Question

You observe that a country has a current account deficit and the foreign reserves of this country’s central bank are increasing. What does this tell you? Explain.

Answer 1

The current account deficit tells us that the value of the imports of the country is less than than the value of the exports.

On the other hand foreign reserves refer to the amount of the foreign currency the central bank keeps with itself.

Now coming to the situation that the country has the current account deficit and the foreign reserves of the country are increasing; this means that the country is importing more products than what it is exporting to other countries. On the other hand the increase in the foreign reserves tells that the government is preparing for meeting the obligations of the payment to the other countries from which the imports have been done or some other obligations. The government accumulates these obligations for atleast three to five months before these are met and the debts are cleared.

Hence if we together see both the conditions then it takes us to the point that the government is preparing itself for the meeting up of the foreign obligations related to the deficits related to the current account.

Reserve accumulation can be an instrument to interfere with the exchange rate. The reserves are an important instrument for the central bank to manage the fluctuations in the exchange rates. Reserves are used as savings for potential times of crises, especially balance of payments crises, mainly related with the current account or the greater value of the imports.