Does a Current Account Deficit always lead to a Budget Deficit?

So this is a supremely legitimate question. Infact, after dipping one’s toes into the vast ocean that is the economics of international trade and the Balance of Payments, I’d go as far saying that this question is inevitable. Let’s put this to bed, shall we?

First, the theory...

Macroeconomic theory suggests that the Current Account Balance (X-M) and the Budget Balance (T-G) of a country are closely related. Lets look at the National Income Identity to see how. 

Note: I’m using the term Current Account Balance to loosely mean Net Exports (X-M), even though the Current Account includes other items such as investment income and current transfers. 

Y = C + I + G + (X - M)

Where Y = Output, C = Consumption, I = Investment, G = Government Spending, X = Exports, and M = Imports. 

Let’s move a few things around.

Y - C - G = I + (X - M)

Adding and subtracting T (taxes) from the LHS, we get:

(Y - T - C) + (T - G) = I + (X - M) 

Where (Y - T - C) = Sp (Private Saving), (T - G) = Budget Balance and (X - M) = Current Account Balance. 

This implies: 

Sp + (T - G) = I + (X - M) 

(Sp - I) + (T - G) = (X - M)

Or

(Private Saving - Investment) + Budget Balance = Current Account Balance

So, this is how the Current Account Balance and the Budget Balance are related in theory.

Twin Deficit Hypothesis

Now that we know what the theory is, let’s assume there’s a Current Account Deficit i.e. the Current Account Balance is negative. Per the equation above, the following scenarios are possible:

• There’s a Budget Deficit (Budget Balance is negative) and Private Saving is < Investment i.e. (Sp - I) is also negative. 

• There’s a Budget Deficit (Budget Balance is negative) and Private Saving is > Investment, but the Budget Deficit is > (Sp - I) in absolute terms. 

• There’s a Budget Surplus, but Private Saving is < Investment, and the absolute value of (Sp - I) is greater that the Budget Surplus. 

If we assume that all scenarios are equally likely, the odds of a Current Account Deficit implying a Budget Deficit are 2/3 or 67%. That said, all scenarios are not equally likely. Budget Deficits are much much more common that Budget Surpluses. Per the CIA World Fact book (Link here), 85% of the countries of the world were running Budget Deficits based on 2015 estimates (some estimates included are for earlier years). Based on these two inputs, it is reasonable to assume that if a country is running a Current Account Deficit, in the vast majority of the cases, it is also running a Budget Deficit. 

This brings us to the “Twin Deficits Hypothesis”, which refers to the tendency of nations to run a Current Account Deficit as well as a Budget Deficit together. The term became popular in the 1980s and 1990s when the US began to run deficits in both these accounts. However, as we’ve shown above, this (running twin deficits) is not a rule - it’s just what is observed in a majority of the cases. 

You can run a Budget Surplus while running a Current Account Deficit e.g. New Zealand in 2015 (source: CIA Factbook). 

What does it really mean to run Twin Deficits? Let’s look at the US. 

Let’s explore further to understand what it means when a nation is running a Current Account Deficit and a Budget Deficit concurrently. Let’s use the example of the US. For context, the US runs the largest Current Account Deficit in the world ($484 Bn in 2015). It’s Budget Deficit for FY2015 was $439 Bn (2.5% of GDP). 

The US has been running Current Account Deficits (CAD) for decades. When the US runs a CAD, it is importing more than it exports, which means that on a net basis, it is buying foreign goods and paying foreigners USD in return. 

(Note: Even if we assume that the US pays importers in their own currency (the importer’s currency), it still effectively means that the US is paying for its net import of foreign goods in USD. Lets see how. The US would exchange USD for foreign currency from the importer country and then use this foreign currency to pay the importer. The buying of foreign currency and then using it to pay for imports would cancel each other out, and the US would still have bought foreign goods and paid in USD.)

When foreigners accumulate net USD (after paying for imports from the US), they invest these dollars in American equity, debt and other assets. They are effectively lending to the US. The US is a net debtor/borrower.

