Country A has a current account deficit of 8% of GDP, a real growth rate of 5%, and a real interest rate on its external debt of 2%. Country B has a current account deficit of 3% of GDP, a growth rate of 1%, and a real interest rate of 4%. Which country's deficit is more likely to be sustainable?
ACountry B, because a smaller deficit always signals greater sustainability
BCountry A, because its real growth rate exceeds its real interest rate, so the external debt-to-GDP ratio shrinks over time even with a persistent deficit
CCountry B, because real interest rates above 3% indicate creditor concern about repayment
DBoth are equally unsustainable since any persistent current account deficit implies growing foreign debt
The key diagnostic is the comparison of r (real interest rate) and g (real growth rate), not the raw deficit size. For Country A, g = 5% > r = 2%, meaning the economy is growing faster than the interest burden — the external debt-to-GDP ratio will shrink over time even without fully closing the deficit. Country B faces r = 4% > g = 1%, meaning the debt ratio is growing even before new borrowing; stabilizing it requires a primary surplus. A large deficit can be sustainable if g > r; a small deficit may be unsustainable if r > g.
Question 2 Multiple Choice
Country X runs a large current account deficit financed mainly by short-term portfolio capital flows (bonds and equities purchased by foreign investors). Country Y runs the same-sized deficit financed mainly by foreign direct investment (factories and long-term assets). Which country is more vulnerable to a sudden stop?
ACountry X, because short-term portfolio flows can reverse rapidly if investor sentiment shifts, whereas FDI is illiquid and committed long-term
BCountry Y, because FDI gives foreign entities ownership of domestic assets, creating political risk
CBoth equally — the deficit size determines vulnerability, not the composition of financing
DCountry X is less vulnerable because liquid markets allow faster adjustment when deficits need to close
The composition of capital inflows is as important as their size. Short-term portfolio flows can be reversed in hours or days as investors sell bonds and equities — this is 'hot money.' When global risk appetite shifts or country-specific doubts arise, these flows can stop suddenly, forcing an abrupt current account adjustment (devaluation, austerity). FDI is embedded in physical assets and ongoing business operations; foreign companies cannot easily liquidate a factory and leave. The Southeast Asian crisis of 1997 illustrated this: countries with high short-term debt were devastated by sudden stops, while FDI-heavy economies were more resilient.
Question 3 True / False
A current account deficit financed by foreign borrowing used to build productive infrastructure can be sustainable if the resulting economic growth rate exceeds the real interest rate on the borrowed funds.
TTrue
FFalse
Answer: True
This is the intertemporal sustainability condition applied to its most favorable case. The US in the 19th century ran persistent current account deficits as European capital financed railroad and industrial expansion. The resulting productivity growth generated incomes that eventually repaid the debt. The CA = S − I identity shows a deficit means investment exceeds saving; if investment is productive, the future output it generates provides the repayment capacity. The formal condition g > r ensures the debt-to-GDP ratio is self-correcting without requiring a primary surplus.
Question 4 True / False
A country with a current account deficit is generally consuming beyond its means, which is a sign of economic weakness.
TTrue
FFalse
Answer: False
A current account deficit means CA = S − I < 0, i.e., investment exceeds saving. This can reflect high investment (building productive capacity, not excess consumption) rather than low saving. A deficit is a sign of excess consumption if S is low and not offset by productive I; it is a sign of economic dynamism if I is high and generating future returns. The US, Australia, and many fast-growing emerging economies have run persistent deficits while remaining creditworthy. The relevant question is always: what is the deficit financing? Consumption-driven deficits with low growth are concerning; investment-driven deficits in high-growth economies may be entirely benign.
Question 5 Short Answer
What is a 'sudden stop,' and why can it render a current account position that appears mathematically sustainable — by the r-versus-g criterion — practically unsustainable?
Think about your answer, then reveal below.
Model answer: A sudden stop is an abrupt reversal of capital inflows: foreign lenders or investors stop rolling over loans and refuse to extend new credit, forcing the borrowing country to immediately close or dramatically shrink its current account deficit. Even if g > r makes the long-run debt trajectory technically sustainable, the country still needs to continuously attract foreign financing to fund its deficit. If creditor confidence collapses — due to political instability, contagion from other crises, or a shift in global risk appetite — the financing dries up before the long-run arithmetic can play out. The country is then forced into a painful adjustment: devaluation, import compression, and recession.
The Southeast Asian crises of 1997–98 are the canonical example. Countries like Thailand and South Korea had defensible debt ratios and reasonable growth outlooks, yet faced devastating sudden stops when short-term foreign borrowing was not renewed. The lesson is that sustainability is not just a property of the debt trajectory — it depends on maintaining creditor confidence, which can be fragile and self-fulfilling. A country that looks sustainable can become unsustainable the moment enough creditors believe it is, creating a coordination failure.