Current Account Deficit, Global Imbalance, and Policy

Implications

Late developing countries in Southeast Asia, including

Cambodia, Laos and Vietnam have been trapped in persistent

current account deficits for Quiet a few years. The largest

deficit for Vietnam appeared in the year of 2008, the year of

a global financial crisis, with its merchandised trade

deficits reaches 20 billion USD. The deficit for Laos ranges

from 10% to 20% of GDP since1980. Cambodia’s current account

deficit moves around 1 to 2 billion USD in the last decade,

with the highest appeared in 2008. This essay claims that the

causes of persistent current account deficit are caused by

structural weakness, competition for foreign direct investment

and import substitution policy. It indicates that the global

imbalance is cause by globalization and different macro

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economical policies of every country. It analyzes the

circumstances in which devaluation and liberalization would

not be effective to cure the deficit, and suggests that

focusing on long term strategy for improving competitiveness

is more crucial that pursuing rapid policy change.

I. The Causes of Persistent Current Account Deficits in

Southeast Asian Late Developing Countries

Generally speaking, there are four sets of factors causing

current account deficit, namely excess of imports over

exports, excess of investment over savings, low savings rather

than high investment, and intertemporal trade (Ghosh &

Ramakrishnan, 2012). These causes of current account deficit

are generalized from a broad view of global economy, however,

there are similarities and differences for the causes of

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deficits in late developing countries in Southeast Asia, i.e.

Vietnam, Laos and Cambodia. The causes of current account

deficits in these countries can be summarized as structural

weakness, competition for foreign direct investment and import

substitution policy.

1. Structural Weakness

The Common problem of these countries is that they all have

a structure problem in their export sector, which is

undiversified. These countries either rely on limited numbers

of manufacture sector or concentrated mainly on primary

products. The structural weakness in these countries is the

main cause of current account deficits, either because it is

vulnerable to external shocks or unsustainable in the long

run. Both Cambodia and Vietnam have limited sources for

export, while Laos depends too much on primary products.

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Cambodia’s biggest industry is the garment manufacturing

sector which is also the main source of trade revenue for the

country. The garment industry in Cambodia has been expanding

rapidly and as a result textiles account for more than 70% of

total exports in 2004 (Hatsukano 2010: p. 39), and expands to

over 80% in 2013 (Styllis, 2014). However, the growth in

exports could be dampened by the disruptions to garment

production while domestic demand will ensure a growth in

imports because the rest of the industry cannot meet the need

of its daily consumption.

About 40% of Vietnam’s export still concentrated on crude

oil, agriculture (including rice), and garment and foot-wear

manufactures, although the diversification of exports had been

improved over the last decade (Vietnam Trade Promotion Agency,

2011). The inelasticity of most of the export products of

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Vietnam would make it subject to price volatility. Price

changes in these products would not likely to contribute to

growth of export revenue while cost of imports may rise.

Laos' main exports products are minerals, electricity

(hydroelectricity based on water resources) and wood. The

natural resources based export accounts for three quarters of

its export revenue (World Band Lao PDR Country Office, 2011).

As one of the most resource rich countries in Asia, Laos can

mine and export primary products to gain revenue, which do not

need too much sophisticated technology and capital. However,

in the long term, this pattern of development will present

constraints to growth and undermine its ability to cure

deficits because there is one day that the mineral resources

will be exhausted and water resources depends too much on

climate. Moreover, it also has disputes with its neighboring

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countries for exploiting water resources of Mekong River.

In addition, lack of trading partners is also counted as a

structural weakness causing persistent deficits. This is

especially the case of Laos and Cambodia. As a landlocked

state, Laos has only a handful of trading partners such as

Thailand, China and Vietnam. Cambodia export mainly depends on

the European Union and the United States, with more than 60%

of the export flow to the two markets. Depending on limited

destinations of export deprives Cambodia and Laos of the

flexibility of trade strategy and makes their export

performance vulnerable to the decline of the demand by these

countries.

