8.2 Current account imbalances and adjustments

Current account imbalances stem from various factors, including differences in savings and investment rates, economic growth, exchange rates, and fiscal policies. These imbalances can lead to significant consequences for both deficit and surplus countries, affecting their economic stability and international relationships.

Addressing persistent imbalances involves several adjustment mechanisms and policy approaches. These include exchange rate adjustments, changes in domestic demand, structural reforms, and international coordination. Countries must carefully navigate these options to promote sustainable economic growth and global financial stability.

Causes and Consequences of Current Account Imbalances

Causes of current account imbalances

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• Differences in savings and investment rates between countries
  • Countries with high savings rates relative to investment rates tend to run current account surpluses (China, Germany)
  • Countries with low savings rates relative to investment rates tend to run current account deficits (United States, United Kingdom)
• Differences in economic growth rates
  • Faster-growing economies tend to import more, leading to current account deficits (emerging markets during economic booms)
  • Slower-growing economies tend to export more, leading to current account surpluses (Japan during the 1990s)
• Exchange rate misalignments
  • An undervalued currency can boost exports and reduce imports, leading to a current account surplus (China in the early 2000s)
  • An overvalued currency can reduce exports and increase imports, leading to a current account deficit (Argentina before the 2001 crisis)
• Fiscal policy
  • Government budget deficits can contribute to current account deficits by increasing domestic demand and imports (United States in the 2000s)
  • Government budget surpluses can contribute to current account surpluses by reducing domestic demand and imports (Norway, thanks to oil revenues)

Consequences of persistent imbalances

• Consequences of persistent current account deficits
  • Increased foreign debt
    • Persistent deficits require borrowing from abroad, leading to a higher external debt burden
    • Higher debt levels make a country more vulnerable to changes in global interest rates and investor sentiment (Greece during the European debt crisis)
  • Vulnerability to sudden stops in capital inflows
    • Reliance on foreign financing makes a country more susceptible to sudden reversals in capital flows
    • Sudden stops can lead to financial crises and sharp economic downturns (Mexico in 1994, Asian countries in 1997)
  • Potential for currency crises
    • Large and persistent deficits can undermine confidence in a country's currency, potentially leading to a sharp depreciation
    • Currency crises can cause inflation, capital flight, and economic disruption (Argentina in 2001, Turkey in 2018)
• Consequences of persistent current account surpluses
  • Accumulation of foreign assets
    • Persistent surpluses result in the accumulation of foreign assets, such as foreign exchange reserves or investments abroad
    • Large foreign asset holdings can give a country more economic and political influence (China's large US Treasury holdings)
  • Exposure to foreign currency risk
    • Large holdings of foreign assets can expose a country to fluctuations in exchange rates
    • If the value of foreign assets declines due to exchange rate changes, it can lead to financial losses (China's exposure to US dollar assets)
  • Potential for trade tensions
    • Persistent surpluses may lead to trade tensions with deficit countries, as they may view the surpluses as a result of unfair trade practices
    • Trade tensions can result in protectionist measures and economic retaliation (US-China trade war)

Adjustment Mechanisms and Policies

Mechanisms for imbalance adjustment

• Exchange rate adjustments
  • Deficit countries: Currency depreciation can make exports more competitive and imports more expensive, helping to reduce the deficit (UK after the Brexit referendum)
  • Surplus countries: Currency appreciation can make exports less competitive and imports cheaper, helping to reduce the surplus (Japan in the late 1980s)
• Domestic demand adjustments
  • Deficit countries: Reducing domestic demand through fiscal austerity or tighter monetary policy can slow import growth and narrow the deficit (Greece after the European debt crisis)
  • Surplus countries: Stimulating domestic demand through expansionary fiscal or monetary policy can boost import growth and reduce the surplus (Germany after the Global Financial Crisis)
• Structural reforms
  1. Deficit countries: Implementing reforms to increase productivity, competitiveness, and savings rates can help reduce the deficit over time (Spain's labor market reforms after the European debt crisis)
  2. Surplus countries: Implementing reforms to boost domestic consumption and investment can help reduce the surplus over time (China's efforts to rebalance its economy towards consumption)

Policies for reducing imbalances

• Multilateral coordination
  • Global imbalances can be addressed through international policy coordination, such as the G20 Framework for Strong, Sustainable, and Balanced Growth
  • Coordinated efforts can help ensure that adjustments in deficit and surplus countries are complementary and do not lead to beggar-thy-neighbor policies (G20 efforts to address global imbalances after the Global Financial Crisis)
• Structural reforms
  • Deficit countries: Policies aimed at increasing competitiveness, such as investing in education, infrastructure, and research and development, can help boost exports and reduce the deficit (Germany's Agenda 2010 reforms)
  • Surplus countries: Policies aimed at reducing savings and increasing consumption, such as strengthening social safety nets and developing financial markets, can help reduce the surplus (China's efforts to expand social welfare and develop its domestic financial markets)
• Exchange rate policies
  • Deficit countries: Resisting currency interventions that prevent necessary depreciation can help facilitate adjustment (US pressure on China to allow yuan appreciation)
  • Surplus countries: Allowing greater exchange rate flexibility and appreciation can help reduce the surplus (China's gradual yuan appreciation after 2005)
• Trade policies
  • Deficit countries: Avoiding protectionist measures and focusing on policies that increase competitiveness can help reduce the deficit (US efforts to boost exports through trade agreements)
  • Surplus countries: Reducing trade barriers and promoting domestic consumption can help reduce the surplus (Japan's efforts to open its domestic market to imports)