If the sum of consumption and investment is higher than the GDP, current account will be negative, implying that the country did not spend according to its means and hence had a current account deficit.

The other day I spoke at the Izmir Economic Congress. I addressed as a critical problem that due to its low domestic savings rate, Turkey had to have current account deficit even to achieve a moderate investment-GDP ratio. Because of this, the need for foreign borrowing, that is net capital inflow, was critical for Turkey.

I assumed that this was a well-known macroeconomic correlation. I see that I was wrong. Two comments especially came as surprise. The first comment was that Turkey’s savings rate is understated. And the second asked “how do you know what proportion of FX inflows is used for investment and what proportion for consumption? Is there an inscription on the FX notes?” The accusations that Turkey’s savings rate is understated is not convincing for me. I will write about this later if I have the opportunity. Today I am planning to talk about the “inscription on the FX notes.” I think a fundamental national income definition is neglected here.

Take the Gross Domestic Product (GDP). By definition, summation of consumption, investment and net exports gives the GDP. Exports and imports cover services as well as goods. If we take gross national product instead of GDP, net exports in the function will be replaced with the current account deficit. For the sake of simplicity, I will continue with GDP and neglect the insignificant difference between net exports and current account deficit. Consumption (and investment) includes both private and public sector consumption (investment).

Now let’s reorganize the function so that only current account balance will be on the left hand side. In that case, GDP (national income) minus consumption and investment gives the current account balance. If the sum of consumption and investment is less than income, the left side of the function will be positive. So will be the right side, implying a current account surplus. If the sum of consumption and investment is higher than the GDP, current account will be negative, implying that the country did not spend according to its means and hence had a current account deficit.

So, where does the inflowing FX come from? There are two channels: first from the exportation of goods and services (such as tourism). Second, from FX borrowings from abroad in excess of the FX debt you have, that is, net capital inflows. So, don’t you think the answer is obvious: if FX earnings from exports do not meet the FX liabilities arising from imports of goods and services, you have to borrow from abroad to make up the difference. Isn’t this the very meaning of the current account deficit? This story explains the right side of the function (for the sake of simplicity I assumed that the central bank’s FX reserves remain the same).

On the left side, the country had a current account deficit because it consumed and invested more than it earned. In other words, if a country does not want to forego a certain level of investment, the more it consumes the higher the current account deficit gets at a certain level of national income. Income minus consumption gives savings. If the level of investments exceeds that of savings, current account deficit will increase. I am sure the majority of my readers are aware of this correlation; but I could not resist writing about it given the arguments against my remarks.

The conclusion is that, first it is already evident where the FX inflows go. There is no need for a specific inscription on the FX notes. Second, at the same level of income and investment the more you consume (the less you save) the higher current account deficit will be. And higher the deficit, the more you will be at the mercy of foreign investors. The function can be modified for different frameworks of analysis.

This commentary was published in Radikal daily on 02.11.2013