2. Competition for Foreign Direct Investment

Competition for foreign direct investment (FDI) is an

important cause for current account deficit in Southeast Asian

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Countries. A country with a low level of national saving

against a high level of investment tends to have current

account deficit because of a large capital inflows from

abroad. Since Cambodia, Laos and Vietnam had adopted an open

economic policy in late 1980s, they have experience a rapid

growth in foreign direct investment. For example, Cambodia had

achieved a 12-fold increase in FDI from 2004 to 2007; Laos FDI

in percentage to GDP had increased from 1% to 8% during the

period between 2005 and 2007; the FDI in percentage to GDP has

maintained at the range of 6% to 9% for Vietnam (The Global

Economy, 2014). However, foreign capital inflows and foreign

debt may become complementary. In order to attract foreign

investment, a country might have to develop appropriate

infrastructure (roads, ports, power plants, etc.) which

require external borrowing. If the debt is larger than the

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invested, the country will have to earn surplus in current

account to equal the debit amount. Where this is not feasible,

the country would run current account deficits (Lim, 2009).

3. Import Substitution Policy

Persistent current account deficits were also generated by

import substitution policy. A country implementing import

substitution policy is aiming at replacing import with

domestic production in order to achieve industrialization, but

often resulting to the rise of domestic prices and fall of

export competitiveness. If factories in poor developing

countries, e.g. Cambodia, Laos, and Vietnam, are to produce

goods, they need to import machine. After the machines are in

place, factories again need to import intermediate inputs that

could not be produced domestically. Import substitution policy

would lead to the rise of the prices of machines and

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intermediate inputs as their demand go up. The more these

countries want to produce, the larger import they need. In

this situation, the cost of producing goods in these countries

will rise with the growth of the economy. Consequently,

countries with import substitution would gradually find out

that they are unable to export enough to buy the imports they

need (Oatley, 2008: p. 141).

II. Global Imbalance

In recent years, IMF has consistently released reports

pointing out that we are experiencing the global imbalances.

It considers that the global imbalances are the fault of China

and other emerging economies. However, it is irrational to

blame every single country for the global imbalances. To some

extent, it is not the fault of China. Originally, we should

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explore the deep reasons of global imbalance and eventually

find who should be blamed.

1. The definition of global imbalances.

Global imbalance is actually global current account

imbalance. The current account is the inflows and outflows of

capital in a country. More precisely, it means exports and

imports. If the inflows and outflows in a country couldn’t be

cancelled by each other to zero value, then there would be a

global imbalance, i.e. trade surplus or trade deficit.

The national saving is equal to the GDP minus the household

and government consumption. If the country’s output is not all

consumed by the household and government, then what is saved

would be used for the investment and exports. So, basically,

saving minus investment should be equal to exports minus

imports. If there is a current account surplus, it also means

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that the saving is too high and the investment is too low, and

vice versa.

So when we are analysing the global imbalance, we should

focus on these four elements: saving, investment, exports and

imports.

2. The performance of global imbalance.

The dominant expression is that the United States and other

developed countries have run long term current account

deficits. On the other hand, the corresponding surpluses has

happened in the rest countries of the world, especially Asia,

Mid-East countries and Russia (Charles＆Donghyun 2009).

There are some significant features about the performance

of global imbalance. Firstly, before the 1997 crisis, the

United States had run a small current account deficit. After

1997 and 1998, this current account deficits began to enlarge

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with their imports grew rapidly. In the year of 2006, the

United States current account deficit peaked at the point of

1.5% of the world GDP, which is by far the largest current

account deficit percentage in the world (Gang, n.d.).

