Learning Outcomes
After reading this article, you will be able to assess the sustainability of a country’s current account, explain how persistent deficits or surpluses are financed, and identify the risks associated with unsustainable trade imbalances. You will understand key debt and investment flows, adjustment mechanisms, and the indicators used to evaluate current and future risks to macroeconomic stability and exchange rates.
CFA Level 2 Syllabus
For CFA Level 2, you are required to understand the major concepts and risks related to balance of payments (BOP) accounts, capital flows, and the sustainability of the current account. For your revision, focus on being able to:
- Explain the structure and components of the balance of payments, with emphasis on the current account and its financing.
- Assess the sustainability of prolonged current account deficits or surpluses.
- Describe the mechanisms through which external balances adjust and the indicators that signal potential vulnerabilities.
- Identify risks associated with international capital flows and BOP imbalances.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which key factors determine whether a country’s persistent current account deficit is sustainable?
- If a country’s current account deficit persists while private foreign investment inflows weaken, what are the likely consequences for its external position and currency?
- Name two indicators suggesting a current account deficit may be approaching an unsustainable level.
- True or false? The balance of payments current account must always be balanced by net capital flows and changes in official reserves.
Introduction
International trade and the flow of capital are recorded in a country’s balance of payments accounts. The sustainability of a nation’s current account—its balance of exports and imports of goods, services, and income—affects exchange rates, investment, and long-term economic growth. Persistent imbalances can present risks for currency stability and overall financial health. Understanding when a country’s deficit or surplus becomes unsustainable is essential for sound investment decision-making.
Key Term: balance of payments (BOP)
The official record of all economic transactions between residents of a country and the rest of the world, including trade, income, transfers, and capital flows.Key Term: current account
The BOP component measuring a country's trade in goods and services, net income from abroad, and net current transfers.Key Term: capital account (financial account)
The section of the BOP that records investments and loans flowing into and out of a country, including portfolio flows, direct investment, and changes in official reserves.
BALANCE OF PAYMENTS: STRUCTURE AND IMPACT
The balance of payments records all cross-border movements of money involving a country’s residents. Its main sections are:
- The current account (trade in goods, services, primary, and secondary income)
- The capital/financial account (investment flows, foreign lending/borrowing, changes in official reserves)
When a country’s current account shows a deficit, it must be matched by a surplus in the financial account, either through capital inflows (foreign investment or borrowing) or drawing down reserves.
Persistent imbalances in the current account—especially if large relative to GDP—can raise sustainability concerns, lead to higher borrowing costs, and put pressure on the domestic currency.
Key Term: current account sustainability
The ability of a country to finance its current account deficit (or absorb its surplus) over the medium-to-long term without leading to excessive accumulation of foreign debt or major economic volatility.
ASSESSING CURRENT ACCOUNT SUSTAINABILITY
A moderate current account deficit, financed by stable long-term capital inflows, is often benign for developed economies. Problems emerge when deficits are large, persist over time, or are funded by volatile flows. Investors must analyze:
- The sources and types of capital inflows (short-term vs. long-term, debt vs. foreign direct investment)
- The country’s ability to service foreign debt (external debt/GDP, external debt/exports ratios)
- The flexibility of the exchange rate and adequacy of official reserves
If a current account deficit grows faster than the economy’s capacity to generate exports, or relies increasingly on short-term debt, risk premia typically rise and can lead to crisis.
Key Term: debt sustainability
The condition under which a country's external debt rises at a rate no faster than its ability to pay interest and principal, as measured against GDP, export receipts, or other resources.
ADJUSTMENT MECHANISMS FOR SUSTAINABILITY
If a country’s current account deficit begins to exceed sustainable levels, several outcomes or adjustment mechanisms may occur:
- Currency depreciation/re-pricing to make exports more competitive and imports more expensive
- Increases in interest rates to attract more stable capital flows (with possible negative effects on economic growth)
- Policy tightening (fiscal contraction or spending cuts) to reduce import demand
- Market-led correction: reduced lending/investment to the country, forcing adjustment via recession or crisis
Conversely, a persistent surplus may put upward pressure on the domestic currency, leading to intervention or policies to stimulate domestic demand.
Worked Example 1.1
A small open economy runs a current account deficit of 6% of GDP for several years, financing this mostly via short-term bank loans. Suddenly, global credit conditions tighten and capital inflows stop. What risks does this country now face?
Answer:
With capital inflows drying up, the country can no longer finance its deficit easily. It may be forced to use foreign exchange reserves, raise interest rates (slowing growth), or allow its currency to depreciate. If reserves are insufficient or lenders fear default, the result could be a sudden stop in financing, a sharp currency fall, and a potential external crisis.
Exam Warning
Do not assume that the presence of large foreign capital inflows always equals sustainability. Short-term or speculative inflows can reverse quickly and worsen problems. Deficits funded mainly by long-term FDI are more sustainable than those funded by short-term debt.
INDICATORS OF UNSUSTAINABILITY AND WARNING SIGNS
Warning signs that a current account deficit is becoming unsustainable include:
- Rapid growth in external debt-to-GDP or external debt-to-exports ratios
- Declining ratio of foreign direct investment to total capital inflows (greater reliance on debt)
- High and rising levels of short-term foreign currency debt, especially if reserves are low relative to imports or maturing liabilities
- Widening budget deficits and loss of fiscal discipline accompanying external deficits
- High real effective exchange rate relative to historical trends (over-valuation)
- History of frequent capital flow reversals, or falling investor confidence
Key Term: sudden stop
A disruption in financial markets in which foreign investors suddenly stop or reverse capital flows to a country, often triggering crisis.Key Term: reserve adequacy
The extent to which a country’s foreign exchange reserves are sufficient to pay for imports or meet short-term external debt obligations.
POLICY IMPLICATIONS AND RESPONSIBILITIES
Policymakers monitor the sustainability of the current account and mix of capital flows. Tools to support sustainability include:
- Allowing currency flexibility to adjust imbalances naturally
- Building adequate foreign exchange reserves
- Encouraging stable, long-term capital flows (e.g., FDI), and discouraging excessive short-term borrowing
- Supporting fiscal policies that limit overall imbalances
Failure to address unsustainable external deficits or surpluses often results in sharp currency devaluation, loss of investor access, and recession or even crisis.
Worked Example 1.2
An emerging market has a current account deficit of 4% of GDP, 80% of which is funded by foreign direct investment. External debt ratios are stable, and reserves cover six months of imports. Is this deficit a sustainability risk?
Answer:
The risk is low. The deficit is moderate and mainly financed by stable FDI flows. External debt is not increasing faster than GDP, and reserves are adequate. Without signs of over-valuation or fiscal slippage, the deficit appears sustainable.
Summary
The sustainability of a country’s current account depends on the size and persistence of the imbalance, the nature of its financing, the country's capacity to meet external obligations, and the flexibility of its policies. Persistent large deficits, especially if financed by short-term or unstable capital flows, raise the risk of currency crises and abrupt adjustment. Assess relevant debt ratios, the source and maturity of capital flows, and policy responses to judge sustainability.
Key Point Checklist
This article has covered the following key knowledge points:
- Structure of the balance of payments, current account, and financial account
- Definition and assessment of current account sustainability
- Adjustment mechanisms for resolving external imbalances
- Risks associated with persistent deficits and composition of capital flows
- Warning indicators for unsustainable current account positions
- Policy approaches to maintain BOP sustainability
Key Terms and Concepts
- balance of payments (BOP)
- current account
- capital account (financial account)
- current account sustainability
- debt sustainability
- sudden stop
- reserve adequacy