What is Current Account Deficit? and Problems due to it


Current Account Deficit (CAD)

A current account deficit means the value of imports of goods / services / investment incomes is greater than the value of exports.

The current account also includes net income, such as interest and dividends, as well as transfers, such as foreign aid, though these components tend to make up a smaller percentage of the current account than exports and imports. The current account is a calculation of a country’s foreign transactions, and along with the capital account is a component of a country’s balance of payment.

A country can reduce its current account deficit by increasing the value of its exports relative to the value of imports. It can place restrictions on imports, such as tariffs or quotas, or it can emphasize policies that promote exports, such as import substitution industrialization or policies that improve domestic companies' global competitiveness. The country can also use monetary policy to improve the domestic currency’s valuation relative to other currencies through devaluation, since this makes a country’s exports less expensive.

While a current account deficit can be considered akin to a country living “outside of its means," having a current account deficit is not inherently bad. If a country uses external debt to finance investments that have a higher return than the interest rate on the debt, it can remain solvent while running a current account deficit. If a country is unlikely to cover current debt levels with future revenue streams, it may become insolvent.

Problems with CAD

If a current account deficit is financed through borrowing it is said to be more unsustainable. This is because borrowing is unsustainable in the long term and countries will be burdened with high interest payments. E.g:Russia was unable to pay its foreign debt back in 1998.
A factor behind the Asian crisis of 1997 was that countries had run up large current account deficits by attracting capital flows (hot money) to finance the deficit. But, when confidence fell, these hot money flows dried up, leading to a rapid devaluation and crisis of confidence.
If the nation runs a current account deficit, it could be financed by foreign multinationals investing in the country or the purchase of assets. There is a risk that the best assets could be bought by foreigners, reducing the long term income of the country.
A Balance of payments deficit may cause a loss of confidence by foreign investors. Therefore, there is always a risk, that investors will remove their investments causing a big fall in the value of the domestic currency (devaluation). This can lead to decline in living standards and lower confidence for investment.

It’s not necessary that CAD is always harmful. Sometimes, a current account deficit may just indicate a strong economy. And with a floating exchange rate a large current account deficit should cause a devaluation which will help automatically reduce the level of the deficit.

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