indicate an uncompetitive economy or an overvalue in the exchange rate. However, the United States imports more than it exports, but it’s able to balance this difference by being competitive, through depreciation, and efficient allocations.
A current account deficit indicates the level of imports and exports a country engages in and is a sign of competitiveness. It can contribute to advanced economies, increase foreign assets, and increase earnings on investment.
It will often depend on the country and the level of imports and exports. However, a current account deficit can be overcome through a reduction in domestic consumption, a devaluation in the exchange rate of major currencies, or by implementing new policies.
A budget deficit relates to the variation between expenses and receipts for revenue and capital when it relates to the government. A current account deficit relates to the fact a country is spending more money overseas than it’s receiving in return.
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