Secondly, the total increase of the U.S. current account

deficits is to some extent equal to the increase of the

current account surpluses in other countries, such as

developing Asia, Mid-East countries and Russia. It is

obviously that the global imbalances occurred mainly in small

countries. Thirdly, the whole region of developing Asia was in

the current account deficits before 1997 and only began to

indicate the current account surpluses after the 1997 crisis,

which illustrates that the current account surpluses were a

brand new phenomenon rather than a serial one.

3. The reason of global imbalance.

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Basically, the global imbalance is the results of

globalisation which brings the imbalance of economical

structures. Besides, it is also because every nation

implements different macro economical policies.

Essentially, it is the monetary globalisation, i.e, the

global opening market allowing the capital flows from

countries to countries.

Besides, some small and developing countries have huge

amount of banking saving, in particular the developing Asia.

This leads to a phenomenon called the Saving Glut.

In regard to the Saving Glut, there could be some reasons

to explain it. First, after the 1997 crisis, Asian countries

realised that they could not trust the international financial

institutions led by the United States any more. They began to

increase their exchange reserves in case of the future’s

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financial crisis. Second, the low level of social security of

some Asian countries is also a crucial element. The majority

of people in these countries prefer to save their money in

banks to secure their normal life. Third, in some developed

countries such as Germany and Japan, the ageing issue is

becoming more significant. In order to enjoy a good later

life, people also save a huge amount of money in banks leading

to the saving glut as well. The reasons above, I reckon, could

be summarised as the high saving rates low investment rates in

these countries.

4. China is not the main reason for the global imbalance.

When talking about the United States current account

deficits, the Americans always blame China. There is indeed a

trade deficit in United States with China. Because of the

merchandise trade deficits in United States with China, U.S.

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often has a current account deficit. The Americans consider

that China has an unfair trade with the United States, because

China exports much more than imports. There are some counter –

arguments for this phenomenon.

First, the United States trade deficits above are in term

of merchandise trade. The current account includes both

visibles and invisibles. Although the United States have a

high level trade deficit, it is only in term of those

visibles. If we take the invisibles into account, we could

conclude that the United States trade has been surplus. The

United States exported a great amount of financial and

insurance services to other countries. If we take both the

goods trade and service trade into consideration at the same

time, the United States is still in a position of surplus in

the global trade.

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There has been a huge trade surplus of private services in

United States with China. Since 2004 the United States have

expanded the surpluses of private services trade with China.

The United States private service exports to China have surged

from 5.7 billion dollars in 2003 to 20.1 billion dollars in

2010. However, the United States imports of private services

from China have peaked at 10.6 billion dollars in the year of

2007, and then fell to 8.3 billion dollars in 2009. Although

the tendency was still rising, the United States imports

relatively little private services from China. Besides, the

United States private services surpluses with China has surged

from 1.9 billion dollars in 2003 to 10.4 billion dollars in

2010 (David＆Fenwick, n.d.). Second, China do not only export

so much, it also import a lot. The contributions to China’s

rapid GDP growth include both exports and imports. In past

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years, China’s trade was almost balanced. In 2004, for

instant, China’s surpluses took account for only 2 per cent of

GDP. The Americans only see the trade imbalance between U.S.

and China, they do not realise that China actually have a

trade deficits with the neighbouring Asian countries. China

imported a lot from the developing Asia. Asia is emerging a

new phenomenon called “Made in Asia”. It is actually a

production - supply chain, with China as a centre of assembly

and manufacturing. Many productions labeled “Made in China”

are actually “Made in Asia”. Asian countries export semi -

finished product to China. These products then are reprocessed

and manufactured by the cheap labor forces in China. In fact,

China could generate only 10 - 20 per cent of the total

benefits (Gang, n.d.).

Third, the global imbalance is often accounted the outcome

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of Chinese over—saving and American overspending. There is the

case that the United States spends a lot.

However, there would be no case for the Chinese over—

saving. National saving includes household, business and

government saving. First of all, in terms of household saving,

the saving rate of Chinese people is actually very low. Both

rural and urban Chinese people could not save much money at

all (Mike 2013).