Separately, it is well know that Private Savings in the US are low and inadequate to fund all of the investment required in the economy (Sp - I < 0). America is heavily dependent on foreign funds to bridge this shortfall. 

Now look at the identity below and put both these pieces together.

(Private Saving - Investment) + Budget Balance = Current Account Balance

                   (-)                         +          (-)              =                  (-) 

When the US runs a CAD (has run CADs for decades), it borrows funds from the ROW, which are then used to finance the Budget Deficit (has run budget deficits in all years since 1970 except for 1998-2001) as well as the Investment that domestic Private Saving has been unable to finance. 

Finally the Logic - Why a Current Account Deficit makes a Budget Deficit quite Likely 

Lets assume country X is running a balanced budget while its Current Account is in surplus. Great situation really. Now lets assume that country X’s key trade partners fall into recession, or the goods of other nations become more competitive globally, causing X’s exports to fall while its imports remain at the same level. This will lead to a Current Account Deficit.

When country X’s exports fall, it will lower demand for its products which can lead to lower output and unemployment. To counter this scenario/avoid a slowdown, the government will usually tend to increase government spending (G) in order to boost demand. Increased G (while taxes remain the same) funded in part by borrowing from abroad will lead to a Budget Deficit. 

Hopefully now it all makes more sense.

Bottom-line: Current Account Deficits don’t have to lead to Budget Deficits, but they usually do. 

Signing off.

Why is Majority of International Trade Carried Out in US Dollars?

In my previous post, I explained why the net exports of a country are necessarily = its net capital outflow (link here). I used the example of Indian IT exports to the US to make the points I needed to make. The curious reader will ask - when you export goods, which currency do you get paid in? Your own, the importer’s, or a third currency? 

The reality is that most international trade is conducted in US dollars (USD). For context, in 2013, more that 80% of all international trade finance was conducted in USD. Also, ~90% of foreign exchange transactions involved the USD. 

There are a number of reasons why USD is the currency of most international trade. Let me explain.

Why do we need an “International” Currency for Trade at all?

Let’s assume a primitive world where there is no global currency that is used for international trade. Whenever a country, say country A, buys from country B, A will have to pay for B’s products in B’s currency. Suppose India wants to buy cars (Toyota Innova) from Japan. India will pay have to pay for the car in Japanese Yen (JPY). This makes sense. Toyota wants Yen that it can spend in its home market. 

How will India get the Yen needed to pay for the Innova? It can only get Yen from Japan. India offers to sell Japan jewellery, pharmaceuticals and petroleum products in return for payment in Yen. Let’s suppose Japan doesn’t want to buy any of these products from India. Japanese demand for Indian products is nil. In such a scenario, there will be no trade between India and Japan.

If only there was a currency that was acceptable to the both the buyer and the seller i.e. one that the buyer had and one that the seller was willing to receive. What would be the key feature of this currency? It would be a currency that everyone (all nations of the world) was willing to accept, since they’d know they could use it to buy goods from any other nation. There is such a currency today - the USD. 

Why is everyone willing to accept the USD in International Trade?

There are a number of reasons:

1. Historical Pre-eminence: “Reserve Currency” of the world

Historical factors have enabled the adoption of USD as the default currency for international trade. USD is the “reserve currency” of the world. What is a reserve currency you ask? It is a currency that is held in significant quantities by governments/institutions of the world as part of their forex reserves. Today, more than 60% of all foreign currency reserves in the world are in USD. 

Why is this so? This dates back to the Bretton wood agreement of 1944 (following WW2) when all currencies were pegged to the USD (at fixed exchange rates), which itself could be redeemed for gold. So if you (country X) had USD, you could surrender it and get gold in return. (The US held 2/3rd of the world’s gold at that time). The USD was the only currency convertible into gold. 

How did the currency pegs work? Country X would peg its currency to the USD, and then maintain this fixed exchange rate within a band of + - 1% by buying and selling USD. 

