[QUOTE=“GlobalMacro;662770”]Good replies pipnroll and Peterma.
Here’s my contribution.
The current account consists of the balance of trade, net income from foreign investments, and current transfers (which would include foreign aid or other one off transfers of money). If these add up to an inflow of money into the country, then we have a current account surplus, if it indicates an outflow then we have a current account deficit.
The most important concept when dealing with current account analysis is to realize that you can not apply a single metric to all countries. What is considered a healthy current account for developed nations is much different that what is healthy for emerging market nations as their economies are structurally different.
Generally, developed countries tend to run current account deficits as these typically import more goods then they export (it’s cheaper to import goods from developing countries then it is to produce it in a developed country). During good economic times, the current account deficit for developed countries tends to increase as the domestic demand for more goods increase, and thus the country imports more. During recessions, the current account deficits of developed country typically decrease as domestic demand for imported goods fall due to consumers saving more and spending less.
Thus the current account during normal conditions is typically not the cause of market moves but rather a reflection of the current market dynamics. Lets take Australia as an example. Australia’s biggest export is iron ore, and during periods of time when iron ore prices are going up, the Australia dollar also tends to follow, as higher iron ore prices means more export profits. The current account will adjust positively as a result, but it did not cause the market move, it was merely a reaction to the move and therefore isn’t a tradable justification.
Another current example is the US current account deficit shrinking on the back of reduced energy imports. As oil production from the US increases due to the fracking boom, energy imports have been dramatically reduced, which has a significant affect on the trade balance and the current account. In this case, traders would be well aware that the current account would be affected positively BEFORE the effects actually hit the current account and would be making trades based on the developments in the energy market rather then waiting for the slow moving current account to change. Therefore the moves in the current account would be confirmation rather then a cause for a trade entry. Most of the time, the current account is indicative rather then causative.
However, there ARE times when the current account is causative of big moves in the currency market. To figure out when these events will occur, you have to understand that to cover a current account deficit, the country must borrow money from foreign sources. The credit worthiness of the deficit country and the confidence that creditors have in that country’s ability to pay of the debt determines to a large degree how easy it will be for the deficit country to finance a deficit.
As long as global credit markets are extremely liquid, and the deficit country is stable with solid economic numbers, a country can maintain a large current account deficit (4% of GDP or higher) for quite some time. In order to justify shorting the currency based on the current account deficits, one of two things need to occur. The first possible trigger would be global credit markets tightening dramatically. This happened last year when the feds scared the market with faster then expected tapering rhetoric, and will undoubtedly happen again as the feds begin raising rates possibly next year. Without access to easy financing, current account deficit countries can’t find creditors and are forced to reduce their deficit. In this scenario, nearly all current account deficit country’s are affected, with emerging market nations hit the hardest. If a country can’t finance its deficit because the financial conditions are too tight, it’s deficit will be forcefully reduced.
The second possible trigger would be a localized stress placed on a specific deficit country that jeopardizes creditors’ outlook of the risk premium they incur for financing that country. Possible stresses could be a severe natural disaster, political instability, or prospects for a recession. Turkey was a great example of this last year with the Lira collapsing dramatically as its deficit made it vulnerable to political instability. If a country can’t finance its deficit because it can’t find willing creditors, its deficit will have to be reduced.
In both instances, the reduction in the deficit is both a forceful and painful event. The hallmark moment of such an event is a sharp devaluation of the deficit country’s currency. The currency devaluation serves two purposes. The first is that it drastically reduces the value of its existing debts, as these are in terms of its own currency. The second, is that it makes imports more expensive and makes exports cheaper, thus reducing the future deficit as import demand diminishes due to costs.
So a current account deficit isn’t a problem, until it is. Being cognizant of which countries have large deficits allow you to anticipate LARGE and violent moves in their exchange rates when one of the two triggers described above are met. It’s like a car driving down the road filled with explosives. It could keep driving for hundreds of miles, but if it gets a flat tire and goes off the road, its going to explode with a huge fireball, whereas another car (a country with a current account surplus) could safely navigate to the shoulder and stop.
Pipnroll, a current account deficit does not have to mean low foreign reserves, although that will exasperate the situation.[/QUOTE]
Bloomberg posts an interesting article regarding the UK’s current account deficit a day after my post.
I hope this thread will continue on…