A common fallacy is that current account deficits measure dependence on external financing. In reality, external balances and cross border financing are only vaguely related. Vulnerability to “stops” in financial flows does not depend on trade and capital flows (“net concept”) but only on the volume and origin of financing (“gross concept”). Currency crises are not about current accounts that need to adjust, but about funding gaps that need to be closed.
Borio, Claudio and Piti Disyatat, “Capital flows and the current account: Taking financing (more) seriously”, BIS Working Papers, No 525, October 2015
Avdjiev, Stefan, Robert N McCauley and Hyun Song Shin, “Breaking free of the triple coincidence in international finance”, BIS Working Papers, No 524, October 2015
The below are excerpts from the papers. Headings, links and cursive text have been added.
Understanding current accounts
The current account of a currency area encompasses its external balances of [i] trade in goods and services, [ii] net factor income (balance of net earnings on investment and net labor income) and [iii] net cash transfers. A positive current account balance is supposed to indicate an increase in net claims of residents against non-residents. The current account and the capital account of a currency area constitute its aggregate balance of payments.
“The current account is equal to production (income) minus domestic investment and consumption…Equivalently it is equal to the difference between domestic saving and investment…Saving is defined as income not spent… The current account permits…decoupling:…[for example] if a country has a temporarily high income and/or few investment opportunities, it runs current account surpluses.”
“Country A’s current account surplus…just reflects the flow of goods from A to B, to be used for investment there. A’s non-consumption of goods accommodates B’s use of that good for investment. The current account is a description of the resource constraint…In contrast to popular images, saving is not a ‘wall’ that needs to be channelled into financial assets. Rather, it is the ‘hole’ in aggregate demand that makes room for investment expenditure….Saving entails capital accumulation, not financing.”
Misunderstanding current accounts
“Current accounts…are used…to gauge the degree of financial market integration, and to assess a country’s vulnerability to ‘sudden stops’ in external funding. This centrality runs so deep that in policy circles ‘global imbalances’ are often treated as synonymous with ‘current account imbalances’…In a world of huge and free capital flows, the centrality of current accounts in international finance…should be reconsidered.”
“Contrary to a common view, current account patterns are largely silent about the role a country plays in international borrowing, lending and financial intermediation – aspects that must be at the core of the understanding of any financial crisis… What is lost in the translation from theory to empirical observation is that saving and financing are not equivalent – the resource and financing constraints differ.”
“Financing, a cash flow concept, is access to purchasing power in the form of an accepted settlement medium (money), including through borrowing…Financing is a gross, not a net, concept: financing is necessary for all sorts of purchases, well beyond those associated with income flows, including those of existing financial and real assets…There is a corresponding distinction between a resource and a financing constraint.
- Saving alleviates an economy’s resource constraint: if people did not abstain from consuming, they would not release real resources that could be used to invest.
- Cash flows alleviate an economy’s financing constraint: in their absence, no spending could take place. This applies both domestically – to a closed economy – and across borders. “
“It is…misleading…to think of the current account – the gap between domestic saving and investment – as telling whether a country is lending (if in surplus) or borrowing (if in deficit)…If we assume that all banks are located in country A, by construction all the financing comes from there. This has no implications whatsoever for the goods flows or national accounts…Moving from a two-country to a multi-country world undermines our straightforward intuition about bilateral net relations. Now, even in net terms, individual surplus countries need not accumulate claims on deficit countries…In the extreme case, all the financing could come from a third country, which does not trade with the first two – think of it as a pure financial hub.”
“We do believe that current accounts matter…If very large and persistent, they do provide information about long-term sustainability, they do raise the costs of financial crises, and they do pose the risk of trade protectionism. But current accounts have been asked to tell us more than they can…about the volume and direction of capital flows… Even if poor countries finance all of their investments from abroad, with high potential returns attracting foreign investment, they may still run current account surpluses [for example if they have high saving ratios]…Similarly, even if a country is fully financially integrated with the rest of the world [and vulnerable to external funding conditions], its current account may be balanced.”
What can be learnt for macro trading?
“Two key insights follow…
- The direction of cross-border credit risk arising from consumption and investment expenditures is unrelated to the current account position: it depends only on the origin of the financing. The credit risk is indeed borne by residents in country A if banks are located there…The irresistible image that surplus countries are creditors, exposed to credit risk of deficit countries, because these on net ‘borrow’ from them, is fundamentally misleading.
- Capital flows need not increase the volume of financing in a given economy. In fact, most of them probably do not: they simply reshuffle the ownership of existing claims…The volume of financing increases only when new financial claims are issued.”
“Once the focus shifts away from the sustainability of current accounts, it makes sense to zero in on the sustainability of financial exposures, and hence on how external positions link up with a country’s overall balance sheet….Apart from market perceptions – ill-founded as they may be – there is no reason why current account deficits in and of themselves imply such greater exposure… Externally sourced credit booms take place through inflows of foreign financing, not net resource flows as reflected in current accounts… Investors don’t stop financing current accounts. They stop financing debt or engage in asset fire sales. Sudden-stop risks can be present even with no imbalance in either the current account or net external positions. Indeed, whether the holders of liabilities that need to be rolled over are domestic or foreign seems secondary.”
“The emphasis on the ‘need’ for current accounts to adjust when crises do occur appears misplaced…In such situations, the underlying problem typically stems from balance sheet exposures that disrupt the flow of financing rather than some sudden binding constraint on net resource flows. ‘Current account reversal’, or reductions in deficits, are not means to pay back obligations. They typically reflect the macroeconomic adjustment that accompanies the financing disruptions. And the crisis ends not when or because the current account is reduced, but when the funding gap is eliminated through either new financing or debt restructuring.”
Case studies: How current accounts misled markets in 2008/09
“In the mid-2000s, the US dollar depreciated against major currencies even as the US current account deficit widened to an historically large share of output. In an influential paper…[Paul] Krugman warned of an impending collapse in the value of the dollar, fretting that the dollar would fall abruptly when the currency market met its… [crisis] moment…In the event, the US dollar rose sharply with the onset of the global financial crisis in 2008. Its strong appreciation was associated with the deleveraging of financial market participants outside the United States, such as the European banks…who had used short-term dollar funding to invest in risky long-term dollar assets. As the crisis erupted and risky US mortgage bonds fell in value, these financial market participants found themselves overleveraged and with dollar liabilities in excess of depreciating dollar assets. This forced them to bid aggressively for dollars to repay their dollar debts, pushing up the dollar’s value in the process.”
“Korea was running current account surpluses in the run-up to the 2008 crisis, and had a positive net external asset position vis-à-vis the rest of the world. That is to say, the value of its claims on foreigners in debt instruments exceeded the value of its debt liabilities to foreigners. Furthermore…an appreciating dollar is a positive wealth shock for a country such as Korea. Nevertheless, Korea was one of the countries worst hit by the 2008 crisis, with GDP growth slowing sharply in 2009…A closer look at the sectoral decomposition of the international investment position sheds light on why Korea was hit so hard in 2009…There was considerable disparity across sectors. In particular, the corporate sector was a large net debtor vis-à-vis the rest of the world…The capital gains seen on the central bank balance sheet will not help the corporate borrowers who face a surge in the dollar’s value and a resulting bank credit crunch.”