Current Account Deficit
During his lecture at Sberbank Corporate University, Ilya Androsov was talking about countries that find themselves in a situation of current account deficit.
a) (15 rp) Using the example of Turkey, explain why this deficit can be detrimental to economic growth.
Ideal answer: current account deficit is balanced by an inflow of foreign capital. It means that the country is borrowing abroad. To establish if this borrowing is good or not, one needs to look at the use of the credit and the terms of credit.
Turkish banks were borrowing in foreign currencies (dollar and euro-denominated bonds and loans), which means that they were exposed to the currency risk. They tried to address this exposure by extending loans to their customers in dollars as well, but that only transferred the exchange-rate risk exposure off their balance sheets and to the balance sheets of their customers. In the end, banks were still exposed to the exchange rate risk through default risk of their customers. Moreover, the loans extended were of short maturity. All this means that the terms of the credit that Turkey got were unfavorable (short credit with exchange-rate exposure).
Turkey used the credit to finance its construction boom. Despite part of the money going to the construction of infrastructure, there was a also a substantial fraction that financed construction of residential and commercial real estate that had little potential to increase the country's GDP in the future. From the lecture we learned that investment projects were of poor quality as lending standard deteriorated, also bringing into question the ability of such projects to boost GDP growth. Hence, the way Turkey spend this borrowed money was not generating GDP growth.
Grading: (mention one of each)
5pts: Unstable currency. Currency exposure of banks through borrowing in USD, but lending in lira. Substantial leverage and accumulated interest expense.
10pts: Mismatch between maturity of loans and investments. Rollover risk. Currency exposure of banks through default risk of loans. Deterioration of credit standards.
15pts: Investments in construction projects, residential and commercial. i.e. boosting consumption.
b) (15 rp) Can you tell a story where such current account deficit can be beneficial for the economy of the country?
Ideal answer: If the international loans are done at good terms and the funds are invested wisely, then current account deficit can be beneficial for a country. Example of good loan terms - USA, that is able to borrow in $, its domestic currency. Hence, its counter-parties are exposed to the exchange rate risk, not the USA.
If a country, on top of that, is using borrowed funds not for consumption, but for investment goods, then its GDP growth is likely to accelerate in the future.
Quoted from one of the submitted answers: "Imagine a scenario in which lots of companies in a country with lots of sunshine decided to stop their activities and start a joint venture in which with funds or loans partly from abroad they made a huge system that got energy from the sun (solar panels, etc) and produced enough energy not only for the country but also for the surrounding ones. This way, the current account would be in deficit for several years but when the country started being fueled by green energy, energetically efficient and sold energy to there countries not only would the current amount deficit be greatly reduced but also lots of economic activities surrounding the energy sector would develop, thus boosting the country's economic activity."
Grading: (mention one of each)
5pts: Stable currency. Investment in education by foreign aid agencies.
10pts: Loans in domestic currency. Example: USA. Long-term credit.
15pts: Investments in production capacity, not consumption.