Current Account Deficit, LDR and Financial Crisis

Last time, we discussed the IMF report on the shrinking of the Current Account Surplus of China (Yiu, 2019), the evidence has been shown, but what are the implications of a shrinking current account surplus?

First of all, a current account deficit indicates that a country is importing more than it is exporting. However, people normally think about the imports and exports of goods and services. This is also what we teach and learn in the International Trade Theories which tell us that trades are mutually beneficial. Nowadays, however, international trade must include currency trade, which has not yet been seriously studied in Economics as queried by Paul Schulte (2015).

When a country borrows a lot of foreign currencies from overseas, it will be reflected in the current account, because it is an account reporting the balance of assets and liabilities between countries. Currencies and Debts can be regarded as tradeable goods. But in the first place why they trade currencies and debts?

For the borrowing countries, the reason is straightforward. When your own local savings are not enough to achieve economic growth, you are tempted to borrow from foreign lenders. For the lending countries, it may also simply be a consequence of excessive savings seeking higher returns. Yet, there is another unhealthy reason: “countries like China, Japan, Taiwan, and Singapore that they were running ruinous mercantilist policies that are caused by undervalued currencies generating huge trade surpluses. These surpluses necessarily had to be recycled into dollar assets to prevent the currencies from appreciating and damaging the export engine.” (p.27) In other words, currency-debt trade has become a tool to maintain the goods and services trade. It makes the auto-correction mechanism raised by the International Trade Theories fails and thus resulting in long-term trade surplus/deficit.

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Worse still, the reliance of countries on foreign loans to grow is found to be highly related to financial crises. Schulte (2015) found that countries with current account deficits are countries with Loan-to-Deposit Ratio (LDR) over 1.0, because “by definition, an LDR above 1.0 must always come from foreign savings.” (p.25) Any sudden withdrawals of money by foreign bankers or any sudden increases in the exchange rate would cause difficulties in repaying the loans. Schulte (2015) had shown numerous examples of financial crises once the LDR of the country exceeded 1.0, including the Asian Financial Crisis in 1998 and the Global Financial Crisis in 2008.

But even if it is, governments and bankers would not listen. The theory seems to suggest that a country should not borrow more than its own local savings. It would limit its growth opportunities, especially when all the rivals are doing so, if you do not follow the bandwagon, you would be kicked out of the game. Traditionally, when a country wants to lend more, one can raise interest rates to attract more local savings. Raising interest rates would cause a decrease in consumption, a reduction in real estate speculation, and an increase in savings. But it can result in unemployment, deflation, recession or even depression that no governments want to have.

That is why Schulte (2015) said the current economy is a credit-driven economy, Bernanke saved the Global Financial Crisis by QEs, that is a kind of flooding the markets by credit. Now, when it seems to have a global recession coming, many countries including the US have started to cut interest rates and selling REPOs. It has become an addiction to save the economy by more and more debts.

References

Schulte, Paul (2015) The Next Revolution in our Credit-Driven Economy: The Advent of Financial Technology, Singapore: Wiley.

Yiu, C.Y. (2019) China’s Shrinking Current Account Surplus, Medium Dec 20. https://medium.com/@ecyY/chinas-shrinking-current-account-surplus-86d508bf9ec3

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ecyY is the Founder of Real Estate Development and Building Research & Information Centre REDBRIC

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