Deficit is defined as “an excess of expenditure or liabilities over income or assets in a given period.” Thus, a deficit typically occurs when you outspend your income.
For households and individuals, “deficit” is a dreaded word because it means their income does not suffice for their expenses. As a result, they have to resort to borrowings to fund the gap. However, when individuals start relying too much on debt to fund their deficit, it hurts their creditworthiness. As a result, they become overburdened by debt, take high-interest loans, slip into a liquidity crisis and sometimes fail to repay the loans.
Like individuals, economies also have their deficits to handle. Governments of all economies have to deal with three major types of deficits.
- Deficits in foreign trade earnings and expenses (trade deficits)
- Deficit in foreign money inflows and outflows (financial and capital deficits)
- Deficits in the government’s earnings and expenditure (fiscal or budget deficits)
Let’s understand each one of these deficits and their implications on the economy.
Trade deficits occur when the value of a country’s imports is higher than that of its exports. Alternatively, when the country’s value of exports is higher than its imports, it has a trade surplus.
When a country becomes a large-scale, efficient producer of a product or service, it exports a lot. For example, Saudi Arabia is a big producer and exporter of oil due to its large reserves. Another example is China. China is a mass manufacturer and exporter of goods to the developed world due to its massive, efficient production chains and cheap labor. Australia is a large gold producer, while India has a massive skilled workforce for IT services.
The major point of contention that nations and governments face is how much of the trade deficit is healthy and when it starts hurting the country.
The answer to this question isn’t straightforward. When a country lacks the capability to manufacture certain goods, it will decide to import those. In contrast, oftentimes, that country has some products that other countries want and, in turn, becomes an exporter. However, if the country cannot fill the demand gap entirely with imports, it tries to build capabilities to become an efficient producer and substitute imports with domestic manufacturing.
However, some countries like the United States try to build intellectual capability and outsource the actual manufacturing to another country because production is expensive in the U.S. Then, they bring the product back to the U.S., essentially driving exports for other countries and increasing imports for the U.S. This results in persistent trade deficits for the U.S. However, it does help stimulate economic activity. This way, U.S. consumers get products at lower prices, and U.S. corporations earn higher profits.
In 2019, the U.S. exported goods and services worth $2.5 trillion, and imported goods and services worth $3.1 trillion. This result was a trade deficit of $617 billion. However, this deficit was a manageable 2% of U.S. Gross Domestic Product. Despite the deficit, the U.S. GDP grew 2.2% in 2019, with all economic indicators showing marked improvement from the previous year.
A trade deficit is not a big problem if it is manageable and the country’s internal economy is robust enough to support the deficit. However, if the internal economy is weak and importing much more than its exports, it can create a big problem. Heavy imports mean a large supply of domestic currency and a great demand for foreign currency. This will result in a dwindling currency value.
In the long run, an import-driven deficit leads to higher dependence on foreign goods, which has to be funded by increased borrowings. On the other hand, an export-driven surplus that is too high makes the country too dependent on exports for growth. While this is not bad, the economy can run into trouble if the country’s major export partners stop importing. Therefore, the country needs to develop enough internal demand to keep the economy upbeat when the exports are not growing.
Financial and Capital Account Deficit
A financial account deficit is affected by short-term money flows in and out of the economy. Countries receive overseas capital as overseas borrowings, portfolio investment in financial instruments, and direct financial investment in domestic firms. The outflow of money results from financial investments by domestic citizens and firms in foreign firms, portfolio investments by citizens in foreign countries, and overseas loans given by domestic institutions.
Simply put, countries that are hot investment destinations because of their high growth rates and conducive business policies tend to be major beneficiaries of finance flows. Thus, they tend to have a financial account surplus.
Note that the financial account flows are typically short-term because these flows are not bound by any minimum time threshold. This money can enter and leave the country at any time with only basic checks. However, this does not mean this money stays only for a short period. For example, an investment qualified as a financial investment can stay in the country for decades and still be categorized as a financial investment only.
Capital accounts refer to investment by foreigners in fixed assets of the country. These assets include land, properties, ports, highways, and other fixed assets that are expected to stay for longer time periods. Some of these investments even have lock-in periods that require the investor to stay invested for a particular time threshold. The deficit resulting from such transactions is referred to as a capital account deficit.
Governments across the world aim to get long-term capital inflows in the country to fund their growth. In addition, such investments create long-term assets in the country, increase productivity, create employment, and help the nation’s overall prosperity.
