There has been a lively debate on current account (CA) imbalances around the world. Georgia is not an exception with its politicians and economists often complaining about Georgia’s current account deficits (see Figure 1) and discussing potential ways of reducing or even eliminating them without actually reasoning why one should do so. It seems that these people a priori assume that current account deficits are bad. But are CA deficits always bad? The answer will depend on a country’s specific circumstances and the reasons that give rise to them.
Let us recall what the CA deficit actually measures. The most widespread way in which CA deficits are interpreted by economists, politicians, and journalists alike is that they measure the difference between the value of total exports and total imports of goods and services. In this sense, the CA deficits would reflect that a country imports more goods and services from the rest of the world than it exports. (In addition to the trade balance, the CA also includes net interest income and transfers from abroad, but we will restrict our attention to net exports.)
The national income identity approach provides another definition of the CA that yields other economic insights. The national income identity decomposes the economic output of a country into its components consumption, investment, government expenditure, and net exports. After further decomposition and making additional assumptions, the CA balance can be written as the difference between national savings and domestic private investments. In this sense, the deficits measure the difference between domestic savings (private plus public) and domestic investments. Thus, a negative CA balance would indicate that national savings remain below domestic investments. From this view follow ambiguous implications for the desirability of trade deficits. It says that CA deficits may actually be good if caused by profitable investment opportunities within a country. High levels of domestic investments (relative to domestic savings) foster further economic growth and development. Such circumstances are typical for developing countries that abound with attractive investment opportunities and where, consequently, returns to capital are high. And since at a low stage of economic development national savings are low, these opportunities are usually financed by foreign investments leading to higher CA deficits.
An example can illustrate this argument. Suppose that there is a profitable investment opportunity - some project that requires building a factory, installing machinery, etc. - that cannot be realized with domestic capital due to low levels of domestic savings. In that case, a foreign investor could carry out this project, resulting in an increase in aggregate investments in the country. Yet since implementing the project requires importing building materials, machinery, and other inventories, the imports also increase. Though pushing the economy forward, leads to a CA balance deterioration.
AN INTRICATE PROBLEM
Whether CA balance deficits indicate economic strengths or economic weaknesses of a country is indeed a question that is not easily answerable. Low domestic savings that cause foreign investors to help out are partly caused by the taxes on domestic income. The money taken away from the people may flow into unproductive expenditures of the government, or public expenses may be spent in the most productive way possible. In the first case, low national savings and thus CA deficits would be related to detrimental economic circumstances, in the second case, they would be beneficial.
Similarly, investment opportunities in a country can be bubble-type asset booms or they can be solid business opportunities in the real economy. In the first case, the resulting CA deficits would be problematic, in the latter one would not have to worry. In line with the common negative view on CA deficits mentioned in the beginning, they may also reflect the lack of competitiveness of domestically produced goods, caused by an overvaluation of the currency, low productivity, or high production costs, to name just a few possibilities. If this would be their main cause, they would indeed be alarming.
Economic theory suggests that CA deficits are not the problem per se and hence, need not be worried about unless they are due to bad reasons. If indeed bad reasons give rise to the deficits then fixing them and consequently reducing the deficits would be the first best solution.
THE CASE OF GEORGIA
The major factor that guided the observed CA deficit dynamics over the recent years seems to be aggregate investment behavior. Since the Rose Revolution, the prospects of Georgia’s economic growth have always been quite promising, with the new government strongly attempting to make the country’s business environment as attractive as possible. All these policy measures together with low initial capital stock and hence, high returns to capital, created a lot of investment opportunities in the country. Yet since there were not enough national savings for these investment projects to be financed domestically, foreign capital started to flow in, resulting in CA balance deteriorations. At the same time, the government undertook quite a lot of public investment projects mainly directed towards either improving already existing infrastructure or building a new one. Despite further reducing national savings, these public investments have been essential for future economic growth and development. Thus, one can fairly argue that deteriorations in CA balance were actually rooted in positive economic fundamentals.
In 2008-2009 the trend of deteriorating CA balance sharply reversed largely due to the dual shocks – the armed conflict with Russia and the global financial crisis. Clearly, the major channel through which these two shocks affected the CA balance was a significant reduction in both domestic and foreign private investments (see Figure 2). We would have probably observed an even larger reversal in CA if after these crises Georgia would not have received substantial aid from the United States and other countries. After 2009, investments seem again to have determined the general pattern of CA deficits behavior, mainly guided by Georgia’s growth prospects and high risk-adjusted rates of return.
Clearly, there are some bad reasons contributing to Georgia’s CA deficit as well. These include the lack of competitiveness of domestically produced goods and services on international markets. The first National Competitiveness Report for Georgia, released in early June by the ISET Policy Institute, finds that Georgia has significant potentials for increasing its exports that seem to not have been fully utilized yet. The report also argues that low levels of private savings and a possibly bubble-driven demand on residential housings are perilous. While eliminating the bad reasons should definitely be one of the main objectives of the government, it seems that Georgia’s CA deficit is largely a reflection of good economic fundamentals – in particular Georgia’s future growth prospects and its ability to attract foreign capital. At the early stages of transition, these are important factors for economic growth.
One line of criticism of the large and persistent CA deficits focuses on long-run sustainability issues, ignoring the reasons for the deficits. It is true that a country running a CA deficit effectively borrows from the rest of the world, accumulating foreign debt that needs to be paid back in the future.
There are several practical criteria for assessing current account sustainability. The most common criterion is that CA deficits are sustainable as long as foreign creditors (investors) are willing to lend to the country and the country in turn is willing to serve its debt. If CA deficits would become so large that the repayment of the country’s foreign debt became questionable, foreign creditors would refrain from further lending. These or other reasons may cause changes in investor sentiments that result in a sudden stop of capital inflows, leading to a sharp depreciation of the domestic currency and a reversal in the current account. Such a development can be extremely painful, potentially triggering off currency and banking crises, especially in countries like Georgia where the economy is highly dollarized.
So far Georgia has managed to remain an attractive borrower in the eyes of foreign investors, with its foreign debt to GDP ratio being in a safe range. In addition, since the main source of financing Georgia’s CA deficit is foreign direct investments rather than short-term portfolio inflows (“hot money”), sustainability is less of an issue. On top of that, the amount of international reserves the National Bank of Georgia has managed to accumulate over the past decade strengthens its capacity to respond to crises.
By and large, Georgia’s CA deficit seems to be sustainable unless there are major exogenous shocks jeopardizing the country’s economic and political stability… and since these major negative events sometimes do happen, there is a rationale for the Georgian policymakers for eliminating the bad reasons for the CA deficits. This will reduce the deficit itself and foster Georgia’s economic growth through many channels.