Current Account Deficit vs Currency

[jessiepepsi]

Dear all
I am confused by the ”relationship between current account deficits with currency”
In volume3, Reading 18 ( page 80), current account deficit need to be financed—which could be two way
1. through debt —-currency depriciation and economic slowdown follow
2. through foreign direct investment–currency appreciation coz FDI create productive assets.
However in practice problem of Reading 18 #18 “see a strengthening currency” of which country, anwser is “current account surplus”,
Does this mean that in real exam, we have to assume the deficit is finaced by second way?
TKS
Jessie

 

[rahuls]

Current account deficit means higher imports than exports. Domestic Importers demanding foreign currency to settle the payments resulting in high demand of foreign currency resulting in the domestic currency to depreciate.
To finance current account deficit - means to pay foreign currency denominated import bills, foreign debt may be resorted to. This also leads to currency depreciation & slowdown in economy.
If FDI - means foreign cos are investing in domestic markets i.e setting up production plants etc. (not in financial markets otheriwse - FII ). This leads to domestic currency appreciation.
In ques 18 : Country having surplus account (means high exports than imports) is more likely to have a strengthing of currency (being reviewed independently)

 

[rahuls]

Current account surplus, means high exports than imports could also mean that foreign countries are finding their products cheap due to high devaluation of the currency on forex front (i.e. IMO probably one of the reason why china has surplus account since they Yuan is allowed to move only in band & touted be highly undervalued wrt other currency)
However in context of question per se, country having surplus account is likely to see strenghing of the currency. Any other views?

 

[Alladin]

I came across that question yesterday and the only explanation i can come up with is the j-curve.
Basically:
Currency appreciation->ST effect : Price of imports decreases/Price of exports increases but Quantities remain constant so that Current account is in surplus
Currency appreciation->LT effect : Quantities start to change so that Q(imports) increases and Q(exports) decreases hence Current account is in deficit.
Clearly I am assuming that the question relates to ST/Medium term effects…but otherwise don’t really know how to explain this.
Come to think of it…the direction of causation is incorrect :-(…the book asks Current Account surplus->Appreciation not the other way around