AS Level Economics 9708: Current Account Deficit as a Percentage of GDP

Meridia has run a current account deficit for the past three years. Last year, Meridia's current account balance was a deficit of $27 billion, while its nominal GDP was $450 billion.

(a) Calculate Meridia's current account deficit as a percentage of its GDP. [2]

(b) Many economists regard a current account deficit exceeding 5% of GDP as a warning sign that it may not be sustainable in the long run. State whether Meridia's deficit is above or below this threshold, showing your reasoning. [2]

(c) Explain one likely consequence of Meridia's persistent current account deficit for its external debt or official reserves. [2]

(d) Explain one likely consequence of Meridia's persistent current account deficit for its exchange rate. [2]

Part (a): Deficit as a percentage of GDP

Expressing the deficit relative to the size of the economy: $\frac{27}{450}\times100 = 6$

So Meridia’s current account deficit is 6% of GDP.

Part (b): Comparing against the 5% threshold

Meridia’s deficit, at 6% of GDP, is above the 5% threshold many economists use as a rough guide to when a current account deficit becomes a cause for concern, since $6>5$ . This suggests Meridia’s deficit is large enough, relative to the size of its economy, to be viewed as a potential warning sign of unsustainability rather than a minor imbalance.

Part (c): Consequence for external debt or reserves

A deficit of this size cannot simply be left unfinanced: currency flowing out to pay for imports, primary income and secondary income outflows must be matched by an equivalent inflow. Meridia is likely to have to attract this inflow by borrowing more from abroad (for example, foreign investors buying more Meridian government debt), which raises Meridia’s external debt, and/or by allowing its central bank to run down its official reserves of foreign currency to help bridge the gap. The longer the deficit persists, the more these effects build up.

Part (d): Consequence for the exchange rate

A persistent deficit means more of Meridia’s currency is, in net terms, being sold to buy foreign currency (to pay for imports and other outflows) than foreign currency is being sold to buy Meridia’s currency. Other things equal, this tends to increase the supply of Meridia’s currency relative to demand for it on the foreign exchange market, creating downward (depreciating) pressure on its value. To help offset this and keep attracting the capital inflows needed to finance the deficit, Meridia’s authorities may feel pressure to keep domestic interest rates relatively high.

Final answers

(a) Deficit as % of GDP $=$ 6%
(b) Above the 5% threshold ( $6>5$ )
(c) Growing external debt and/or a run-down of official reserves, as the deficit must be financed from abroad
(d) Tendency toward depreciation, and possible pressure to keep interest rates relatively high to attract capital inflows