Current Account Deficit
A high number of imbalances in balance of payments occur due to current account deficits, specifically the excess of imports over exports in long time periods.
NoteEven though cyclic current account deficits and current account surpluses do not pose problems, in the long run, it can cause multiple consequences.
- Recall, from 4.6.3 and 4.6.4, where we discussed the relationship between current account and financial account.
- Current account deficits are offset by financial account surpluses. Especially in the long run, the central bank will not have foreign currency or other forms of reserve assets it can sell to demand the currency.
Sales or borrowing of assets can be problematic if done for a long time, which are pointed out below.
Consequences of Current Account Deficit
Depreciating Exchange Rate
- Current account deficits causes a downward pressure on the exchange rate, leading to depreciation of the currency.
- Large levels of such depreciation can cause inflation for imports (imported inflation).
- Also, if there is further risk of depreciation, the downward pressure increases in multitudes as individuals would not want to hold onto the currency and will start selling them off.
- This increases the supply of the currency and thus, cause even further depreciation.
High Interest Rates
- If the country struggles to acquire further reserve assets through loans or sales to counteract the current account deficits, it may need to increase its interest rates.
- By increasing the interest rates, it makes the country attractive for foreign direct investments as there is a higher return.
- Though, it can severely impact and reduce domestic investment and spending in the economy (contractionary monetary policy effects), possibly even causing a recession.
Foreign ownership of domestic assets
- In order to acquire further reserve assets to achieve a financial account surplus, countries could be made to sell their domestic assets to foreign entities or individuals.
- Such assets include: stocks in stock markets, bonds, land, factories, etc.
- This could lead to a loss of control over its own assets.
High Debt
Risk of Default
The risk of not being able to pay accumulating debt back when country is borrowing for long periods of time.
- In this case, the risk of default happens in an attempt to offset the current account deficit.
- The risk of default lead to the following:
- significant currency depreciation
- difficulties getting more loans
- strict demand-side policies
- opportunity cost of paying interest on debt/loans
- the money could have been utilised for domestic investment for public goods.
- paying interest utilises export revenue, which could have been utilised for imports of capital goods.
Low Credit Ratings
Credit Rating
determined by international agencies, who rank countries with respect to how probable the country is to repay their loans completely and on time.
- Low credit ratings are given to those who have persistent current account deficits.
- This makes it really difficult to get more loans in the future as no country would be willing to loan them money if they are unable to pay it.
- Due to this, countries might raise its interest rates (contractionary policies) really high, which could lead to the consequences mentioned previously in the interest rates section.
- Further, the ability for foreign investors to keep investing in the country highly depends on the confidence they have.
- If the investors have low confidence, where the currency might depreciate, they will not be willing to invest.
- This can lead to a immense depreciation of the domestic currency.
Strict Demand Management Policies
- Mentioned briefly, contractionary policies are often implemented to try combat current account deficits.
- This can lead to lowering incomes, which could lower imports that could have helped reduce the current account deficit, essentially acting as a downward spiral.
Lower Economic Growth
- The sum of the impacts above that occur due to accumulating debts/loans could lead to lower economic growth.
- This is because resources and money are used to repay loans and pay interests.
- The opportunity cost if the deficit persists could be immense as the funds could have been utilised for domestic investments on public goods, etc.
Australia’s Persistent Current Account Deficit
Background
Australia has historically experienced a persistent current account deficit (CAD), where the value of imports of goods, services, and income outflows exceeds that of exports. For decades, Australia ran a CAD averaging 3–6% of GDP, making it one of the largest deficits among developed nations. In the June quarter of 2024, Australia’s current account deficit increased to AUD 10.7 billion, reflecting the nation's reliance on foreign capital to sustain economic activity.
Exchange Rates
A prolonged CAD often results in depreciation of a country’s currency, as continuous demand for foreign currency puts downward pressure on the exchange rate. However, despite decades of deficits, the Australian dollar (AUD) has not consistently depreciated. Factors such as high global demand for Australian commodities, especially iron ore, coal, and liquefied natural gas (LNG), have supported the AUD. However, during global economic downturns or commodity price collapses, the AUD tends to depreciate. For example, during the 2015 commodity price slump, the AUD fell from USD 1.10 in 2011 to USD 0.70 in 2015.
Interest Rates
To attract foreign capital and finance the CAD, Australia has historically maintained higher interest rates compared to other advanced economies. The Reserve Bank of Australia (RBA) has frequently set interest rates above those of the US Federal Reserve to encourage foreign investment in government bonds and financial assets. While this has helped finance the CAD, it has also led to higher borrowing costs for households and businesses, increasing private sector debt and reducing consumer spending.
Foreign Ownership of Domestic Assets
Financing the CAD has led to an increase in foreign ownership of Australian assets, particularly in mining, real estate, and infrastructure. In 2023, foreign investors controlled over AUD 4.7 trillion worth of assets in Australia, with significant ownership in energy and resource projects. The United States, United Kingdom, Japan, and China have been the largest investors. Foreign direct investment (FDI) has been crucial in expanding Australia’s mining sector, but concerns have emerged over foreign influence in strategic industries and the impact on national security and economic sovereignty.
Debt
A persistent CAD contributes to the accumulation of foreign debt. Australia’s net foreign liabilities have been substantial, reflecting the nation's reliance on external financing. By September 2024, Australia’s net international investment liability position reached AUD 716.5 billion, highlighting its dependence on foreign borrowing to sustain domestic spending and investment. A high level of external debt makes Australia vulnerable to changes in global interest rates and capital outflows during economic uncertainty.
Credit Ratings
Continuous CADs and rising foreign debt levels can prompt credit rating agencies to reassess a country’s sovereign rating. However, Australia has maintained a strong credit rating (AAA) due to robust GDP growth, a stable financial system, and strong institutions. Nonetheless, in 2020, credit rating agencies placed Australia on a negative outlook, citing concerns over rising government debt and an economic slowdown during the COVID-19 pandemic. A credit rating downgrade would increase borrowing costs for both the government and private sector, potentially worsening the CAD.
Demand Management
To address its CAD, the Australian government has implemented various demand management policies, including:
- Monetary policy tightening: Raising interest rates to reduce domestic demand and limit excessive import spending.
- Fiscal consolidation: Reducing government expenditure to lower the public sector’s contribution to the CAD.
- Export promotion strategies: Supporting key industries such as mining, education, and agriculture to boost export revenues.
Despite these efforts, Australia remains reliant on commodity exports and foreign investment, making the CAD a structural feature of its economy.
Economic Growth
Despite the persistent CAD, Australia has maintained strong economic growth, averaging 3% annually over the past three decades. This has been driven by:
- High levels of foreign investment, supporting infrastructure and resource development.
- Strong demand from China and other Asian economies, driving exports.
- A stable financial sector that withstood global shocks, including the Global Financial Crisis (GFC) of 2008.
However, reliance on foreign capital inflows makes Australia vulnerable to external shocks. For example, during the 2015 commodity price collapse, mining investment declined, leading to a slowdown in GDP growth to 2.1%.
Questions
- Explain how a persistent current account deficit can affect a country’s exchange rate.
- Discuss the role of foreign investment in financing Australia’s current account deficit.
- Evaluate the effectiveness of Australia’s demand management policies in addressing its persistent current account deficit.
- To what extent has Australia’s persistent current account deficit impacted its long-term economic growth?
- What are the potential consequences of a persistent current account deficit on economic growth and employment?
- How might a persistent current account deficit influence investor confidence and foreign direct investment (FDI).
To what extent can economic models accurately predict the long-term consequences of a persistent current account deficit?
