How does current account imbalance affect the economy of a country?

The previous article explained how the growing current account deficit has been beneficial for India and can be treated as an indicator of growth. There are many determinants of the current account imbalance. They are unique to different economies. It is important to identify them because it helps policymakers understand the underlying causes of the deficit and develop appropriate policy changes (Knight & Scacciavillani, 1998). The current account imbalance is an important macroeconomic variable to explain the movement patterns and take necessary policy action to induce changes.

For the past 13–14 years, India has experienced a growing current account deficit. Only the years 2001–2002, 2002–2003, and 2003–2004 showed a current account surplus after economic changes were put into place. Understanding the variables that affect the current account balance in the setting of India and result in deficits and surpluses is crucial. India’s current account imbalance is primarily determined by the trade imbalance, oil imports, capital outflows, exchange rate, difficulties in the services sector, remittances, and government policies on international trade.

The fiscal deficit has a direct relationship with the current account imbalance

A fiscal deficit is a condition in which the government’s spending exceeds its revenue (Hayes, 2020). A high and persistent fiscal deficit can lead to inflation and inflate the debt burden. Most academic literature point to a positive correlation between fiscal deficit and current account deficit (Abbassi, Baseri, & Alav, 2015; Gebremariam, 2018; Rath & K, 2019). In other words, an increase in fiscal deficit leads to a decrease in the current account deficit. This relationship is causal, positive and bidirectional in the short and long run. Over the years, it has been proven by researchers in the context of many countries using a range of statistical tests like Granger Causality (Asrafuzzaman & Gupta, 2013), VAR (Ebrahim, 2012) and ARDL (Idil, 2010) models.

Gross domestic product (GDP) affects the current account deficit inversely and directly

The GDP is a measure of the economic activity and growth of a country. It represents the total value of goods and services produced in a country during a specific period of time (Fernando, 2022). The standalone impact of GDP on the current account deficit has not been established in the literature. This is because GDP is impacted by factors such as exchange rate, savings and investment rate, and macroeconomic policies.

Debelle and Fuller (1996) and Calderon, Chong and Loayza (2000) found that with a rise in GDP, there is an increase in the current account deficit too. This is because when GDP grows, it leads to an increase in domestic consumption and investment. This in turn increases imports and can lead to a widening of the current account deficit. However, Kandil and Greene (2002) found that a growing GDP leads to an increase in exports, decreasing its current account deficit.

External debt has a direct relationship with current account imbalance

The part of a country’s debt that is obtained from foreign lenders, such as commercial banks, governments, or international financial organizations, is referred to as its external debt. (Keaton, 2022). A country’s external debt can be a result of trade deficits, low savings rates, or government spending. According to  Ibhagui (2018), the impact of external debt on the current account balance depends on the country’s trade openness. The current account deficit of countries with high openness increases significantly with a rise in external debt (Bulut, 2011).

Additionally, countries with high external debt, face difficulties in attracting foreign investments which can lead to a depreciation of the country’s currency. This also negatively impacts the country’s current account balance. On the other hand, if a country has low external debt, it may have more flexibility in terms of its international trade and financial transactions, which can help to improve its current account balance (RBI, 2004).

Trade openness leads to a positive current account balance

Trade openness describes how much a nation engages in international commerce. Typically, it is determined by the proportion of a country’s gross domestic product (GDP) to its total trade (exports + imports). It and the country’s current account balance are significantly related. A country with a high trade openness will probably have more exports and imports, which could result in a bigger trade imbalance or surplus. A country’s current account balance will be positively impacted by having a trade excess (ADBI, 2012).

Government expenditure is inversely related to the current account balance

Government expenditure is classified into two categories; current expenditure and capital expenditure. According to Abbas (2020), when capital expenditure is high, it may lead to a lower current account deficit. But, in the short to medium run when the current expenditure is high, the current account deficit rises. Even Tanner (1994), found that “permanent” spending, i.e. long-term expenditure in the form of capital investment does not affect the current account imbalance in the long run.