A fiscal deficit or budget deficit is the difference between the government’s receipts and expenditures in a given time period. Governments primarily earn revenue from taxes and levies and spend that money on social welfare and other activities, including building long-term federal assets.
Borrowings from people in the country, domestic institutions, and foreigners typically fund the fiscal deficit of governments. In the U.S., the government accomplishes this by issuing government treasuries.
A measure of indebtedness of a country is its debt-to-GDP ratio. The higher it is, the more problematic it is. In earlier times, deficits were mainly used in recessionary periods, when the government needed to stimulate the demand. Then, in times of surplus, the government would return the money to nullify the deficit. However, that theory has lost its relevance now. These days, governments across the world are increasingly relying on deficits in good and bad times. As a result, they rake up large debts, which, in some countries, are now approaching alarming levels.
Take, for example, the Euro Bloc member, Greece. Greece found itself in a huge problem when its gross external debt shot up after the 2009 recession. Its debt reached alarming levels of 127% of its GDP. Such a huge debt was a result of back-to-back government deficits. From 2004 to 2009, Greece’s GDP increased by 40%. This resulted from government expenditures rising by 87%, while tax revenues only increased by 31%. Such high expenditure without a corresponding increase in revenues created chaos in the country. As a result, it started receiving step treatment from the fellow bloc members, who were reluctant to bail the country out.
After much deliberation, the country had to be bailed out by other Eurozone countries on conditions to adhere to strict fiscal discipline. So it enacted 12 rounds of tax increases, cut its government spending, and induced a host of reforms. But, of course, this did not go over well with its citizens, triggering local riots and protests.
The United States’ situation is peculiar when it comes to the budget deficit. Because the dollar is the world’s reserve currency, a large part of world trade happens in U.S. dollars, increasing the global demand for the dollar. For this reason, the Federal Reserve has been printing a lot of money without any of the ill effects. So far, printing this much money has not been problematic. The debt has been easily serviceable because of perennially low interest rates and this ruthless money printing by the Fed.
The U.S. budget deficit was close to a trillion dollars in 2019, or 4.4% of the country’s GDP. Starting in 2008, when the financial crisis hit, it has had a stream of high deficit years, running above a trillion dollars.
The heavy deficits have also bloated the U.S. national debt. America’s public debt-to-GDP ratio reached 79.2% at the end of 2019. This doesn’t include the debt held by inter-government bodies. Approximately 37% of the U.S. government debt in May 2020 was held by foreigners, making the U.S. the largest holder of external debt in the world.
Balance of Payments
Countries with trade deficits sustain themselves with an equal amount of finance and capital surpluses. This ultimately results in a zero impact on the country’s accounting books. However, if the government has no other avenue to fund its trade deficits, it will resort to foreign borrowings to generate the financial surplus. This phenomenon, which is also a part of national account keeping, is called the “balance of payments.”
If a country has huge trade as well as capital deficits, its situation will be precarious. It will be borrowing heavily, its currency will have lost a lot of its value, and foreigners must have lost confidence in the economy.
India faced such a problem in the early 90s when its trade deficit shot up due to problems at its major exporting destinations, the Soviet Bloc and Eastern Europe. In addition, high oil prices (India imported most of its oil requirements) in the wake of the Iran-Kuwait war, political uncertainty, restrictive business policies, the weak domestic economy, and fiscal indiscipline were all reasons for its large trade deficit. All these factors led to a loss in investor confidence, and foreigners started pulling money off India.
The country barely had reserves to fund its import bill for two and a half months. As a result, it had to resort to costly external commercial borrowings and costly deposits from its residents abroad to fund its outflows. Eventually, these borrowing also went dry, and the country had to mortgage its gold reserves to the International Monetary Fund (IMF) to get emergency loans. Unfortunately, that only provided a short-term fix. Later on, it opened up its economy by relaxing its business policies and moving towards a more capitalist structure. This eventually averted a major economic collapse.
Theoretically, the country’s trade deficits and financial and capital accounts deficit should add up to zero. This essentially means that the country is funding its consumption demand with capital and investment flows. Of course, this isn’t a problem until foreigners invest in the economy and the Central Banks have enough reserves. However, when investment dries up, excessive import demand can wreak havoc on the country’s currency because of too much supply. This might lead to inflation, the decimation of the domestic currency, and a decline in the living standard of the citizens.
