The current account summarizes transactions that fall within the categories of imports or exports of good and services, income earned abroad, domestically generated income belonging to foreigners, and unilateral transfers. The common denominator behind all these transactions is the involvement of an inflow or outflow of currency. Unilateral transfers include foreign aid and gifts of money from residents of one country to family members living in another country. Cross-country investments, such as buying and selling foreign stocks and bonds, also involve currency inflows and outflows, but are summarized in another account called the capital account. A third account, the official reserves transactions account, summarizes central bank transactions that involve an inflow or outflow of currency and that change official reserve holdings. A Federal Reserve purchase of gold with dollars is an example of the type of transaction covered by the official reserves transactions account. These three accounts make up the balance of payments.
The current account balance is considered a significant indicator of the economic and monetary health of a country. It is among the handful of indicators that the Economist magazine reports for major countries of the world. The Economist reports the current account balance both in absolute numbers and as a percent of gross domestic product (GDP).
On the current account, transactions that involve an outflow of currency are a debit item, and transactions that involve an inflow of currency are a credit item. Exports of goods and services are a credit and imports are a debit. The foreign expenditures of a U.S. family visiting Greece count as an export on the U.S. current account. The interest income that a resident earns on a foreign bond counts as a credit. The interest income that a domestic bond pays to a foreign owner is a debit. Money residents send to family members living abroad counts as a debit. If the money value of the debits outweighs the money value of the credits, then the outflow of currency outruns the inflow of currency, and a country has a current account deficit. If the credits exceed the debits, the country has a current account surplus.
Persistent current account deficits is often regarded as an indication that a currency is overvalued and therefore faces a heightened risk of future depreciation. The largest component in the current account balance is net exports (exports minus imports). A current account deficit is nearly always an indication that imports exceed exports. As the value of a country’s currency goes up in foreign exchange markets, foreign imports into that country become less costly while exports from that country become costlier in foreign markets. An excess of imports over exports suggests that a domestic currency is too strong and likely to weaken in the future. A current account deficit indicates that the currency outflow on the current account exceeds the inflow. If the excess outflow of currency from a current account deficit is not offset by an excess inflow on a capital account surplus, a currency will depreciate unless a government is able and willing to take action. Governments usually hold sufficient official reserves to defend domestic currencies against speculative attacks, but not against long-term downward trends driven by market forces.
Currencies can remain strong in foreign exchange markets for extended periods of time in situations where a large current account deficit is offset by a large capital account surplus. A capital account surplus indicates that the inflow of foreign capital exceeds the outflow of domestic capital to foreign countries. A net inflow of capital equates to a net inflow of currency. Countries with persistent current account deficits often maintain elevated interest rates. The high interest rates encourage the inflow of foreign capital, offsetting the tendency of a current account deficit to undermine the value of a currency.
Even with strong capital inflows, a current account deficit is regarded as a risk factor in foreign exchange markets. The components in the current account are not tightly linked to the volatility and varying psychology of financial markets whereas capital flows are tightly linked to conditions in financial markets. Capital flows are much more sensitive than exports and imports to changes in expectations, and can therefore be more volatile. A net capital inflow can quickly change to net capital outflow, leading to almost certain currency depreciation and crashing financial markets for a country with a current account deficit. Currency speculators are always closely watching countries using elevated interest rates to sustain current account deficits offset by capital account surpluses. If these speculators see signs that elevated interest rates are pushing a country with a current account deficit into recession, they will dump the currency of that country. The value of the currency will crash in foreign exchange markets, domestic financial markets will crash, and the country will likely undergo a full-blown economic collapse.
For several years, the United States has been able sustain current account deficits with little difficultly. That is because the United States holds a reputation as a safe haven for foreign capital. United States’ investments are considered among the safest in the world. Over the last 30 years, however, the Japanese yen has gained strength relative to the dollar, reflecting the fact that Japan usually has current account surpluses and the United States usually has current account deficits.
See also: Balance of Payments, Currency Crises, Foreign Exchange Markets