Naturally, it made sense for the countries of the world to keep majority of their forex reserves in the form of USD. The USD took over the role that gold played under the “gold standard” system since it was the only currency that was convertible into gold. You could buy any currency in the world in exchange for USD. Other nations were always willing to accept dollars in exchange for their goods. And finally, in the unlikely case that the USD became weak/unstable, you could always redeem it for gold. 

The USD thus became the reserve currency of the world, and the currency in which most international trade was conducted. 

In 1971, the US suspended the convertibility of the USD into gold. By then, the USD was already firmly established. That said, the US still had to ensure that other nations of the world continued to feel confident about the dollar and continued to use it as the “international currency” for trade. To accomplish this, America signed deals with all OPEC countries. I’ll explain below. 

2. The Petrodollar Coup: All oil deals priced in USD
In 1973, the US signed a secret deal with Saudi Arabia according to which: 1) all of it’s oil sales would be denominated in USD i.e. Saudi Arabia would accept payment for all its oil sales only in US dollars, and 2) it would invest all the dollars remaining after it had met its import/ other requirements in US debt securities. In return, the US offered Saudi Arabia military aid and protection from foreign forces. Saudi Arabia readily signed this deal, but under the condition that it be kept a secret, as it didn’t want backlash from its Arab neighbours for lending money to America, Israel’s top supporter (by buying US debt securities, Saudi Arabia was effectively financing US government deficit). By 1975, all OPEC nations had signed similar deals with the US.

The USD became the currency in which the vast majority of the oil trades of the world began to be conducted. Once again, the US was able to put in place an economic system that created strong global demand for the US dollar, just like it had with the Bretton Woods agreement. With every nation of the world needing oil to keep its economy running, the USD continued to remain the international currency of trade - everyone needed it to by oil, and was ready to sell goods in exchange for dollars. 

3. Quantum and Diversity of US Exports
The US exports a huge quantum of goods/services. It is the third largest exporting country in the world with Exports of ~$1.5 trillion (behind China at $1.9 trillion and Germany at $1.55 trillion). Along with the sheer quantum of exports, it is also the wide variety of goods and services that one can buy from the US that gives it supreme status. While China is the manufacturing factory of the world, for high technology products, education, cutting-edge research, defence equipment, pharmaceuticals etc., US is still the top exporter. The US’s range of exports is unmatched. Note: Large high technology product exports from China are an exaggeration. China mainly assembles high-tech products with imported parts, but when it ships these abroad, Chinese customs classifies them as “high tech-exports” regardless of whether China’s contribution is labour or technology1. 

What this means is that whatever you (country X) want to buy, you’ll most likely get it from the US. So holding USD is desirable. You can import whatever you want from the US in exchange for USD. 

4. Stability
The USD offers stability. It is backed by the largest economy in the world and world’s strongest military. It enjoys robust demand given that it the currency in which most international trade is conducted. About 1/3rd of all US debt is held by foreigners - China and the OPEC nations being large holders. They’ve on occasion made veiled threats about selling their debt, but the reality is that it will hurt them as much as the US. It is not in the world’s interest for the USD to be unstable or fall. This is why despite large amounts of debt and high fiscal deficits over the years, the USD has remained stable. 

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1 I’ve taken this excerpt from “China’s High-tech Exports: Myth and Reality”, a paper written by Yuqing Xing, National Graduate Institute for Policy Studies, Tokyo. Link here. 

How to Record Transactions in the Balance of Payments (BOP)

So my last post, Why are the Net Exports of a Country = its Net Capital Outflow?, sets up this post really well. In this post, I will explain how transactions are recorded in a country’s Balance of Payments (BOP) account and why the Current Account Balance is always = - (Capital Account Balance) i.e. a deficit in the Current Account is always balanced out by a Surplus (of the same magnitude) in the Capital Account and vice versa. Don’t freak out if you don’t/only vaguely understand what these terms mean....

“Patience you must have, my young padawan."

....we’ll go through everything. 

