A country’s balance of payments that entails current, capital and financial accounts is the manifestation of flow and direction of transactions between domestic residents and the rest of the world. The current account balance also indicates a nations gap between its saving and investment and therefore reflects residents’ consumption and investment decisions.
When a country runs a current account deficit, its domestic savings are less than its investment. That is, a country experiences a negative transfer of financial wealth across borders when purchases of goods and services from abroad and the income paid to nonresidents exceeds the amounts residents receive from other countries in the world.
Large and persistent current account deficits are detrimental to economic welfare, and hence there arises the issue of sustainability of deficits. A country that continuously runs a current account deficit will become ever more indebted to foreigners.
The sustainability of current account deficits depends on certain characteristics such as approaches to the measurement of the deficit, size of the deficit, financing of a deficit, and whether the deficits are used for investment or consumption. An increase in fiscal deficit induces upward pressure on interest rates, leading to an increase in capital inflows and the appreciation of the currency.
Ultimately the appreciation of domestic currency leads to an increase in current account deficit. According to the Keynesian absorption theory, an increase in fiscal deficit would increase domestic absorption and hence imports, and the expansion of imports leads to the worsening of the current account deficit.
However, if borrowings are invested wisely, the deficits need not be a problem, since future economic growth should allow the debt to be serviced. On other hand, if foreign resources are not employed properly, or if the current account deficit grows too fast, a country may not be able to meet its obligations to foreign creditors. Hence, a large current account deficit that fuels consumption or a property price bubble may become a problem.
The saving-investment approach states that the current account balance is the difference between national savings and investments. If savings are less than investment (saving gap), this indicates that an economy needs to import resources to finance investment beyond the level of capital accumulation in the domestic country.
The economies suffer from trade deficits when the imports exceed exports. The trade balance is a component of the current account balance. The trade deficit will lead to a current account deficit. The depreciation of currency can positively affect a country’s export and negatively affect a country’s imports.
When the currency is depreciating, the products are available at cheaper prices and exports of a country can be increased while on other hands, the price of imported products increases. External debt is a foreign cash inflow (including aid) and the increase in foreign cash inflow can reduce or increase the current account balance.
Trade openness, terms of trade, external debt are the factors that determine the current account deficit. The consumer price index, world oil prices, interest rate and exchange rate are also the major determinants of current account deficits while trade openness, terms of trade and consumer price index are the major determinants of current account surpluses.
The empirical evidence indicates that variables that influence the movement of current account balance include monetary policy credibility, exchange rate, and budget deficit. Economies suffer from fiscal deficits when government expenditures exceed government revenues. When government expenditures increase, governments impose more taxes and get foreign loans to cover their expenses.
This leads to a decrease in private saving. Lower savings create an investment gap in the economy and to full, this gap investors need to borrow money from the outside. The country also has to pay interests on borrowed money which causes a current account deficit. In Pakistan, savings are always less than investment creating an investment gap in the economy.
In the last three decades, Pakistan has been facing the issue of an investment gap that is filled by different capital inflows. Trade deficit and fiscal deficit have a positive and significant impact on the current account deficit of Pakistan in the short run.
The first step towards evaluating whether a deficit is good or bad is to understand its drivers what underlying conditions might explain a deficit? Some of the drivers reflect economic, social, and demographic characteristics that imply a benchmark for normal current account deficits; while other drivers include government policies and institutional features that may mitigate or exacerbate a departure from the benchmark.
A bad current account deficit is characterized by underlying consumption and investment drivers, including policies that raise doubts about a country’s long-term external solvency or are symptomatic of problems elsewhere in the economy.
A good deficit supports smooth transitions, for instance, from building productive capacity while accumulating external debt to subsequently accumulating assets, and then drawing them down as population ages. While traditional determinants continue to help explain deficits, the complexity of globalized economic activities requires more careful consideration of measurements and frameworks for assessments.
Good deficits, or even surpluses, are not necessarily safe from financial stress at any moment in time. The vulnerability to stress depends on the characteristics of gross financial stocks, especially if they are large, and balance sheets of different sectors. Sound policies and institutional features can go a long way to attracting and sustaining a healthy demand for domestic assets.