Foreign Currency Reserves
Unlike the U.S., other countries across the globe need to maintain foreign exchange reserves to curb excess volatility in the value of their currency.
Let’s understand what it means.
Let’s consider a country like India. India’s national currency is the Indian Rupee. Contrary to the U.S. dollar, which is valuable worldwide, the Indian Rupee is valuable only in India. Therefore, any trade outside India has to happen in the USD or the currency of the trading partner (Euro, Yen, etc.). However, when foreigners want to invest in India, they need to convert their currency into the Indian Rupee to buy domestic assets.
Let’s assume India has become a hot investment destination, and investors are lining up to invest in India. The influx of a large amount of foreign currency increased the demand for rupees, leading to its appreciation against other currencies. The Indian Central Bank does not like the appreciation because it impacts the country’s exporters as most of its exports are realized in foreign currencies. With the appreciation, each unit of foreign currency gives the exporters fewer rupees.
To tame the appreciation, the Central Bank starts increasing the supply of rupees by printing more. Then, it exchanges the newly printed currency for the foreign currency, and this foreign currency is then held in “foreign currency reserves.”
Years later, due to policy changes, India is no longer a favorite destination for investors. Foreign investors come in big numbers, redeem their investments, and rush out of the currency. Now the Central Bank is faced with an opposite problem. The excess supply of rupees results in the depreciation of the rupee. Unfortunately, this is also not a desirable outcome because it makes imports expensive, and India relies on imports for major commodities.
Then, the Central Bank came up with a new plan. It started selling the foreign exchange reserves accumulated when foreigners were rushing to invest in India. Now, the sale of the foreign currency heavily supports the Indian Rupee and saves the day for importers.
This is how foreign currency reserves work. The U.S. does not maintain major foreign currency reserves because it simply does not need to. The USD dominates major trades across the world. American exports and imports are mostly in USD. Therefore, America does not have a foreign currencies problem. Unless, of course, U.S. companies and investors want to invest in other countries, in which case, companies, and investors will bear the currency risks.
For countries that need foreign currency reserves, it is pretty easy to control their currency’s appreciation because of their unlimited printing power of their domestic currency. However, when it comes to controlling currency depreciation, their power is limited to their currency reserves. Once they exhaust all their reserves, the currency is on its own, and there is not much that Central Banks can do. Therefore, it is always important to keep foreign investors happy with progressive, stable policies.
Foreign Direct Investment (FDI) vs. Foreign Portfolio Investments (FPI)
Capital is an important element for business and growth. However, it is also a commodity that has opportunity costs. That is one of the reasons why investors move capital globally in search of better returns. Some of this capital is “patient” capital and can sit in one place for years or even decades. In contrast, other capital is “hot” money that tries to make a quick buck and then move on.
When foreigners invest directly in assets in a country intending to keep the investment there for the long-term, that investment is a Foreign Direct Investment (FDI). As discussed earlier, some countries impose lock-ins on such investments to ensure that the investor remains invested for a minimum period of time. This “patient” capital helps in the real growth and the building of an economy. Some of these investors also involve themselves in the day-to-day management of their assets, making them serious long-term players.
A prospering economy presents various financial investment opportunities for investors. Foreign investors invest in financial assets like equities and bonds for the short and long term. These foreign investors can be hedge funds, mutual funds, corporations, or even individuals investing directly in overseas financial assets. Such investments are referred to as Foreign Portfolio Investments (FPI). These investors can move from country to country in search of higher returns with no strings attached.
Governments typically prefer to grow an economy, and, therefore, they prefer FDI instead of FPI. Some governments try to lure foreign investors by offering higher returns if they remain invested for longer periods, even when it is a Foreign Portfolio Investment (FPI). Simply put, the longer the capital remains in the country, the better it is and the more it contributes to the nation’s growth.
In 2019, the U.S. was the biggest recipient of Foreign Portfolio Investments with net inflows of $479 billion. The U.K. came in second with an inflow of $300 billion.
The FDI-to-GDP ratio is a good indicator for understanding the relative attractiveness of an economy for FDI. For the U.S., this number was 2.6% in 2019, while it was 20.7% and 58% for smaller economies like Singapore and Luxembourg.
Foreign Direct Investment takes a serious commitment from investors. Therefore, governments implement stable and predictable policies so investors can feel assured that their capital and assets are safe.