Current account of the balance of payments
The balance of payments (BoP) is a record of all economic transactions between residents of a country and the rest of the world over a specific period. The current account is the most significant component, recording the flow of goods, services, and income.
The current account consists of four main sections:
- Trade in Goods (Visible Trade): Exports and imports of physical items (e.g., cars, oil, food).
- Trade in Services (Invisible Trade): Exports and imports of intangible services (e.g., tourism, banking, insurance, education).
- Primary Income: Income earned from factors of production (labor and capital) across borders. This includes:
- Wages earned by residents working abroad.
- Profits, dividends, and interest received from foreign investments held by residents.
- Secondary Income: One-way transfers where no good or service is exchanged in return. This includes:
- Government grants (foreign aid).
- Remittances sent by migrant workers to their home countries.
The Current Account Balance Formula:
\text{Current Account Balance} = (X_g + X_s) - (M_g + M_s) + NI
Where:
- X_g = Exports of goods
- X_s = Exports of services
- M_g = Imports of goods
- M_s = Imports of services
- NI = Net Primary Income (Income received from abroad minus income paid to foreigners)
- Note: Secondary income is often included in the broader 'Net Current Transfers' but for calculation purposes, it is added to the balance if positive or subtracted if negative.
| Example |
|---|
| Japan exporting cars to the UK; UK importing oil from Saudi Arabia. |
| A French student paying tuition to a UK university (UK export); A German tourist staying in a Spanish hotel (Spain export). |
| Dividends paid by a US company to its British shareholders; Wages earned by a Filipino nurse working in the UK. |
| The EU sending aid to a developing country; A worker in Canada sending money to their family in Mexico. |
Current Account Deficit: Occurs when the total value of debits (imports, income paid) exceeds the total value of credits (exports, income received). The country is a net borrower from the rest of the world.
Balance of Payments Identity:
The current account cannot exist in isolation. By definition:
\text{Current Account} + \text{Capital/Financial Account} = 0
Therefore, a current account deficit must be financed by a surplus in the capital/financial account. This means the country is either:
- Borrowing from abroad (increasing foreign liabilities).
- Selling assets to foreigners (e.g., selling land, companies, or government bonds).
This implies that a persistent current account deficit leads to an increase in the country's net foreign debt.
- Exports of goods: 100bn</li> <li>Imports of goods:120bn
- Exports of services: 40bn</li> <li>Imports of services:35bn
- Net Primary Income: -5bn (more income paid out than received)</li> <li>Net Secondary Income: +2bn (more aid/remittances received than sent)
Calculation:
- Balance on Trade in Goods: 100 - 120 = -20 bn
- Balance on Trade in Services: 40 - 35 = +5 bn
- Net Primary Income: -5 bn
- Net Secondary Income: +2 bn
Total Current Account Balance:
(-20) + (+5) + (-5) + (+2) = -18 \text{ bn}
Country A has a current account deficit of $18bn. This must be financed by a surplus in the capital/financial account (e.g., foreign investment inflows).
Correction:
- Current Account Deficit: Relates to international trade (imports > exports) and income flows between countries. It is a macroeconomic external balance issue.
- Government Budget Deficit: Relates to domestic fiscal policy where government spending exceeds tax revenue (G > T).
While they can be related (e.g., through the 'Twin Deficits' hypothesis), they are distinct concepts. A country can have a current account surplus and a government budget deficit simultaneously.
Correction: You must sum all four components. A country can have a massive surplus in primary income (e.g., Norway from oil investments) but still run a current account deficit if its trade in goods and services deficits are even larger. Always calculate the net total.
Why examiners accept this: Examiners look for clear identification of credits (positive) and debits (negative). A common error is forgetting that Primary Income can be negative. If income paid abroad exceeds income received, it is a debit.
Correct Usage Example:
'First, calculate the balance on trade in goods: Exports (100m) minus Imports (120m) equals -20m. Then add the balance on services (+5m), net primary income (-5m), and net secondary income (+2m). The total is -$18m, indicating a deficit.'
Why examiners accept this: This addresses the composition of the current account. A student must recognize that trade in goods is only one part. Large outflows of primary income (e.g., profits repatriated by multinational corporations) can turn a trade surplus into a current account deficit.
Correct Usage Example:
'Although Country X has a surplus on trade in goods, it may still have a current account deficit if its net primary income is significantly negative. This occurs when foreign-owned companies operating in Country X send their profits back to their home countries.'
- High demand for imports: Rapid economic growth increases domestic income, leading to higher demand for imported consumer goods and capital equipment (machinery) needed for development. If the marginal propensity to import is high, this widens the trade deficit.
- Lack of competitiveness: Developing countries may lack advanced technology or infrastructure, making their exports less competitive in terms of quality or price compared to developed nations. This leads to low export volumes.
- Low inflation relative to trading partners: If a country has lower inflation than its competitors, its goods become relatively cheaper, increasing exports and decreasing imports (improving price competitiveness).
- Strong brand reputation/Quality: High-quality products (e.g., Swiss watches, German cars) have inelastic demand globally, allowing the country to export large volumes at premium prices, generating significant trade surpluses.
- Deficit: A current account deficit means M > X. Since GDP = C + I + G + (X - M), a larger M reduces net exports, acting as a drag on GDP growth. However, if the deficit is due to importing capital goods that boost future productivity, it may be beneficial.
- Surplus: A surplus increases net exports, directly boosting aggregate demand and GDP in the short term.
Impact on Employment:
- Deficit: High imports can lead to job losses in domestic industries that cannot compete with foreign goods. However, if the deficit is financed by foreign direct investment (FDI), it may create jobs in export-oriented sectors.
