Current account imbalances shift financial wealth from deficit nations to surplus nations. Over time, this may lead to shifts in global asset preferences, which, in turn, could affect the path of exchange rates and hence optimal portfolio holdings.
Quoted from Institute readings
In first line , current account imbalances should shift financial wealth from surplus to deficit nations ( because current account deficit nations have a higher interest rate genrally) ? Am i right ?
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This refers to the Portfolio balance approach. When there is a persistent current account imbalance, the deficit nations face a higher risk premium. This leads to a shift of the wealth from the deficit nations to surplus nations and thus changes the portfolio of global holdings.
Hope this helps!
In the portfolio balance approach, global investors are assumed to hold a diversified portfolio of domestic and foreign assets, including bonds. Now, these bonds are issued mostly by countries running Current Account deficits ( say the US). They’re borrowing from the rest of the world ( by issuing such bonds) and running their operations, thereby, capital account surplus and current account deficit.
Now, these bonds will be willingly held only if investors ( maybe countries with current account surplus), are compensated in the form of a higher expected return. Such a return could come from an immediate depreciation of the currency to a level sufficient to generate anticipation of gains from subsequent currency appreciation, The currency adjustments required in such a case is the core of the portfolio balance approach.
Secondly, such current account surplus countries might find that their US dollar-denominated holdings actually exceed the amount they desire to hold in their portfolio. Thereby, they might decide to reduce their holdings and sell-off. This in turn will depreciate have a negative impact on the dollar’s value. Thereby, money is moving out from deficit nations ( say the US) to surplus nations.