Friday, June 30, 2017

Current Account Confusion

This came out about a month ago, but the subject is important enough that it’s worth revisiting (excerpt):

The Malaysian economic indicator that is raising red flags

OF all the statistics trotted out to show the health of the economy, one indicator is causing some concern among economists, who said it spells trouble for every Malaysian over the long term.

The current account balance is a gauge for the state of the economy and if it goes into a deficit for an extended period, it affects everything from wages to the price of vegetables.

Malaysia’s current account balance still shows a surplus but the bad news is that it has been declining steadily from 2014.

Economist Ali Salman said that the surplus dropped by more than half or 57.75%, from the fourth quarter of 2016 to the first quarter of this year.

If this decline is not addressed, it will mean years of tepid growth and hit the pockets of ordinary Malaysians. Economists said these are among the impacts of a declining surplus:

  • It makes it harder to create new jobs and sources of income for citizens thus, curbing their spending power.
  • It saps investor confidence, which can then weaken the ringgit.
  • A weak ringgit would make imports, such as food and goods, more expensive and drive up supermarket prices.
  • The worst part is that the above factors can compound and feed off each other, thus, leading to slower overall growth.

It’s been nearly 250 years since Adam Smith published “The Wealth of Nations”, and exactly 200 years since David Ricardo put forward the theory of comparative advantage in “Principles of Political Economy and Taxation”. One would have thought we would know better by now.

The problem with the narrative in the article is that for the most part, the causality typically runs the other way i.e. the current account is a reflection of the economy, and not a variable that affects it. I can’t think of a situation where the current account itself causes changes to the economy.

Some might argue that a decline in the current account will cause investors to shy away from a country, and thus a decline in the current account balance is bad. This betrays a fundamental misunderstanding of the balance of payments.

A current account surplus is always matched by a corresponding outflow of capital. This could be private (via the financial and capital accounts) or public (via international reserves). A current account deficit is the exact mirror image: there must be a corresponding inflow of capital. Ergo, a decline in a current account balance necessarily implies an equal (net) decline in the outflow of capital (with a surplus) or increase in the inflow of capital (with a deficit). This goes back to the underlying fundamentals of the balance of payments and the national accounts – the current account balance is identical to the savings-investment gap:

Y = C + I + G +(X - M)

where Y = Income, C = Consumption, I = Investment, G = net government spending, and (X-M) = net trade (the current account, ignoring income flows). This can be restated as:

(X – M) = Y - C - I - G

Consolidating government spending with households and considering income less consumption equals savings (Y - C = S), this collapses to:

X - M = S - I

A current account surplus (X – M > 0) is the equivalent of savings exceeding investment in the domestic economy. Or to put it more bluntly, a current account surplus = a deficiency of local investment, with the excess savings flowing overseas. Not something to be proud of.

We can break things down even further, once its recognised that a surplus on the current account is almost necessarily solely a corporate sector surplus, since few households export goods or services. But while corporations are benefiting from the surplus, the fact that imports are less than exports implies relatively lower domestic purchasing power. Households do not benefit.

In fact, surplus countries almost all share one defining characteristic: relatively low wage to national income ratios. Case in point, Germany in the 2000s. At the turn of the century, there was a concerted (and successful) policy effort to rebuild Germany’s export machine. How did they do this, by promoting exports? Nope. By weakening their currency? No; at that juncture, Germany was already part of the Eurozone which was a freely floating system. By imposing tariffs on imports? No; EU-wide trade policy was managed by the European Union. What they actually did, was to get the trade unions to agree to lower wage hikes. Note how the causality runs – weakening worker wage growth created a bigger current account surplus.

If you don’t believe me, read this.

The other important problem is that the balance on the current account is a net total of the gross inflows and outflows. Here’s why this is important – a decline in the current account balance could occur due to:

  1. A drop in inflows;
  2. A rise in outflows;
  3. Both inflows and outflows drop, but with inflows dropping more than outflows;
  4. Both inflows and outflows rise, but with outflows rising more than inflows.

The interpretation of what’s happening to the economy would obviously be very different based on which of the above cases is in play. In other words, a change in the current account balance doesn’t exactly convey a lot of information; you have to investigate the underlying gross flows to understand what’s happening, and why it might matter. It’s not a straightforward current account balance increases = good, current account balance decreases = bad.

Going back to the national accounts identities, we can restate the cases above in terms of savings and investment. A decline in the current account balance could occur due to:

  1. A decrease in savings;
  2. An increase in investment;
  3. A decrease in both savings and investment, but with savings dropping more than investment;
  4. An increase in both savings and investment, but with investment rising more than savings.

Sounds a bit different doesn’t it? The connotations are the opposite of what a bare examination of the balance of payments would imply. For example, a drop in net exports is for many people in these parts something that should be avoided (as the article amply demonstrates), as that means outflows have increased relative to inflows. This mindset harks back to the notion that an economy is like a household, which the second set of statements shows it’s not.