Balance of Payments (BOP) and its Sub-Accounts 

The Balance of Payments account of country X records all international transactions undertaken between the residents of country X and the residents of the Rest of the World (ROW) during a given period of time, usually a year.

The BOP is divided into 2 sub-accounts: 1) Current Account, and 2) Capital Account. 

1. Current Account 

The Current Account records all trade (export/import) transactions of country X in goods and services, income receipts/payments on investments made abroad/investments made by foreigners in country X, as well as current transfers. Transfers are transactions where money or goods/services are transferred but nothing is received in return. For e.g. foreign aid, remittances by citizens working abroad, charitable contributions/gifts from foreign residents etc. 

The Net Balance on the Current Account (credit entries - debit entries) is called the “Current Account Balance”. If credits are more than the debits, the Current Account is said to be in “surplus”; if credits are less that the debits, it is said to be in “deficit”. 

The Current Account includes:

• Merchandise Trade Account: This records all international trade transactions (export/imports) for goods. The balance on this account is called the “Merchandise Trade Balance”.

• Services Account: This records all export/import transactions for services. The balance on this account is called the “Services Balance”. 

• Goods and Services Account: It is the record of all international trade transactions for goods and services. Goods and Services Account = Merchandise Trade Account + Services Account.

Note: The balance on the Goods and Services Account called the “Goods & Services Balance” is more commonly referred to as the “Balance of Trade” or “Trade Balance”. So, when you hear that country X has a Trade deficit, it means that the country’s net export of goods and services is negative i.e. it is a net importer of goods and services. If it has a Trade Surplus, it is a net exporter of goods/services. 

2. Capital Account

The Capital Account (of country X) records all international transactions involving a change in the ownership of foreign physical or financial assets held by residents of country X as well as the change in the ownership of domestic physical or financial assets held by residents of foreign nations. Foreign Direct Investment or FDI (investment in the form of a “controlling interest” defined as 10% or more of outstanding stock of a foreign business), Foreign Portfolio Investment or FPI (investment in foreign stocks, bonds and other financial instruments), foreign currency deposits, foreign real estate purchases etc. are all recorded in the Capital Account. 

A Capital Account Surplus means that the credit entries in the account are greater than the debits. This means that foreign capital is flowing into the country. A Capital Account Deficit means that domestic capital is flowing out of the country, to the ROW. 

Now that I’ve provided a brief overview of the BOP and its sub-accounts, lets get to the important part - how to record transactions in the BOP. Once you understand this, everything else will make sense automatically. 

Rules for making BOP Entries 

There are 3 basic rules one needs to remember while recording transactions in the BOP. These are the same rules that are applied for recording transaction in double entry accounting.

• Each transaction is entered twice, once as Credit and once as a Debit because each transaction has two sides - you give up something, and you receive something in return. These credit and debit entries can be in the same or in different accounts, depending on the type of transaction.

• A transaction is recorded as a Credit if it: 1) increases revenues 2) decreases expenses, 3) decreases assets, or 4) increases liabilities. 

• A transaction is recorded as a Debit if it: 1) decreases revenues, 2) increases expenses, 3) increases assets, or 4) decreases liabilities. 

Keeping these basic rules in mind, I will now make entries for some credible looking transactions, so that the mechanism becomes clear. 

1. Exchange of Currency (for trade) 

Suppose you’re me. You live in India, and want to order a great dress that you saw online on the White House Black Market (WHBM) website. White House Black Market is an American women’s clothing retailer. It’s one of my favourite stores - but I digress. What I wanted to say was....let’s make the BOP entries for this transaction. 

This is an import (of goods) transaction. I (a resident of India) am going to buy a good from a US retailer who will ship it to me in India. 

I will need to pay WHBM in USD. When I use my credit card to make this transaction, my credit card company will perform the currency exchange for me. Supposing the cost of the dress is $100 or Rs 6,600 (I’m assuming an exchange rate of $1= Rs 66), my credit card company will exchange my INR (Rupees) for USD on the forex market. 

