Central Banks have few options to manage the currency in case of a Current Account deficit. Such a deficit is financed by a Capital Account Surplus. This can be done via higher incoming investments or lower foreign currency reserves. In case of Current Account surplus, the Central Bank will have the option to keep its currency artificial low in the eyes of the rest of the world. How does that work?

This article focuses on the impact of a deficit or surplus of the Current Account on the Capital Account and the domestic currency.

This article is a fourth in a series of five that explains the economic concepts of Current Account, Capital Account and Reserve Account and how they relate with foreign debts, public deficits and currency exchange rates. If you are interested to get an understanding of how the economy works, how money flows between nations and its impact on currency trends and the economic well-being of nations, please read on.

If you just want to know more about stock market timing signals that tell you when to buy or sell your funds, please read here more about Stock Trend Investing.

National Savings and Investments

With the Balance of Payments in mind, the Current Account Balance is also a representation of the difference between National Savings (all public and private income in a country minus all consumption) and National Investments. The surplus or deficit in this Net Income with the rest of the world is spent on or financed by foreign investment and currency reserves.

A Net Income surplus (difference between National Savings and National Investments) is available for investments in the foreign assets (more investments going out than coming in). Or a Net Income deficit (a shortage between National Savings and National Investments is financed by foreigners (more investments coming in than going out).

Financing the Current Account Deficit

A Current Account deficit can be financed by a Capital Account surplus in two different ways:

1) More investments are coming in than going out (liabilities to foreigners increase),

• Foreign investors buying the domestic debt (bonds, treasuries)
   
• Foreign investors making investments in the country (stock, real estate, ventures)
   
• Domestic investors selling overseas assets

2) The Central Bank is lowering its Reserves of Foreign Currencies by exchanging part of its holding of foreign currencies to those who have and want to sell the domestic currency.

• If the Central Bank needs to buy its currency back (since others want to sell it), there is too little market demand for the currency and the currency will weaken.
   
• If the Central Bank wants to keep up its currency, it will have to pay a higher price than the market rate and it burns through its foreign currency reserves.
   
• If the Central Bank does not buy the currency back, it will collapse.

Keeping the Currency Low

If in case of a Current Account Surplus, the surplus is not completely used for net overseas investments, the Central Bank will need to supply the requested currency and increase its foreign reserves. The domestic currency will get stronger with the negative impact on exports etcetera.

The assumption here is that the Central Bank charges the market exchange rates. If they would charge a lower price in foreign currencies when they sell the domestic currency to for example foreigner buyers of exports, they keep the exchange rate artificial low. Only Central Banks who have sufficient foreign reserves and who see the advantage of their lower currency compared to earning more foreign currencies will use this practice.

Other countries do not like it since they feel that their exports are put at a disadvantage since the country that keeps its currency artificially low, keeps its exports extra attractive. Countries act in a way that is best for their own interest. China is a prime example here.

Once our next article in this series is published, click on “next” below for an explanation on what the drivers could be for a large Current Account deficit.

The following articles from this series may also have your interest:

The Current Account and How Money Flows

The Balance of Payments and Current Account Deficits and Surpluses

 The Capital Account and Reserve Account: Money Flows for Capital Investments

These articles could also be of interest to you:

History of US federal debt as percentage of GDP: Why is this now important?

Debt or Deficit: are we into trouble compared to other countries?

Factors contributing to Economic Growth and Causes for Recession and Economic Crisis

Why is the Japanese Yen so Strong?