United States budget and current account deficits
Data showing the budget and current account deficits of the United States between 2005 and 2011.
Change of budget and current account deficits over time
From the table above, the budget deficit of the United States was low between 2005 and 2007 after which it skyrocketed from the year 2008. Between 2009 and 2011, the budget deficit has been extremely high. The data on the current account deficit of the United States shows that the current account deficit was higher between 2005 and 2007. From the year 2008 to 2010, the current account deficit fell consistently but rose a bit in the year 2011.
The link between budget deficit and current account deficit
Most economists agree that there is a close relationship between budget deficits and current account deficits. This relationship can be understood by looking at the following identity obtained from the national income accounting:
Y = C + S + T = C + I + G + X-M, which can be re-written as:
(X-M) = (I-S) + (G-T)
This equation referred to as the twin-deficit relationship, implies that a country’s trade deficit (the difference between exports and imports) is equal to the difference between private sector investment and private sector saving plus the government deficit or surplus (the difference between government expenditure and revenues). This relationship is based on the assumption that the difference between the private sector investment and saving is constant over time, so that any change (whether positive or negative) in the magnitude of the budget deficit is translated into an increase (decrease) in the trade deficit.
The policy implication from this hypothesis is that a government can reduce the trade deficit by reducing its budget deficit. Many economic experts argue that a reduction in the budget deficit is both a necessary and sufficient condition for an improvement in the trade deficit (Hossain & Chowdhury, 1998). The twin-deficit hypothesis can be interpreted as an extreme case of the capital inflow hypothesis, which suggests that an increase in the government budget deficit leads to an inflow of capital from abroad which in turn attenuates the link between budget deficit and the interest rate.
Within the framework of the open economy Mundell-Fleming model, this implies that an increase in budget deficit increases capital flows from abroad, which makes the real exchange rate to appreciate thereby leading to a rise in current account deficit. Although the above discussion supports a direct relationship between budget deficit and current account deficit, the data on the United States’ budget and current account deficits show otherwise.
The data and chart show that when the fiscal/budget deficit is high, the current account deficit is low and vice versa. This trend is supported by the weak version of the capital inflow hypothesis which argues that an exogenous increase in private investment can lead to an appreciation of the domestic currency and consequently deterioration in the current account because the domestic goods will become more expensive hence fewer exports.
This, therefore, implies that the current account deficit can be reduced through an increase in private investment and this may not necessarily have any effect on the budget deficit. As a result, the lack of a link between budget deficit and current account deficit can be explained in terms of private investment and saving (Reinert, Rajan, Glass & Davis, 2009).
Reducing/eliminating the current account deficit
A current account deficit is caused by an excess of imports over exports. To reduce the current account deficit, the government should implement policies that increase exports and reduce imports. These policies can be classified as monetary and non-monetary policies.
Monetary policies
Deflation
Deflation means the contraction of money supply in the economy. It leads to a fall in purchase hence it will increase exports. It will also lead to a fall in incomes and so it will reduce our propensity to import. The success of deflation in correcting a current account deficit depends on the price elasticity of demand for commodities in question.
Exchange rate depreciation
Exchange rate depreciation leads to a fall in the external value of one currency relative to another currency owing to the market dynamics. It takes place by itself, that is, through the market forces. It makes domestic goods cheaper and foreign goods more expensive (Makin, 2004). However, this only works if the trading partner does not depreciate its currency. A similar measure to depreciation is the exchange rate devaluation, which unlike depreciation, is undertaken purposefully by the monetary authority rather than by the market forces of supply and demand.
The monetary authority lowers the value of the domestic currency against foreign currency deliberately through an official announcement. It can be done against the currency of one or more trading partners. Devaluation lowers the value of domestic currency thereby making domestic goods cheaper and foreign goods more expensive (Kim & Roubini, 2008). The result is an increase in exports and a decrease in imports.
Non-monetary policies
Import duties
Under this policy, the government can impose taxes on selected import commodities. Taxes raise the prices of the commodities by the amount of tax imposed. This in turn lowers the demand for the items in question hence reducing imports. The importer will sell less and therefore import less because the commodities will be moving slowly (Cavallo, 2005). However, the effectiveness of this policy depends to a large extent on the price elasticity of demand for the commodities in question.
Non-tariff barriers
Non-tariff barriers impose restrictions on the physical flow of commodities. It can work at different levels. Quotas are used to restrict the volume of certain commodities imported. Total bans are used to completely prohibit the importation of certain commodities. Voluntary export restraints (VER) in which the government persuades the trading partners to reduce (or stop) the exportation of certain commodities to the country.
Export promotion
The government can implement policies used to encourage the exportation of domestic commodities. Export-promotion policies include the establishment of export-processing zones (EPZ), manufacturing under bond schemes (MUBs), and export promoting councils (EPC).