This is how the exchange of currency (INR for USD) will be recorded in the Indian BOP:

	Debit	Credit
Capital Account	Rs 6,600 (currency - USD)	Rs 6,600 (currency -INR)

Remember currency is an asset. When the credit card company exchanges INR for USD, INR (Indian currency asset) leaves India, and USD (foreign currency asset) is purchased by India. So, in India’s BOP, the decrease of Rs 6,600 (which is what I have to pay to get $100) = decrease in an asset = Credit entry in the Capital Account (where changes in financial assets are recorded). The $100 that I get in return = increase in an asset = Debit entry in the Capital Account. 

Bottom-line: For the exchange of currency, both entries are made in the Capital Account, so net impact on the Capital Account Balance is = 0. 

2. Import of Goods

Now that I have the $100 I need to buy the dress I want from WHBM, lets see how this import transaction is recorded in the Indian BOP. 

	Debit	Credit
Current Account	Rs 6,600 (Import of dress)
Capital Account		Rs 6,600 (currency - USD)

The import transaction is recorded in the Current Account as a Debit since it increases expenses (importing the dress costs Rs 6,600) for the nation. 

How did we pay for the dress import? With the USD that we got through the currency exchange. As a result of this payment, our foreign currency assets are reduced (by $100), which is why we record a credit worth Rs 6,600 in the Capital Account. Note: all the entries in the Indian BOP are made in INR, even when the asset being depleted/accumulated is foreign currency. 

Bottom-line: A debit of Rs 6,600 in the Current Account is counter-balanced by a Rs 6,600 credit in the Capital Account. This is how a deficit on the Current Account is always balanced out by a Surplus on the Capital Account, and vice versa. 

3. Purchase of Foreign Assets (stock of a company, government bonds, real estate etc.) 

Let’s assume that instead of buying a dress, I want to invest the $100 that I received through the currency exchange to buy Apple stock. Let’s assume that the share price of Apple is $100, so I can buy one Apple share. 

Here’s how this transaction is recorded in the Indian BOP:

	Debit	Credit
Capital Account	Rs 6,600 (Apple stock)	Rs 6,600 (currency - USD)

Both entries are made in the Capital Account because both sides of this transaction involve financial assets. Since I’ve bought a share of an American company, there is an increase in assets i.e. a Debit worth Rs 6,600 is recorded. How did I pay for this transaction? I used the $100 received in the currency exchange. This means that there is a decrease in foreign current assets i.e. a Credit worth Rs 6,600 is recorded. 

Even if the foreign asset purchased is a US government bond or a rental property in the US, the entries in the Indian BOP would be the same (of course the debit in the Capital Account would now reflect an increase in the purchased asset instead of Apple stock). 

I could give more examples, but hopefully you get the picture. 

Because each international transaction (export, import, purchase/sale of asset, exchange of currencies etc.) involves 2 sides: what you receive (a good/service or an asset) and what you give up (currency/other asset or a good/service), and because of the way transactions are recorded in the double entry accounting system, the deficit on the Current Account will always be = to the surplus on the Capital Account and vice versa.

Another way of stating this truism is:

The Balance of Payments will always balance

Or 

The Net Exports of a country are always = its Net Capital Outflow

In my post Why are the Net Exports of a Country = its Net Capital Outflow?, I explained this inevitability using the same underlying logic. Let’s connect the dots...i mean the posts....here.

In Why are the Net Exports of a Country = its Net Capital Outflow?, I explained how when India exports goods, we get paid in foreign currency and end up holding foreign assets - foreign currency assets. Whether we simply hold this foreign currency, or we use it to buy foreign stock, bonds or any other assets - we are making an investment abroad i.e. capital is flowing out of India to the ROW (capital outflow). So, net exports imply a net capital outflow from the country. 

A net capital outflow means that the Capital Account is in deficit (you’re investing more abroad than what foreigners are investing in India). So when the country has positive net exports (i.e. when the Current Account is in Surplus), the Capital Account is always in Deficit (there’s a net capital outflow). That’s what I’ve discussed and illustrated in the current post as well. 