As for business and government savings, they saved indeed a

lot. However, they also invested a lot as well. China is now

encouraging consumption, so there emerges a great amount of

constructions. Recently, China’s leaders visit other countries

frequently. In every visit, Chinese government will purchase a

huge amount of foreign products and technology. The entire

country invests 40 per cent of its GDP in industrial

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capacities, housing and public infrastructure (Gang, n.d.).

Besides, in terms of global balance of payments, it refers

to the foreign assets savings in a country which is precisely

the net national savings. Nevertheless, China did not have a

salient net national savings. It only accounted for 30 billion

dollars per annum. However, the United States current account

deficits are over 600 billion dollars per annum (Gang, n.d.).

It is irrational to blame China as the main culprit for global

imbalances.

5. The United States is the reason of global imbalance.

In terms of American’s overspending, it is very important

to focus on four significant periods: 1951- 1980, 1981- 1992,

1993 – 2000 and 2001 – 2004. In these four periods, the

proportion of household, business and government saving

indicated a salient change. American’s household saving was

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becoming much less. Since the United States government carried

out a deficit fiscal policy and loose monetary policy, the

government saving is becoming extremely less.

In the 1990s, because of the wealth effect led by stock

price, the majority of American people invested a lot in the

stock market. In 2001, the stock market bubbles collapsed.

Then the real estate market emerged, which developed rapidly.

The Americans then further expanded their saving to pursue the

benefits generated by real estate. Furthermore, owing to the

rise of labour productivity and the financial innovation, the

average saving rate of Americans is relatively low.

Since Americans over consumed and the spending is much more

than saving, it stimulates the huge amounts of imports. The

oil import is one of the examples. The United States need a

great deal of oil import from the mid—east countries. Due to

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the high price of oil, the mid—east countries has been a trade

surplus with U.S. and obtained a huge windfall.

From 1950s, the United States began to update the industry

system. The manufacturing industry was moved to Asia. Because

of the low cost of labour and the huge amount of raw

materials, most of Asian countries manufacture lots of

products. The excess products which are not consumed in the

country are exported to the states, where the demand for these

products is extremely huge, in particular the United States.

To sum up, because of the globalisation and the different

strategies in every country, there could be a global

imbalance. It is irrational to blame every single country for

this imbalance. However, the United States should take

measures to change the over saving situation. Mid—East

countries should fix the oil price based on the market. The

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developing countries should improve the level of social

security and encourage consumption. Changing the global

imbalance needs all countries’ effort.

III. The Limitation of Devaluation and Liberalization on

Curing Current Account Deficits

According to the IMF a country with a persistent and large

current account deficit should devalue and liberalize.

Theoretically speaking, devaluation of a country’s currency

will achieve a fall in the foreign price of its exports,

making its goods and services more competitive and therefore

there will be an increase of export. Similarly, devaluation

will reduce the demand of import by increasing the prices of

imports. Current account deficit would be improved by both

ways. It also suggests that trade policies do not affect the

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trade balance because they do not alter national saving or

domestic investment. So removal of trade barriers will help

each economy to specialize in areas where it has comparative

advantage and balance of payment will be balanced over time.

However, this essay suggests that they should not be

implemented indiscriminately because there are limitations on

these set of tools.

1. Limitations on Devaluation

Devaluation may has an effect on the improvement of current

account deficit, however, its implementation implies a

political-economic risk that the reputation of the country

will be damaged and future trading relations will be damaged.

Even if the country has decided to devalue its currency

regardless of the risk, there are some technical constraints

on the effect of devaluation. Elasticity of demand, inflation

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and external demand are three factors that should be

considered if devaluation is implemented to improve current

account deficit.

