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George Soros had this to say about the factors surrounding his famous short of the British pound:

The U.K. had a large current-account deficit…, modest FX reserves and no capital controls to rebuff the speculators,” he said.“In short, it was a sitting duck.

I'm thinking maybe the opposite would be true. The fact the UK had a current account deficit would seem to imply a depreciating currency, with cheaper exports and more expensive imports. At this juncture, I would think more investors would buy in to the currency, enticed by the prospect of asset appreciation. So wouldn't it make more sense to view current account deficits as having appreciating pressures (rather than depreciating)?

I doubt my econ is better than a billionaire, so I'm hoping (and anticipating) someone can explain the flaw in my logic.

Question

Why does having a current account deficit contribute to making a country vulnerable to hedge funds shorting the currency?

Note: I did not stipulate assumptions about the currency regime in question. Base case can be for a peg (the system used by the GBP at the time), but if other regimes (floating, currency board) merit a look, I'll leave them as optional.

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    $\begingroup$ Your question does not seem to take into account that the British pound was pegged at the time. For a floating currency - like the pound now - the usefulness of the current account in predicting currency changes is questionable. Conversely, pegged currencies are subject to runs, which is what Soros was discussing. $\endgroup$ – Brian Romanchuk Jul 28 at 10:24
  • $\begingroup$ @BrianRomanchuk you should post this as an answer $\endgroup$ – 1muflon1 Jul 28 at 12:39
  • $\begingroup$ @1muflon1 The issue is that the question might be changed in response. $\endgroup$ – Brian Romanchuk Jul 28 at 13:24
  • $\begingroup$ @BrianRomanchuk I was aware of the peg but perhaps not so aware of its importance to the question. I'm ok with an answer along those lines, how the current account impacts currencies under floating and pegged regimes. (will simply add a footnote to the question) $\endgroup$ – Arash Howaida Jul 29 at 5:28
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I do not think this answer is definitive, but want to point out that there are two very different regimes: pegged or floating currencies.

For a pegged currency, the central bank (or similar body) is attempting to keep the currency value pegged to an external currency or gold. (I am assuming this is a traditional peg, and not a currency board.) A current account deficit implies a capital inflow, and implies a drain on central bank reserves if the private sector is not acting to support the peg. Since the central bank cannot create whatever it is pegging at will, it would eventually be forced off the peg or to devalue. (It can absorb inflows indefinitely.) One can look at the history of the Gold Standard/Bretton Woods era to see this, or search for the literature on “rational currency runs.”

For a floating currency, the currency value can go up or down. The currency market is a market, and at least some weak version of the Efficient Markets Hypothesis applies - it is not easy to make money with simple rules based on public information (other than taking on risk premia, like owning equities for the long term). One cannot look at central bank foreign currency reserves and decide that the currency will move one way or another. Presumably, a country that loses export competitiveness will eventually have its currency lose value, but we can look at countries like the United States or Australia and see that they can support current account deficits for long periods without anything too interesting happening to the currency. That said, many people extrapolate the pegged situation to floating currencies in market commentary.

Since there’s not a whole lot of interest in articles that state “we cannot find a relationship between the current account deficit and the currency value,” it would be harder to find literature on the subject.

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