A portfolio manager is analyzing a country with a persistent current account deficit. The country's government has recently initiated discussions to join a regional free trade agreement (FTA). The manager is assessing the potential long-term impact of this FTA membership on the country's current account balance. Which of the following is the most likely long-term effect of joining an FTA on the country's current account balance?
- AA sustained improvement in the current account balance due to greater export opportunities.
- BAn ambiguous effect, as it depends on whether trade creation outweighs trade diversion and the country's comparative advantages.
- CNo significant impact, as current account balances are primarily driven by domestic savings-investment imbalances.
- DAn immediate and sustained increase in the current account deficit due to increased import competition.
Show answer & explanationAnswer & explanation
Correct answer: B. An ambiguous effect, as it depends on whether trade creation outweighs trade diversion and the country's comparative advantages.
The long-term impact of joining an FTA on a country's current account balance is ambiguous. It depends on several factors, including whether the FTA leads to more 'trade creation' (replacing inefficient domestic production with lower-cost imports from a partner) or 'trade diversion' (shifting imports from a more efficient non-member to a less efficient member). It also depends on the country's comparative advantages, its ability to increase exports to partner countries, and how the agreement affects domestic production and consumption patterns. There is no guaranteed improvement or deterioration.
Why the other options are wrong
- A. Incorrect. While greater export opportunities are possible, there's no guarantee, and potential import increases or trade diversion could offset this.
- C. Incorrect. While savings-investment imbalances are fundamental drivers of the current account, trade agreements directly impact the trade balance (a component of the current account), making their effect significant, even if not always predictable.
- D. Incorrect. While increased import competition is possible, it's not the only outcome, and export opportunities could also arise.
Trade Creation vs. Trade Diversion
Trade creation occurs when FTA members shift from high-cost domestic production to lower-cost imports from a partner. Trade diversion occurs when FTA members shift from lower-cost imports from a non-member to higher-cost imports from a partner.
- Trade creation generally improves welfare; trade diversion generally reduces welfare.
- The net effect of an FTA on welfare (and trade balance) depends on the relative magnitude of these two effects.
- Factors like comparative advantage and initial trade patterns influence the outcome.
Memory trick: FTA: Create or Divert? The balance is key.