Current Account Deficit: Definition, Components and Causes

What Happens When a Country Can't Pay for Its Imports?

Current account deficit
The U.S. has both a trade and current account deficit with China. Photo: Joe Raedle/Getty Images

Definition: A current account deficit is when a country imports more goods, services and capital than it exports. The current account measures trade plus transfers of capital. The Bureau of Economic Analysis counts specifies three types. First is international income. Second are direct transfers of capital. The third is investment income made on assets.

A current account deficit is created when a country relies on foreigners for the capital to invest and spend.

Depending on why the country is running the deficit, it could be a positive sign of growth. It could also be a negative sign that the country is a credit risk.

Components

The largest component of a current account deficit is the trade deficit. That's when the country imports more goods and services than it exports. Find out the Current U.S. Trade Deficit

The second largest component is a deficit in net income. That's when foreign investment income exceeds the savings of the country's residents. This foreign investment can help a country's economy grow. But if foreign investors worry they won't get a return in a reasonable amount of time, they will cut off funding. That causes widespread panic.

Net income is measured by the following four things.

  1. Payments made to foreigners in the form of dividends of domestic stocks.
  2. Interest payments on bonds.
  3. Wages paid to foreigners working in the country.
  1. Direct transfers, mostly money foreign residents send back to their home countries. It also includes government grants to foreigners. This component is the smallest, but the most hotly contested.  (Source: "Current Account," Bureau of Economic Analysis.)

Causes

Countries with current account deficits are big spenders that foreign investors consider credit worthy.

These countries' businesses can't borrow from their own residents. They simply haven't saved enough in local banks. Businesses in a country like this can't expand unless they borrow from foreigners. That's where the credit-worthiness comes into the picture. If a country has a lot of spendthrifts, it won't find any other country to lend to it unless it is very wealthy and looks like it will pay back the loans.

Why would another country lend to such a spender, even if it is credit-worthy? The lender country also exports a lot of goods and even some services to the borrower. The lender country benefits. It can manufacture more goods, thus giving more jobs its people.

Consequences

In the short-run, a current account deficit is helpful to the debtor nation. Foreigners are willing to pump capital into it. That drives economic growth beyond what then country could manage on its own.

But in the long run, a current account deficit saps economic vitality. Foreign investors question whether economic growth will provide enough return on their investment. Demand weakens for the country's assets, including the country's government bonds.

As foreign investors withdraw funds, bond yields rise. The national currency loses value relative to other currencies.

That lowers the value of the assets in the foreign investors' strengthening currency. It further depresses investor demand for the country's assets. This lead to a tipping point where investors will dump the assets at any price.

The only saving grace is that the country's holdings of foreign assets are denominated in foreign currency. As the value of its currency declines, the value of the foreign assets rise. That further reduces the current account deficit.

In addition, a lower currency value increases exports as they become more competitively priced. The demand for imports falls once prices rise as inflation sets in. These trends stabilize any current account deficit.

Regardless of whether the current account deficit unwound via a disastrous currency crash or a slow, controlled decline, the consequences would be the same.

That's a lower standard of living for the country's residents.

How to Correct a Current Account Deficit

A country with a current account deficit should invest the foreign capital wisely. It should build roads and ports, and educate its workforce, to boost international trade

The country's leaders should create current account surplus as soon as possible. This means they should improve domestic productivity and the competitiveness of its local businesses. It should also seek to reduce imports of basic necessities, such as oil and food, by boosting that ability at home.

How the Current Account Deficit Is Part of the Balance of Payments

What Is the Balance of Payments?

  1. Current Account
  2. Capital Account
  3. Financial Account