Price of increased growth in deficit is not clear

The current account deficit could rise to 5.6% of GNP in 2007, writes Alan Barrettof the ESRI

The Quarterly Economic Commentary by the ESRI, the Economic and Social Research Institute, always provides forecasts for a wide range of economic variables.

Typically, the ones that get most attention are the forecasts for gross national product (GNP) growth, employment growth and inflation. Other variables tend to attract attention if significant movement is anticipated relative to trends in the recent past.

In this commentary, the forecasts for the current account on the balance of payments fall into this category and so it useful to look at the trends and consider the implications.

The current account balance is made up of three main components: the difference between merchandise imports and merchandise exports; the difference between services imports and services exports and the net flows of incomes into and out of the State.

In the Irish case, this third part is dominated by profit outflows from multinationals based here.

As recently as 2004, the three components combined to produce a small current account deficit. We had a large positive balance on the merchandise side, with exports exceeding imports by €31 billion and a deficit on the services side of about €10 billion.

Combining merchandise and services, this left us with a trade surplus of about €21 billion that was matched by net income flows of about the same amount.

Since 2004, the net trade surplus (on goods and services combined) has been declining.

It fell by 8 per cent in 2005 and is likely to fall by about 3 per cent this year. At the same time, net outflows of income have increased and by roughly the same percentages as the reductions in the trade surplus.

Combining these movements, we find that the current account deficit has risen from below 1 per cent of GNP in 2004 to a likely value of about 4 per cent of GNP in 2006.

For 2007, we are forecasting a further fall in the trade surplus and a further rise in the outflow of income. This would lead to the current account deficit rising to 5.6 per cent of GNP in 2007.

Such deficits must be matched by a surplus on the capital account of the balance of payments. By this we mean that capital funds, either borrowings or investments, must flow into the State to fund the current outflows. Should the Republic be concerned about the growth in this deficit? The answer to this question is not entirely clear.

There are conflicting views on the causes of the increasing deficit and different causes will have different implications.

One view is that the current account deficit is the result of investment exceeding savings in the Republic, with capital flowing into the State to fund the investment. Investment is certainly high in the Republic due to our infrastructural needs in the areas of housing and roads.

It could be that the current account deficit will reduce in the years ahead without any negative consequences arising through an adjustment process, as infrastructural demands slow down.

An alternative view is that the current account deficit is a consequence of the growth in consumption and Government spending, in addition to investment.

In effect, international borrowing is facilitating the rising indebtedness of Irish people and businesses on international markets. This may eventually translate into higher risk premiums on loans to these people in the Republic, as lenders see the economy exposed to higher levels of debt.

Higher borrowing costs may then lead to reduced levels of debt-financed spending and through this route, excess demand will be reduced.

All of the above is clearly complicated as there are numerous flows of funds and complex interactions. We can, however, provide one statistic that may illustrate the point about growing international indebtedness.

According to the economist Dr Patrick Honohan, writing in the same Quarterly Economic Commentary, the net import of funds by credit institutions doing business in Ireland to lend to Irish residents amounted to 41 per cent of GDP by the end of 2005.

As the corresponding figure was only 10 percent at the end of 2003, we do have evidence of dramatic developments in international financial movements.

It is not clear which process is giving rise to the growing current account deficit in Ireland, and elements of both views discussed above could be at work. Either way, it is desirable that the underlying causes and implications of the deficit be understood and it is our intention to return to this issue in future commentaries.