China’s financing of U.S. twin deficits
Chinese financing of U.S. twin deficits
The U.S. twin deficits are caused by the Chinese and Japanese Central Banks that make efforts to actively depreciate their currencies by intervening in the currency market and buying large amounts of US bonds to boost exports to the U.S. and thus promote the growth of their economies (Worrall, O’Shea & Chung, 2006). These two countries can do this because both central banks, the Bank of Japan (BOJ) and the Bank of China (BOC), have enough foreign reserves (especially US dollars) to invest in foreign assets (especially US Treasury Bonds).
This surplus in foreign reserves is as a result of the large trade surpluses with their major trading partners such as the US and the European Union and the capital inflows that are mainly influenced by FDI that are caused by the comparative advantage of both countries (the cheap labor force in China and the technological know-how in Japan) (Johann, 2005, p. 13). The central bank of China finances the U.S. twin deficits by accepting relatively low-interest rates for their funding and giving the U.S. government relatively cheap money and cheap goods to encourage the consumption of their goods (Iley & Lewis, 2007, p. 3-4).
Benefits to the U.S. from large trade deficits and China’s financing of the deficit
Although China announced a shift from a fixed exchange rate regime to a flexible one in 2005, the RMB has been strictly pegged to the dollar since 2008 to encourage Chinese exports during the global recession. Despite the growing worries that the value and role of the U.S. dollar are falling, China has continued to be at the forefront in buying U.S. government assets. The dollar is presumed to constitute approximately 65 percent of the portfolio.
Between 2008 and 2010, China’s holdings of U.S. Treasuries in U.S. $ billion were: 684.1, 938.3, and 906.8 respectively (Bartholomew, 2010). The reason that China continues to buy dollars is based on the fact that China’s policy of strictly controlling the value of the RMB depends upon its holdings of U.S. treasuries. This gives China the upper hand when it comes to issues dealing with the exchange rate between the currencies of these two trading partners.
By running a large trade deficit with China financing its deficits, the United States benefits only to the extent that the interest rates in the country are low which in turn attracts foreign and local investors (Gwartney, Stroup, Sobel & MacPherson, 2008, p. 664). An increase in investment in turn promotes the economic growth of the country.
On the other hand, China also benefits significantly by financing U.S. twin deficits and from large trade deficits of the U.S. With a large trade deficit, it implies that the U.S. is a net importer of Chinese goods which increases Chinese exports and propels China’s economic growth (Bartholomew, 2010, p. 24). If the U.S. were to reduce its trade deficit, China would lose from reduced exports and lower economic growth.
China’s currency regime
China’s currency regime since 2005
For a decade, before 2005, the Chinese currency regime was a fixed nominal exchange rate regime in which the Chinese renminbi was pegged to the U.S. dollar (Calomiris, 2007). In July 2005, the Chinese monetary authorities announced a change of the currency regime from a fixed system, to a flexible exchange rate regime determined by the market forces of supply and demand. The renminbi would also be pegged to a basket of currencies rather than the U.S. dollar alone (Goldstein & Lardy, 2009). Thus, the current currency regime of China is a flexible exchange rate regime.
Advantages and disadvantages of a flexible currency regime
The shift from a single-pegged exchange regime to a peg of a basket of currencies as a reference is beneficial to China through an increase in the real stability of the RMB exchange rate. Due to the increasing economic integration of developed countries through increased trade and investment, there is a high dependence of one country on its trading partners (Ling, Zekai & Wei, 2007). As a result, the depreciation or appreciation of one currency in the basket would have an impact on other currencies in the basket.
Another advantage of a peg of a basket of currencies is that the average fluctuation of the entire basket is lower compared to the fluctuation of a single currency, for instance, the US dollar, on which the domestic currency is pegged. Taking into account the high proportion of U.S. treasuries in China’s foreign asset reserves, a basket of currencies reduces China’s reliance on the US dollar which in turn lowers the risk of international reserve asset management.
Also, a basket of currencies ensures that RMB is not undervalued or over-valued. This reduces the conflict between China and its major trading partners, such as the U.S. There has been a major conflict between the United States and China over the value of Chinese RMB, with the United States arguing that China undervalues its currency to make it’s cheaper to foreigners and foreign goods expensive to Chinese. This under-valuation of Chinese RMB is seen as the main cause of China’s large trade surplus and America’s large trade deficit.
Besides the peg of a basket of currencies, China also announced the shift to a freely floating currency regime. The major advantage of a freely floating exchange rate regime is that the monetary independence associated with the regime can reduce the impact of external shocks (Argy & Grauwe, 1990). The disadvantages of floating exchange rate regimes include: first, a flexible exchange rate regime has the risk of exchange rate volatility (Anderton, 2000).
Elimination of exchange rate risk is beneficial to international investors and trade and thereby it promotes economic growth. Exchange rate risk causes firms to adopt a wait-and-see strategy with regards to non-reversible investment, which delays investment decisions. Second, a floating exchange rate regime makes it impossible for countries to import a favorable monetary policy from its trading partners as is the case with a fixed exchange rate regime about a currency with a desirable track record of inflation and growth (Walden & Thoms, 2007).
Reference List
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