Current account composition and sustainability of external debt

Abstract

If an economy runs a current account (CA) deficit and finances it via a corresponding net inflow of equity capital the external debt (ED) does not change, i.e. the CA deficit does not add to ED. This is no paradox. It simply comes from the definition of CA deficit and ED, and points to different degrees of sustainability of CA deficits according to the way they are financed and to the composition of the CA itself. By the evaluation of the determinants of interest rates spreads vis a vis US lending rates we assess the sustainability of CA deficits. We find that FDI net inflows (proxy of equity capital) allow emerging economies to sustain larger CA imbalances with respect to CA deficits financed by inflows of more liquid assets. Equity capital is a way to finance the CA. It does not contribute to the ED and it affects the solvency assessment of a country.