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Balance of Payments and Exchange Rates: Question 6

Syllabus 6.3

Multiple choice AS 1 mark

A country has been running a current account deficit for several consecutive years. To keep financing this gap, it has had to attract funds from abroad, for example by selling government bonds to foreign investors, and by drawing on its official reserves of foreign currency.

Which of the following is most likely to be a consequence of this persistent current account deficit?

Choose an answer to check it, then compare with the worked solution below.
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Worked solution

Step 1: Recall how a persistent current account deficit must be financed

A current account deficit means more currency is flowing out of a country (to pay for imports, primary income and secondary income outflows) than is flowing in. This gap does not disappear on its own; it must be financed, typically by attracting inflows of foreign funds (for example, foreign investors buying government bonds or other domestic assets) or by the central bank drawing down its official reserves of foreign currency.

Step 2: Check option C

Since the deficit has to be financed from abroad, a persistent deficit is likely to lead to growing external debt (as more is borrowed from foreign lenders and investors over time) and/or a run-down of official reserves (as the central bank uses up its stock of foreign currency to help cover the gap). This is exactly what option C describes.

Step 3: Rule out options A, B and D

  • Option A: financing a deficit by drawing on reserves depletes them; it does not build them up.
  • Option B: financing a deficit generally requires borrowing more from abroad, raising external debt rather than reducing it.
  • Option D: net primary income is a distinct component of the current account (profits, interest, dividends and compensation of employees); running an overall deficit does not automatically raise it.

Final answer

Option C. A persistent current account deficit has to be financed from abroad, so it is most likely to lead to growing external debt and/or a run-down of official reserves; A, B and D all describe the opposite of what actually tends to happen.