Nomura

Surplus or Deficit: What drives the current account matters

  • Current account deficits in Indonesia and the Philippines are not necessarily a bad sign; equally, current account surpluses in Northeast Asia are not necessarily a good sign. The key is what is driving them.
  • A large current account deficit driven by a sharp fall in the gross domestic savings is often the “bad” type for longer-run growth prospects.
  • Ironically, while large current account surpluses have insulated Northeast Asia from the EM turmoil, they are generally not a positive sign in terms of long-run growth potential.

With intensified risks in emerging markets, ongoing monetary policy normalization in developed markets, US trade protectionism increasingly centered on China and financial conditions tightening, Asia’s incipient growth slowdown is at risk of accelerating.

When examining Asia countries’ current account balances hoping to figure out the medium term prospects of economies, global investors have often been very discriminatory, focusing on the current account deficit trio of India, Indonesia, and the Philippines. The truth is, current account deficits are not always bad, and nor are current account surpluses always good.

Asia’s current accounts: The devil is in the details

Current account deficits or surpluses can be either good or bad signals in the medium term; the key is what is driving them. A useful lens through which to view current account balances is the GDP accounting identity:

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

(Y=GDP or income, C=consumption, I=investment, G=government spending, X=exports and M=imports)

This identity can be rearranged as follow:

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

The difference between a country’s national income (Y) and private plus government consumption (C+G) is national savings (S) (i.e., private and government savings). So viewing the current account as exports minus imports or as the difference between gross domestic saving and investment is equivalent from an accounting perspective.

Current account = X-M = S-I

What are the good types and bad types?

From the above current account identity, we can see that a large current account deficit driven by a sharp fall in the gross domestic savings is often the ‘bad’ type for longer-run growth prospects, as it signals that the country’s foreign liabilities are being used to finance domestic consumption, with little prospect of generating future returns to repay these foreign debts.

On the other hand, a current account deficit driven by a sustained rise in domestic investment can be viewed as the ‘good’ type in the longer run, if the investments earn a high return (e.g., worthwhile public infrastructure projects or high-tech manufacturing plants).

A closer look at the countries

We would classify Turkey and India as two countries with current account deficits of the “bad” variety, and Turkey has already been severely punished by a full-blown currency crisis, see our report Damocles: Our early warning indicator of exchange rate crises for more detailed analysis. Turkey’s domestic investment-to-GDP ratio jumped to 32% this year from 28% in 2016, but it has all the hallmark signs of misallocation, including rapid credit growth, high inflation and surging property prices, along with negative growth in total factor productivity and weak gross FDI inflows.

India’s current account deficit is of the ‘bad’ type for a different reason: the excess of investment over saving is small relative to Turkey, but both the domestic investment and saving ratios have been in a secular decline since 2012, which bodes poorly for long-term potential growth. Weak investment can be partly attributed to private companies burdened by high debt in capital intensive sectors, such as power and construction, but investment in high-end real estate has also slumped due to a crackdown on speculation, which can be viewed as a positive medium-term development.

On the other hand, current account deficits in the Philippines and Indonesia are of the “good” type. The Philippines is in the midst of an investment boom that seems to have been allocated efficiently, with ample fiscal room helping to crowd-in private investment. However, to keep the economy from overheating and guard financial stability, interest rates need to be hiked by at least another 100bp.

Ironically, while large current account surpluses have insulated Northeast Asia from the EM turmoil, they are mostly “bad” types and not a positive sign in terms of long-run growth potential.

Take Korea for example, domestic saving ratios are high due to the aging populations building a nest egg for retirement and limited investment opportunities for companies. In Thailand, the massive current account surplus resulted from high household debts and prolonged political uncertainty. These economies are struggling with domestic structural headwinds, ranging from rapidly ageing populations, high sensitivity to rate hikes, to low productivity growth. They are also open economies, highly dependent on exports and, therefore, very exposed to the rising risk of an export slump, because of worsening trade protectionism, slowing growth in China and the global electronics cycle turning down.

Please read the report here for more insights into how best to interpret a country’s current account matters and the investment insights they offer.

Contributor

  • Rob Subbaraman

    Head of Emerging Markets Economics and Head of AEJ Fixed Income Research

Suggested views