A Current Account Deficit That Will Not Close
The current account deficit has widened to 8.2% of GDP even though the terms of trade improved by 12% as uranium and fish prices rose. Exports are 30% of GDP; imports are 45% and dominated by fuel, machinery, vehicles and food. Domestic credit is growing 13% and household spending 6%. Reserves cover 3.2 months of imports. The currency is pegged to the rand, and about 60% of external debt is denominated in US dollars. Inflation is 5.5%. The finance ministry is choosing between a one-off 15% devaluation and a package of higher taxes and lower public spending. Exporters support devaluation; importers and unions oppose it. Studies estimate that the sum of export and import price elasticities is about 0.8 in the first year and 1.6 after two years.
1. Explain how the current account deficit could widen despite a 12% improvement in the terms of trade.
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A terms-of-trade gain raises the purchasing power of each unit of exports: the same volume of uranium and fish now buys 12% more imports. The income effect is powerful in a country where imports are 45% of GDP. Higher export earnings raise national income, and a large share of each extra dollar is spent on imported fuel, machinery, vehicles and food, so the trade balance can worsen even though export prices have risen.
The volume response may be limited. If the uranium mine is already at capacity, higher prices raise revenue without raising export volumes, while the income and investment response raises imports immediately. Mining investment itself imports machinery. Profits remitted abroad by foreign-owned mines also worsen the income account, so the current account can deteriorate while the trade account looks healthy.
There may also be a Dutch disease mechanism. Resource revenues support domestic spending and a strong real exchange rate, pulling resources into non-tradable services and making other exports less competitive. Credit growth of 13% and household spending growth of 6% indicate strong domestic demand, which sucks in imports. Finally, the J-curve effect means volume responses lag price changes. A wider deficit after a terms-of-trade gain is therefore not a contradiction; it is the expected result when the income effect dominates and supply is capacity-constrained.
2. Using the elasticity estimates, assess whether a 15% devaluation would correct the deficit, and evaluate its side effects.
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The Marshall-Lerner condition says a devaluation improves the trade balance if the sum of the export and import price elasticities exceeds one. Here the sum is 0.8 in the first year, so a 15% devaluation initially worsens the trade balance: import volumes fall only a little while import prices in domestic currency rise, so the import bill rises more than export earnings. After two years the sum is 1.6, above one, so volumes dominate and the trade balance improves. The path is a J-curve.
Side effects are serious. If imports are 45% of GDP and the import content of the CPI is similar, a 15% devaluation adds up to 0.45 x 15 = 6.75 percentage points to consumer prices over the following year. Inflation of 5.5% could double, real wages fall, and the union may demand indexation, producing a wage-price spiral that erodes the competitive gain. About 60% of external debt is in US dollars, so the local-currency cost of servicing rises by 15%, worsening the fiscal position and possibly the credit rating. Reserves of 3.2 months are thin, and a one-off devaluation under a peg may invite speculation about further devaluations, causing capital flight. Trading partners may also see it as a beggar-thy-neighbour policy.
Judgement: devaluation could work on the two-year horizon given elasticities of 1.6, but only if accompanied by fiscal restraint, a clear nominal anchor and measures to protect the poor from food and fuel prices. A devaluation without supporting policy would mainly raise inflation.
3. Evaluate whether the alternative package of higher taxes and lower public spending is preferable, and assess a proposal to impose tariffs on food imports.
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Expenditure-reducing policy attacks the deficit from the demand side. Higher taxes and lower spending reduce national income and therefore import spending; with imports at 45% of GDP, a fall in domestic demand of, say, 3% could cut imports by more than 1% of GDP. It also reduces the risk premium and protects reserves without the inflation shock of devaluation. But it is contractionary: growth and employment fall, and cuts to health, education and infrastructure may lower long-run productivity. The composition matters: cutting untargeted fuel subsidies or low-priority consumption spending is less damaging than cutting capital projects.
A food tariff is a second-best instrument. It raises the domestic price, reduces import volumes and may improve the trade balance if demand is elastic, while protecting domestic farmers. But it is regressive, since poor households spend a larger share of income on food; it invites retaliation and smuggling; it distorts production towards crops in which the country may have a comparative disadvantage; and the welfare loss to consumers usually exceeds the producer gain. Tariff revenue is small relative to the distortion.
Judgement: a combination is best. Fiscal consolidation should be gradual and protect capital and social spending; devaluation should be considered only with a credible anchor and after fiscal tightening, because it works after two years but raises inflation and debt service immediately. Food tariffs should be avoided in favour of targeted transfers and investment in irrigation and storage, which address the supply constraint rather than suppressing trade.