Current Account Deficits During Heightened Risk: Menacing or Mitigating?

Large current account deficits, and the corresponding reliance on capital flows from abroad, can increase a country’s vulnerability to periods of heightened risk and uncertainty. This paper develops a framework to evaluate such vulnerabilities. It highlights the central importance of two financial factors: income on international investments and changes in the valuations of those investments. We show how the characteristics of a country’s international investment portfolio – the size of its international asset and liability holdings, their currency denominations, their split between equity and debt, and their return characteristics – affect the dynamics of these financial factors. Then we decompose those dynamics into their drivers, explore how they are affected by domestic and global risk shocks, and apply this framework to 10 OECD economies. These examples, including a more detailed assessment for the UK, show that a substantial degree of international risk sharing can occur through current accounts and international portfolios. Our flexible framework clarifies which characteristics of a country’s international portfolio determine whether a current account deficit is “menacing” or “mitigating”.