Private investments affect current account balance positively

Private investments are made by individuals, businesses, or other non-government entities in another country. This can include investments in real estate, stocks, bonds, and other financial assets, as well as investments in physical assets such as factories, equipment, and infrastructure. Olivei (2000) found that in the long run, the rebalancing of the current account occurs mainly through changes in investment. A low rate of investment is potentially detrimental to a country’s future performance. A country’s current account balance suffers when reserves and demand both declines (Adegboyega & Oladeji, 2020).

FDI positively affects the current account imbalance

Foreign Direct Investment (FDI) is an investment made by a company or individual in one country into a business or company based in another country. It typically takes the form of establishing new operations or acquiring existing assets in the host country. There is substantial evidence of the impact of FDI on current account balance, with most of them showing a direct negative impact (Ali, Ahmad, & Sadiq, 2019; Ali, Bibi, & Sadiq, 2021; JAFFRI, ASGHAR, ALI, & ASJED, 2012; Sahoo, Babu, & Dash, 2015). This is because when foreign companies invest in a country, they may import raw materials, capital goods, and other inputs from their home country. This can lead to an increase in imports, and a decrease in exports, resulting in a current account imbalance.

The inflation rate is detrimental to the current account imbalance

The general rate of increase in prices for products and services, which results in a decline in purchasing power, is known as the inflation rate. It is usually calculated as the percentage change in an index of prices over a predetermined time period, such as a month or a year, such as the Consumer Price Index (CPI) or the Producer Price Index (PPI) (Ibrahim, 2019).

Research has shown that, for countries like India or Russia, inflation rates are negatively correlated with the current account balance (Bank et al., 2000; Kanungo, 2018; Klnç, Tunç, & Yörükolu, 2016). This connection exists because of the current state of the economy, in which domestic products are becoming more expensive as a result of inflation. As a consequence, exports decline and the economy becomes more dependent on imports, increasing the current account deficit. Even high inflation reduces households’ ability to save effectively, rendering assets unproductive and increasing the current account imbalance.

The exchange rate is an important determinant of the current account imbalance

The price of a currency stated in the currency of another nation is known as an exchange rate. The exchange rate is a crucial economic variable because changes in the exchange rate have an impact on the choices made by businesses, governments, and people by affecting the inflation rate, the balance of payments, and economic activity. (Hamilton, 2018).

The Central Bank (2014), Fratzscher, Juvenal, and Sarno (2007), Priyatharsiny (2017), Vilela & Macdonald 2020, and other studies have shown that there is a negative correlation between an economy’s exchange rate and its current account balance. The reason for the negative association is that an increase in exchange rates makes imports more expensive for one country, which lowers the demand for imports, while an increase in exchange rates makes the country’s currency cheaper for another country, which increases the demand for exports. Therefore, this increase in exports over imports reduces the country’s current account balance and imbalance.

Broad money supply’s negative relationship with current account balance

The definition of the broad money supply is the form of currency that is used to calculate the total amount of money in circulation in the economy. Deposits with a two-year average maturity, deposits that can be redeemed with three months warning, currency, and repurchase agreements make up the money supply (Das, 2010).

Existing studies (ECB, 2012; Lim & Sriram, 2003; Mohammad, 2010) have verified that a broad money supply tends to have a negative relationship with the current account balance. The rise in the money supply results in reducing the spending of the individual and raising the export of the country. The discrepancy in the export and import leads to a rise in a decrease in the current account deficit and hence building a favourable condition for the economy.

The performance of a country’s economy is significantly influenced by its current account imbalance. The current account deficit is influenced by a variety of economic variables, including the GDP, external debt, government spending, trade openness, private investment, exchange rate, inflation rate, and foreign direct investment. Therefore, it is important to comprehend how each of these variables affects the current account balance. In addition to assisting in the identification of variable associations, it would also recommend government policies for resolving the current account imbalance issue.

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