Bearing in mind the above, lets parse the “consequences” the article quotes as likely to happen with a decline in the current account surplus:

  1. Relative decline in domestic household income – not true, and quite likely the opposite. That’s certainly the case for Malaysia: the decline in the current account surplus has coincided with an increase in domestic wages relative to national income.
  2. Saps investor confidence – whether that happnes depends on the specific movements of the underlying gross flows. To take a good example, Thailand after the coup that overthrew the Shinawatra government. Thailand’s current account surplus increased in the aftermath, mainly due to a collapse in consumption and imports. The increase in the surplus was thus a sign of a weakening economy, not a stronger one.
  3. Weaker Ringgit raises supermarket prices – hasn’t happened yet. If you look at food price inflation before and after the Ringgit started weakening in 2014, guess what? No change.
  4. Compounding effect leading to weaker growth – I’ll just note here that Malaysia’s period of fastest growth (late-80s to early to mid-90s), coincided with a persistent current account deficit. The period of surplus (since 1998) has seen slower growth and lower rates of domestic investment, a complete 180° from the article narrative.

If you were to ask me why Malaysia’s current account surplus has declined over the last few years (you can actually trace the decline back much farther than 2014), my response would be:

  • A drop in domestic “savings” i.e. corporate profits, partly driven by higher wage bills (workers are being paid more relative to capital owners);
  • This was compounded by the drop in commodity prices from 2014 onwards, but this effect was partially offset by Ringgit weakness. This is an income effect, and is definitely negative, but note the role of the currency here. Ringgit weakness is a positive for the current account, not negative;
  • A rise in domestic investment, which pulled in greater capital goods imports. You can “blame” the ETP and stronger domestic investment for this;
  • Lastly, global trade growth has been in a secular downturn since the Great Financial Crisis. Malaysian trade has done pretty well, considering that global trade volume actually fell last year. But this of course has nothing to do with the domestic economy.

That’s a very different narrative from what the article outlines, with equally different implications.

Lastly, I’d like to point out the role of demographics and stage of development. As a relatively young nation with a median age below 30, Malaysia by rights should be a deficit nation because the household savings rate would be relatively low. On top of that, economic development theory suggests that less developed countries should run deficits while more developed economies should run surpluses, as global savings goes to finance investments with higher returns – as developing economies by definition are inside the global technology frontier rather than on it, gains from investment should be higher where development is lower.

From the foregoing, it’s hard to see why a reduction in Malaysia’s current account surplus should be viewed negatively (aside from foreign holders of Malaysian bonds, whose main concern is being paid back). On the basis of economic development, on the basis of demographics, on the consideration of needing to build up worker incomes, Malaysia really has no business running a surplus in the first place.

P.S. Sheridan, you have my number. I’d be more than happy to explain all this in as much detail as you’d like.

11 comments:

  1. Tebing Tinggi XVIIJune 30, 2017 at 9:57 PM

    What about real wages?

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    Replies
    1. @Tebing Tinggi XVII

      Real wage growth has been positive, but there's some differences in the distribution. Wage growth has been strongest in the bottom 40% (especially after the minimum wage was implemented), and to a much lesser extent the top 20%. The middle has been squeezed.

      Delete
  2. Lol @ the end

    That being said...
    BoP interpretations can be difficult for most *doesn't justify what was published - particularly the points*

    Also,

    Some added points (things to ponder)...

    1) analysis of the BoP of primary commodity exporters/importers or tourism/remittance countries would have to be explained a different way (middle east will never have it so easy, ever again)

    2) currency regimes and ability of those countries to defend those regimes matter (poor 2015 kazakhstan)

    3) nature of domestic banking system and reliance on short term external financing (turkey is so vulnerable, in so many ways, you just have to see our rating history of it)

    4) ability to ask for international aid (lol)...or conversely, attract sanctions

    just contributing to the body of knowledge on this blog...haven't done so in a while

    Figured it's about time considering all my time spent in my current job

    ReplyDelete
  3. To contribute a bit to this. The push by government to increase domestic infrastructure investments actually has the implications of a declining current account surplus ( S - I decreases ) but attracts more capital into the country. Depending on the funding sources, governments typically issues bonds ( increase interest rates ) and with free capital mobility, foreign capital will flow in and result in a larger balance of payment surplus. For people complaining that the ringgit is weak, note that increased government spending actually strengthens the ringgit, though it comes at an expense of higher interest rate and higher inflation. ( fiscal policies typically raise interest rates and inflation as opposed to monetary policy ).

    ReplyDelete
    Replies
    1. @ho

      Not much I'd add to that, though I would say that fiscal expansion causing interest rates and inflation to rise is predicated on a closed economy at full capacity. In an open economy with full capital mobility, the excess demand could equally manifest itself as just higher imports.

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  4. Well written article explain comprehensively point by point.

    Although this has been a commmon knowledge taught by every introductory economic course, why do think the 'horror' of current account deficit is still being perpetuated and distorted now and then?

    CJ

    ReplyDelete
    Replies
    1. @CJ

      Because a lot of the media and public commentary comes from financial economists at fund managers or investment banks, rather than policy-makers. They have a vested interest in ensuring there's enough FX accumulated to pay them back when they sell their investments and pull out. They're obviously not going to look at it from an economic development/growth perspective.

      Same thing goes for the IMF - their structural adjustment programs are designed so that their loans get paid back, and hang the consequences on the domestic economy.

      Delete
    2. Hishamh, thanks for the insight. Always enjoy your content.

      CJ

      Delete
  5. Yeah well said on the narrowing CAB! CA deficit is not that worse for developing country like Malaysia as investment still play a vital role in our economy. But I guess the important thing here is whether the financing CA deficit (soon) if happened is sustainable i.e. long term (FDI) vs short term financing

    ReplyDelete
  6. Well written sir. Enjoyed reading it.

    ReplyDelete