If a country export mainly inelastic goods, devaluation

will not improve current account deficits. Inelastic goods are

products where demand changes slightly with the changes in

price. These kind of goods are those consumers need in their

daily life, e.g. agricultural products and clothing. The

exports of industrialized countries are mostly manufactured

products with high elasticity. Generally speaking, devaluation

would therefore have a positive effect on the balance of

current account. However, the exports of developing countries,

especially late developing countries, are relatively inelastic

products. Vietnam mainly exports crude oil and agricultural

products; Laos’ minerals are the lion’s share of its export

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products; and Cambodia mainly rely on garment industry to earn

trade revenue. A large portion of their exports are inelastic

good. Therefore, devaluation of their currencies would not

improve their current account deficits.

Domestic inflation can dampen the effect of devaluation on

the improvement of current account deficit if the inflation

rate is larger than the exchange rate devalued. It will

stipulate import spending because the increase of import price

caused by devaluation cannot offset the decrease of real value

of imported goods caused by inflation. Even if a country wants

to pursuit a large scale devaluation to offset the effect of

inflation, it may not work because devaluation per se would

probable cause inflation. In the first place, devaluation will

make import more expensive. In a country where a large part of

CPI goods are imported and the demand is inelastic, the

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increase in the prices of imported goods will be passed on to

consumers. This is especially true in the three late

developing countries since a large part of their CPI products

are imported from industrialized countries. In addition, if

devaluation make export easier, domestics firm would have less

incentive to control their cost. At the end of the day,

inflation will be triggered by high cost in production.

External Market is also a determinant for devaluation to

take effect. Other things being equal, an external market with

a high demand will increase import from a devaluing country,

while an external market with a lower demand will not

necessarily increase its import. In the global recession in

2008 for example, Vietnam did not improve its current account

deficit by devaluation of Vietnamese Dong, because its export

partners could not buy its products even though they were

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cheaper than before. External market factor has a special

implication for Cambodia and Laos, because they have only a

few export partners. Thus the reliance on their partners is

more profound.

2. Limitations on Liberalization

According to comparative advantage theory, countries will

specialize in areas where they have comparative advantage in a

free trade environment. However, due to the difference in the

stages of development, many developing countries will suffer

from free trade if a rapid liberalization is implemented.

Liberalization will enlarge the gap between developed and

developing countries. Many developing countries, including the

three late developing countries shown above, have comparative

advantage in producing primary products because of the lack of

technology and skilled workers. Depending on primary products

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for export will make the current account vulnerable because of

the volatility of their prices and inelasticity of their

supply and demand. Moreover, under a free trade environment,

they have incentives to concentrate their efforts on the

primary sector and do not have incentives to promoted

education and technological advancement. Thus the economic

status of developing countries, as well as their ability to

correct the existing current account deficits, would not

improve.

Liberalization will hinder the diversification of economies

in developing countries. To diversify the economy, a country

would have to establish new industries. However, the newly

established industry is not likely to win in the competition

with its foreign counterparts in developed countries. In

addition, most economies have experienced a period of

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protectionism at the beginning. So it is argued that

developing countries can place some degree of protection

measures in the first place, and remove the measure after it

has achieved an economy of scale (Miller, 2008: p. 117).

IV. Policy Implication for Late Developing Countries

The persistent current account deficits in late developing

countries are caused by the structure weakness of their

economies, as well as some policies employed during the

development of economy. This essay holds that the fundamental

cause of the problem is the lack of competitiveness in their

economies, thus short term policies, especially devaluation

should not be taken as panacea for curing current account

deficit. Long term strategies, including the increase of

government spending on education, are favorable measures to

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diversify the economy of developing countries and improve

their competitiveness. Along the way to pursue the

diversification of economy, some degree of protectionism

should be implemented until they achieve an economy of scale.

At the same time, some pragmatic measures such as

strengthening relations with their limited number of export

partners are also helpful. Besides, changing the global

imbalance needs all countries’ effort. The United States

should take measures to change the over saving situation. Mid—

East countries should fix the oil price based on the market.

The developing countries should improve the level of social

security and encourage consumption.

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