Current account deficit - why can it be detrimental for the economy

Question

i understand that current account is not necessarily good or bad for the economy (eg. Australia - awesome economy - current account in deficit ) however, if current account in deficit is not that bad why doesn't every country have it. i also understand that current account deficits can occur due to high foreign investment within the country. foreign loans also apply, but one thing that was interesting was that when the exchange rate is stronger these loans would be in some ways 'offsetted'. perhaps more explanation from you professionals in this field might be required.

Answer 1

1. There could be problems financing the deficit in the long term. A short term deficit is not a problem, but if you have a deficit of over 6percent  of GDP then it is a problem if you rely on Capital flows. A significant part of the current account deficit in Australia is finance by Asian investors buying Australia securities, at relatively low interest rates.

2. Most countries would not be able to borrow such large amounts at low interest rates. Australia currently can because Australia is seen as a very stable reserve currency. However if attitudes to the Australian economy change and investors lose their confidence in the US economy, they will stop buying Australian debt. This will cause 2 problems.

   1. Australian interest rates will need to rise to attract enough people to buy the debt. These higher interest rates will reduce demand in the economy. Higher interest rates will particularly hurt Australian consumers who have large amounts of debt at the moment.

   2. If capital flows can’t be attracted then the dollar will continue to devalue further. This could cause inflationary pressures, interest rates may need to rise to stabilize the Australian pound.

Basically to correct the deficit would be a painful experience for the Australian  economy and result in a slowdown or possibly recession

3. In Australia  the current account deficit is to a large extent caused by excess spending in the economy. It is partly caused by government borrowing which increases Aggregate Demand in the economy and hence growing demand for imports. A large current account deficit is often a sign of an unbalanced economy. It could be a sign of structural weakness and an uncompetitive manufacturing sector.

4. A deficit on the current account increases foreign liabilities. In the beginning a current account deficit could be just a deficit on buying goods. However over time the deficit will be increased by the interest payments on the capital surplus. Foreigners invest in Australia . On these investments they receive interest payments or dividends. These dividends count as a debit on the current account. Therefore the longer the deficit goes on the higher the level of investment income debits will be accrued. This means that in the future the economy will need to attract capital flows just to pay off the investment income. As well as the deficit on goods and services.