Economics: Savings-Imbalance Approach

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mr.devlilock

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Cant seem to figure this one out as I’m especially weak in economics.
One of the approaches to forecasting exchange rates is the savings-imbalance approach, which stipulates that in order to finance the investment-domestic savings imbalance, foreign investments are needed. Then it goes on to state that in order for this (attract foreign savings) to happen, a current account deficit using sustained import>export is needed.
My question is how does having a current account deficit attract foreign savings??
Any insights would be much appreciated…
 
Its mean the country that has a current deficit needs foriegn investors to come in and open new business to increase demand of the currency. its like their currency is cheap to buy and to do business.
 
When domestic savings is not enough to fuel the country’s growth, it requires foreign savings. To attract capital domestic interest rate increase. This will in turn also increase currency value. This explains why currencies may diverge from fair value for extended period.
 
Look at the Balance of Payments. For a floating currency, it needs to be balanced.
So the Current Account deficit needs to be financed by a Capital/Financial account surplus. Which means foreign savings flowing in.
 
I understand the balance of payments theory but what is the actual mechanism that causes foreign savings to flow in though?
Is it the implications of a Current Account Deficit (ie. strong economy) that attracts foreign savings?
What I mean is a country can always create a current account deficit by importing more… but what is the reason why foreign savings flow in (other than balancing a formula).
I’m not sure if i’m misunderstanding anything so it would be great if you folks can clarify….
 
If you do not have foreign reserves (or it’s stable), then you cannot create a deficit with money that isn’t there. You attract capital by raising interest rates, and investment by lowering them.
 
Current account deficit = country’s savings < country’s investment. So, rates have to be increased to promote savings. CA Deficit implies Higher imports which means more demand for foreign ccy. Again foreign ccy will be attracted by higher rates. If it’s done, then foreign savings translate to investments in your country.
 
So in this case (Savings-investment imbalance approach), the prospects of economic growth implied by higher rates outweights the potential impediments of higher rates on the stock market, which ultimately results in attracting foreign currency for investments.
Is my understanding correct?
Thank you!
 
Higher rates needn’t mean trouble for the stock market if higher rates is due to expected inflation - which is good.
 
mr.devlilock wrote:
So in this case (Savings-investment imbalance approach), the prospects of economic growth implied by higher rates outweights the potential impediments of higher rates on the stock market, which ultimately results in attracting foreign currency for investments.
Is my understanding correct?
Thank you!
Click to expand...
It’s a little more complicated than that.
Let’s say the current account is in constant deficit, and the currency does not depreciate due to constant funding as well from higher rates. If the current account deficit plays a big role in economic growth through critical inputs, then the higher rates would be better for the economy than low ones. This should be a scenario for an emerging market.
For developed nations like the US running constant CA deficits, they have rates near zero, and large inflows of capital annually. So it depends.
 
When investment exceeds savings, pressure will build on interest rates. Foreigners will take interest in the country’s assets because interest rates will be relatively high. The country should experience currency appreciation because money flows in. A strong currency favors imports vs exports, so it is consistent with a current account deficit. I don’t think foreigners are attracted by the deficit per se but more the growth prospects and relative interest rates. The current account deficit is just an outcome of these circumstances.
At one point if the deficit is too large, foreign investors become more cautious and the currency will stop appreciating, possibly start depreciating. Inflation would then build and the central bank would tighten policy to control inflation. That would slow economic activity and cause capital outflows. So it would now be the opposite, with weak growth (so weak investment) and a depreciating currency that would cause capital outflows (and vice versa), which would nonetheless help bring back the current account to equilibrium.
 
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