Question

Describe three means by which a current account deficit in a developing country

is financed. (By “financed,” I mean “paid for,” “covered” or “balanced” in

accounting terms. “Increase exports” or “decrease imports” are not correct

answers since they refer to future actions a country may take, not to how a

current account deficit is balanced/financed today.)

Answer 1

A current account can be financed in several ways depending upon who is financing the deficit. As the question is concerned with financing the current account deficit in the short run, below are the three ways in which it can do that.

1. Financing through international financial institutions - A country can finance its current account deficit by borrowing funds from an international financial institutions with the promise of returning the principal amount and interest rate applicable at the time agreed by both the parties. For example - Russia borrowed $22.6 billions from  IMF and world bank in 1988.
2. Financing through other country's government - Government of country A can borrow funds from government of country B. One of the ways is that the government of country A issues the government bonds which is then bought by government of country B. For example, Greece borrowed funds from Germany before the euro crisis of 2008.
3. Financing through international private players - A country can borrow funds from foreign private players like commercial banks. For example, India had around 20%-25% of the total capital inflows in terms of external commercial borrowings in 2012.

Though increasing imports and exports may not be considered as the short run cure to the current account deficit problem, but a country can consider devaluing its domestic currency which can be done immediately. Though the effects of change in exchange rate will take some time to show.