Signing off.

Why are the Net Exports of a Country = its Net Capital Outflow?

The Trade Balance of a country is = its Net Export (Export - Import) of goods and services. It’s taught in school and colleges that net exports of a country are necessarily = its net international capital outflow. In this post, I will explain the logic behind this statement, hopefully in a way that henceforth, this statement will appear to be truism. (Which it is, but it usually never feels like that, since it’s often misunderstood or poorly explained). 

This equality is derived from the National Income Identity, Y = C + I + G + NX

In an open economy (which trades with other nations), 

Y = C + I + G + NX                  - (1) 

Where C = Consumption, I = Investment, G = Government spending and NX = Net exports i.e. Exports - Imports. 

This is the National Income Identity that always holds true. 

Re-arranging (1) we get:

Y - C - G - I = NX 

Where Y - C - G = S (National Saving) 

So, S - I = NX                           - (2)

i.e. Saving in the economy less investment in the economy = Net Exports of the economy.

Now, if Saving is > Investment, then capital (the excess saving) will flow out of the country. Similarly, if Investment > Saving, this means capital has flown into the country. (How else would investment be > saving?)

So, S - I = Net International Capital outflow                     - (3)

Substituting (3) in (2) gives us:

Net Exports = Net Capital Outflow 

Great. But what does it mean?

Per the National Income Identity, we now know that Net Exports = Net Capital Outflow. Buy why? What is the logic behind this statement? Let me explain with an example.

Let’s suppose that TCS (Indian technology company) sells IT services to a client in the US. It gets paid 10,000 USD for its services. I will now explain how no matter what happens with these 10,000 US dollars, net exports for India will always be = net capital outflow. 

1. TCS invests the 10,000 USD in the American stock market.

When TCS invests the 10,000 USD it has received for its exports into the American stock market, it is investing in an American financial asset - the stock of an American company. Capital is flowing out of India into the US. Hence, India’s net exports are = its net capital outflow. 

2. TCS just holds on to the 10,000 USD i.e. hoards it. 

When TCS holds on to the 10,000 USD, it is in essence made an investment in American currency. It is holding USD - an American financial asset. This still amounts to a capital outflow from India (into America). So, net exports for India are again = its net capital outflow.

3. TCS uses the 10,000 USD to pay its employees in the US. 

When TCS uses the 10,000 USD to pay the salaries of its employees in the US, it is importing services from the US. The 10,000 USD it received for its exports are spent in paying for imports, so net export = 0. The capital outflow that happened when TCS exported its IT services and was paid USD 10,000 is also reversed because when TCS pays its US employees 10,000 USD as compensation, it liquidates its investment in USD. Hence, net capital outflow from India = 10,000 USD - 10,000 USD = 0. Net exports are again = net capital outflow = 0. 

4. What if TCS was paid for its exports in Rupees instead of USD?

If TCS was paid by its US client in Rupees (INR) instead of USD, it would receive ~ Rs. 6,60,000 (we assume exchange rate of Rs 66/USD) for its export of IT services. Does the identity still hold? Yes. 

When the client pays TCS in INR, it means that the US had an investment in Indian currency (i.e. there was a capital inflow into India), which has now been liquidated in order to pay for US imports. This means the capital inflow into India has fallen by Rs. 6,60,000 or alternatively, there’s been a capital outflow from India worth Rs. 6,60,000. Net exports are again = Net capital outflow = Rs, 6,60,000 (or 10,000 USD). 

5. What if TCS decides to exchange its USD for INR after it is paid in USD? 

Lets suppose after TCS gets 10,000 USD from its US client in return for its services, TCS decides it wants INR instead. So the company goes to a bank and exchanges its 10,000 USD for 6,60,000 INR. What happens now? Nothing different really. Instead of TCS holding the USD, an Indian bank is now holding USD. India has still made an investment in USD. Capital has still flow out of India. Net export is still = net capital outflow. 

Bottom-line: Whatever scenario one chooses to look at, Net Exports are always = Net Capital Outflow.