Balance of payments: a record of all financial transactions between a country and the rest of the world over a period of time.
Current account: the part recording trade in goods and services, primary income and secondary income.
Capital and financial accounts: the parts recording flows of money and transfers of asset ownership, including investment and official reserves.
- The overall balance of payments always sums to zero: the current account, capital account, financial account and net errors and omissions must offset one another by definition.
- A current account deficit is therefore matched by a surplus on the financial account.
- A country that spends more abroad than it earns must attract matching inflows of money or sell assets to finance the gap.
The Current Account
Trade in goods: exports − imports of physical goods, also called the visible balance.
Trade in services: exports − imports of services such as finance, tourism and insurance.
Primary income: net income earned from assets and work abroad, such as interest, profit and dividends.
Secondary income: net transfers made with nothing given in return, such as foreign aid and remittances.
- The current account balance is the sum of these four components; a deficit occurs when total outflows exceed inflows and a surplus when inflows exceed outflows.
- Countries specialise differently: the UK runs a large surplus on trade in services, led by the City of London, but a persistent deficit on trade in goods.
- Manufacturing exporters such as Germany and China instead run large goods surpluses, the United States runs the world's largest current account deficit, and several developing economies rely heavily on secondary income from workers' remittances.
Suppose a country records a current account deficit of 80 billion pounds in a year when its nominal GDP is 2,000 billion pounds. To judge how significant the deficit is, express it as a share of GDP:
Current account as % of GDP=−802,000×100=−4% \text{Current account as \% of GDP} = \dfrac{-80}{2{,}000} \times 100 = -4\% Current account as % of GDP=2,000−80×100=−4%A deficit of 4% of GDP is generally regarded as moderate. Economists often treat deficits sustained above roughly 5% to 6% of GDP as a warning sign that the imbalance may become hard to finance.
The Capital and Financial Accounts
Foreign direct investment (FDI): long-term investment in productive assets abroad, such as a firm building a factory overseas.
Portfolio flows: purchases of financial assets such as shares and bonds, often called hot money because they can move in and out very quickly.
Reserve assets: holdings of foreign currency and gold that a central bank can use to influence the exchange rate.
Capital account: a small account covering capital transfers such as debt forgiveness and the assets of migrants.
- A financial account surplus finances a current account deficit by bringing in foreign money.
- Inflows of investment offset the net outflow of spending on imports, which is why the overall accounts balance.
Causes of Deficits and Surpluses
- The current account balance depends largely on a country's competitiveness against the rest of the world.
- Weak relative competitiveness widens a deficit as buyers switch to cheaper or better foreign goods.
- A strong exchange rate makes exports dearer and imports cheaper, worsening the current account.
- High relative inflation erodes price competitiveness when domestic prices rise faster than those of competitors.
- Low relative productivity raises unit labour costs and weakens both price and non-price competitiveness.
- Strong domestic growth draws in imports as households and firms spend more.
- Conversely, a recession tends to narrow a deficit as import spending falls.
- Deindustrialisation shrinks the manufacturing base and leaves fewer goods to export.
- The UK's long-run shift from manufacturing to services contrasts with surplus manufacturers such as Germany, while many commodity exporters depend on a narrow range of goods.
- Structural factors such as weak investment or overreliance on a single export can entrench a persistent deficit or surplus.
Correcting an Imbalance
Expenditure-reducing policy: a policy that cuts total demand and so reduces spending on imports.
Expenditure-switching policy: a policy that shifts demand away from foreign goods towards domestic ones.
Supply-side policy: a policy that raises productivity and competitiveness over the longer term.
- Deflationary fiscal or monetary policy, such as higher taxes or interest rates, lowers demand for imports.
- But cutting demand risks slower growth and higher unemployment, so it treats the symptom rather than the cause.
- A depreciation under a floating exchange rate, or a devaluation under a fixed one, makes exports cheaper and imports dearer.
- This improves the balance only if demand for exports and imports is sufficiently price elastic, which the Marshall-Lerner condition states as ∣PEDx∣+∣PEDm∣>1|PED_x| + |PED_m| > 1∣PEDx∣+∣PEDm∣>1.
- Protectionism such as tariffs and quotas cuts imports directly.
- But it risks retaliation from trading partners and raises prices for domestic consumers.
- Supply-side policies raise productivity and export quality over the longer term.
- Investment in skills, infrastructure and innovation lowers unit costs and improves competitiveness, tackling the root cause of a deficit.
Global Trade Imbalances
Global trade imbalances: the pattern of large, persistent current account surpluses in some economies matched by deficits in others.
- Because one country's deficit is financed by another's surplus, imbalances across countries are closely linked.
- Surplus economies such as China, Germany and the oil exporters lend to and invest in deficit economies such as the US and UK.
- Surplus countries accumulate foreign assets, while deficit countries build up external liabilities.
- Large and persistent imbalances raise questions of sustainability.
- A deficit country may build external debt it cannot service, while surplus countries depend on others continuing to spend.
- Imbalances can also fuel currency and political tensions, such as accusations of currency manipulation and calls for tariffs in US-China trade disputes.
Is a current account deficit always a problem?
- It can be a problem because a deficit must be financed by borrowing or selling assets, building external liabilities that may become unsustainable if lenders lose confidence and withdraw funds.
- But a deficit driven by imports of capital goods can raise future productive capacity, and one financed by stable long-term FDI is far less risky than one financed by volatile hot money.
- It also matters whether the exchange rate floats: a floating rate can partly self-correct a deficit through depreciation, whereas a fixed rate may force painful deflationary policy.
- On balance, the danger depends on the deficit's size relative to GDP, its cause and how it is financed, rather than on the deficit itself.
- To calculate the current account, add the four components: trade in goods, trade in services, primary income and secondary income.
- Always state whether a figure is a deficit (negative) or a surplus (positive).
- In evaluation, judge an imbalance by its size, cause and sustainability rather than assuming it is always harmful.
- Anchor answers in UK context, such as sterling, the Bank of England and the UK's persistent current account deficit.
- Do not confuse the current account with the whole balance of payments; it is only one part.
- Remember the overall balance of payments always sums to zero, so a current account deficit is offset by a financial account surplus.
- Use depreciation for a floating exchange rate and devaluation for a fixed one; they are not interchangeable.
- Do not assume a current account deficit is always bad or a surplus always good.
- What are the four components of the current account?
- What do the capital and financial accounts record, including FDI, portfolio flows and reserve assets?
- Name three causes of a current account deficit.
- How do expenditure-reducing, expenditure-switching and supply-side policies each correct an imbalance?
- Why are global trade imbalances between surplus and deficit economies significant?