- Surplus: Increased demand for exports typically leads to higher employment in export industries.
Impact on Inflation:
- Deficit: A large deficit often puts downward pressure on the domestic currency (see below). A weaker currency makes imports more expensive, potentially causing cost-push inflation.
- Surplus: Can lead to appreciation of the currency, making imports cheaper and helping to keep inflation low.
Impact on Foreign Exchange Rate (Market Mechanism):
- Deficit: To pay for the deficit, residents must sell their domestic currency to buy foreign currency. This increases the supply of the domestic currency in the forex market, causing it to depreciate. A depreciating currency makes exports cheaper and imports more expensive, which helps correct the deficit over time (automatic adjustment).
- Surplus: High demand for the domestic currency to pay for exports causes it to appreciate. This makes exports more expensive and imports cheaper, which tends to reduce the surplus over time.
Financing the Deficit (Crucial Concept):
A current account deficit must be matched by a capital/financial account surplus. This means the country is either:
- Borrowing: Taking loans from foreign banks or issuing bonds abroad.
- Selling Assets: Foreigners buying domestic assets (stocks, property, companies).
Long-term Risk: Persistent deficits lead to a buildup of net foreign debt. If investors lose confidence, they may stop lending, leading to a currency crisis.
Correction: A surplus means high demand for the domestic currency (to buy exports). This drives the currency up (appreciates). Conversely, a deficit means selling the domestic currency, causing it to depreciate.
Mistake: Thinking that increasing import duties reduces a current account surplus.
Correction: Import duties make imports more expensive, reducing imports. This would increase a surplus (or reduce a deficit). To reduce a surplus, a government would typically want to encourage imports or discourage exports.
Why examiners accept this: Examiners look for the distinction between financing and funding. A deficit is not inherently bad if it finances productive investment (capital goods) that boosts future exports. It is only dangerous if it finances consumption.
Correct Usage Example:
'A current account deficit is sustainable if it is financed by foreign direct investment in productive sectors, as this increases future export capacity. However, if it is financed by borrowing to fund consumption, it leads to unsustainable levels of external debt.'
Limitations (J-Curve Effect): In the short term, demand for imports and exports is often inelastic (contracts are already signed). Therefore, the value of imports rises immediately (due to higher prices) before quantities adjust. This causes the deficit to worsen initially before improving, creating a 'J-curve' shape.
Time Lag: It takes time for consumers and producers to find alternatives. Supply-side policies take years, while devaluation works faster but may cause inflation.
- Devaluation: Effective if Marshall-Lerner condition holds. However, it can cause cost-push inflation.
- Tariffs/Quotas: Directly reduce imports immediately. However, they violate WTO rules, may trigger retaliation, and protect inefficient domestic industries.
Direct Controls (e.g., Import Quotas, Tariffs):
- Effectiveness: Very effective in the short term as they physically limit import volumes.
- Drawbacks: Distort market mechanisms, reduce consumer choice, and can lead to black markets. They do not address the underlying lack of competitiveness.
Comparison: Direct controls provide immediate results but are economically inefficient and politically contentious. Expenditure-switching via devaluation is more market-friendly but slower and subject to inflationary pressures.
Effectiveness:
- Pros: They address the root cause of uncompetitiveness. Lower costs and higher quality make exports more attractive and imports less desirable in the long run. They do not distort trade rules.
- Cons: They have long time lags (years or decades). They may be ineffective if the deficit is due to a temporary recession (demand-side issue) rather than structural issues. They are also expensive for the government.
Conclusion: Best for long-term structural deficits, but not suitable for short-term stabilization.
To achieve balance of payments stability, governments can use:
Expenditure-Switching Policies: Aim to switch spending from foreign goods to domestic goods.
- Devaluation/Depreciation: Lowers the value of currency. Makes exports cheaper, imports expensive.
- Tariffs and Quotas: Make imports more expensive or limited in quantity.
Expenditure-Reducing Policies (Demand Management): Aim to reduce overall domestic demand, including demand for imports.
- Contractionary Fiscal Policy: Increase taxes, decrease government spending. Reduces disposable income and consumption.
- Contractionary Monetary Policy: Increase interest rates. Reduces borrowing and consumption.
Supply-Side Policies: Aim to improve the competitiveness of domestic industries.
- Investment in Infrastructure/Technology: Lowers production costs.
- Education/Training: Increases labor productivity.
- Deregulation: Reduces business costs.
Direct Controls:
- Import Quotas: Physical limits on quantity.
- Export Subsidies: Encourage exports by lowering their cost.
Capital Account Interventions:
- Selling Foreign Reserves: The central bank sells foreign currency to buy domestic currency, supporting the exchange rate (used to prevent excessive depreciation during a deficit).
Why examiners accept this: Examiners require you to consider time lags, elasticity, and side effects. A policy is not effective if it causes inflation or recession. You must weigh the pros and cons.
Correct Usage Example:
'Devolution may reduce a deficit by making exports cheaper, but its effectiveness depends on the price elasticity of demand for exports (Marshall-Lerner condition). If demand is inelastic, the deficit may worsen initially (J-curve). Furthermore, devaluation can cause cost-push inflation, which may erode competitiveness again. Therefore, it should be combined with supply-side policies to ensure long-term stability.'
- Rise in exchange rate: Makes exports more expensive for foreigners.
- High inflation: Domestic costs rise, making exports less price competitive.
- Fall in global demand: Recession in trading partner countries reduces their income and demand for imports.
- Lower quality: If the country fails to innovate, its products may become less attractive compared to competitors.