The UK Current account deficit measures:
- the balance of trade in goods
- the balance of trade in services.
- Net current income e.g. from oversees investment.
- Transfer payments e.g. payments to EU.
The net balance of trade in goods and services are by far the biggest factor in determining the current account.
If there is a deficit on the current account, there will be a surplus on the financial / Current account to compensate for the net withdrawals.
The current account is affected by both short term factors and long term factors.
1. Economic Growth / Consumer Spending
A period of consumer led economic growth will cause a deterioration in the current account. Higher consumer spending will lead to higher spending on imports. At the end of the 1980s, the UK economy was booming with rising consumer spending and inflation. This led to a widening deficit on the current account. The recession of 1992 led to an improvement and a brief surplus in the mid 1990s. The recession of 2009 also led to a temporary improvement in the deficit as consumers cut back on spending.
Note: Economic growth in China has not caused a current account deficit because the growth has been export led.
A country with a low savings rate and high % of consumption will typically have a higher current account deficit.
2. Exchange Rate.
A depreciation in the exchange rate makes the currency relatively more competitive. After a depreciation, exports will be more competitive and imports more expensive. This should improve the current account. However, it requires demand for exports and imports to be relatively price elastic. If demand is inelastic, then cheaper exports will only cause a small rise in demand. The actual value of exports can decrease.
- There is often a time lag effect between a depreciation in exchange rate and improvement in current account. See: Terms of trade effect for example in UK economy.
In the long term, the current account will be influenced by the relative competitiveness of their industrial production. If a country becomes uncompetitive then exports will decline relative to imports. For example, in the 1950s and 1960s, the UK didn’t have a large current account deficit. However, starting in the 1970s and 1980s, we have seen a steady increase in the size of the current account deficit. In particular, the deficit in goods (manufactured goods) has increased. This suggests that UK industry has become relatively less competitive. For example, it hasn’t been able to compete with low cost countries such as China or higher productivity countries like Germany. Many factors determine relative competitiveness such as
- relative wages
- Labour productivity
- Standard of infrastructure e.t.c
To some extent the size of the current account depends on how many capital flows a country can attract. For example, the US was able to run a persistent current account deficit of 5% of GDP or more (see: US Current account deficit) because foreign investors wanted to buy dollar assets. Without this demand for dollar assets (such as Treasury Bills) there would have been a decline in the value of the dollar which would have reduced the size of the current account deficit.
- Exchange rate and current account deficit
- Causes of US current account deficit
- Does a current account deficit matter?