Economics (0455) | Current account of balance of payments

Study Notes: The Current Account of the Balance of Payments (0455)

Hello Economists! This chapter is all about how a country manages its money flow with the rest of the world. Think of the Balance of Payments (BOP) as the national financial diary, meticulously recording every single transaction between the country and foreign residents over a year.

Our main focus is the Current Account, which tells us if we are earning enough from trade and investments to cover what we spend abroad. Understanding this is vital because stability in the Current Account is a key goal for any government!

What is the Balance of Payments (BOP)?

The BOP is a systematic record of all economic transactions between residents of one country and the rest of the world over a specific period (usually a year). It must always balance overall, but its key sub-sections—like the Current Account—can show a deficit or a surplus.

Section 1: The Structure of the Current Account (6.4.1)

The Current Account tracks the movement of goods, services, and income (both earned and transferred) across borders. It is often divided into four main components.

Memory Aid: GST-IS

You can remember the components of the Current Account using the simple mnemonic GST-IS: Goods, Services, Income (Primary), and Secondary Income (Transfers).

1. Trade in Goods (Visible Trade)
   

   This records the value of physical, tangible products exported (sold abroad, credit/inflow) and imported (bought from abroad, debit/outflow).

   Example: China exporting smartphones to the UK, or the USA importing oil.

   The balance of Trade in Goods is calculated by: Value of Goods Exports - Value of Goods Imports.

2. Trade in Services (Invisible Trade)
   

   This records the value of non-physical services sold (exports/credit) and purchased (imports/debit).

   Example: A German tourist spending money on a hotel in Spain (a Spanish export of tourism services), or a Japanese firm paying a US company for legal advice.

Quick Note: The Balance of Trade
When we combine the balance of Goods and the balance of Services, we get the Balance of Trade (often called the trade balance).

3. Primary Income (Net Investment Income)
   

   This measures the flow of income earned from factors of production (like capital and labour) owned in another country. It is essentially money earned on international investments.

   Example: Dividends and profits earned by a UK shareholder from shares they own in a French company (credit), or interest paid to foreign investors who hold government bonds (debit).

4. Secondary Income (Net Current Transfers)
   

   These are one-way transactions where money moves across borders with no corresponding flow of goods, services, or assets in return. Think of them as international gifts or charity.

   Example: International aid donated by a rich country (debit), or money sent home by a migrant worker (remittances) to their family in their home country (credit for the home country).

Section 2: Current Account Deficits and Surpluses (6.4.1)

To calculate the overall Current Account balance, you add up the net balance of all four components:

Current Account Balance = (Net Trade in Goods) + (Net Trade in Services) + (Net Primary Income) + (Net Secondary Income)

Current Account Deficit

A Current Account Deficit occurs when the total value of money flowing out (debits) is greater than the total value of money flowing in (credits).
This usually means a country is importing more than it is exporting and/or paying out more investment income than it receives.

Current Account Surplus

A Current Account Surplus occurs when the total value of money flowing in (credits) is greater than the total value of money flowing out (debits).
This means a country is earning more from its trade and international income than it is spending.

Analogy: Imagine the Current Account is your personal bank account dedicated to your job (exports/income). If you spend more than you earn, you run a deficit. If you earn more than you spend, you run a surplus.

Section 3: Causes of Current Account Imbalances (6.4.2)

Why do countries end up in deficit or surplus? The reasons are diverse, often relating to changes in competitiveness, domestic economic activity, or government policy.

Causes of a Current Account Deficit

1. High Domestic Inflation: If prices are rising faster at home than abroad, domestic goods become less price-competitive. Foreigners buy fewer exports (credits decrease), and domestic consumers buy more imports (debits increase).
2. Strong Exchange Rate: A strong domestic currency makes exports more expensive for foreign buyers and imports cheaper for domestic buyers, worsening the trade balance.
3. High Domestic Income/Economic Growth: When an economy is growing quickly, people have more money and tend to buy more, often sucking in imports. This increases debits.
4. Low Productivity and Quality: If domestic firms are inefficient or their goods are of poor quality compared to international competitors (a non-price factor), export demand falls.
5. Structural Issues: Lack of investment in key export sectors or a dependency on importing essential raw materials (like oil).

Causes of a Current Account Surplus

A surplus is generally caused by the opposite factors:

1. Low Domestic Inflation: Makes exports highly competitive.
2. Weak Exchange Rate: Makes exports cheap and imports expensive.
3. Strong Global Demand: If trading partners are experiencing rapid economic growth, they demand more of our exports.
4. High Competitiveness: Advanced technology, high quality goods, and high levels of productivity.
5. Savings Habits: If a country saves a lot and invests heavily abroad, they will generate large inflows of Primary Income, boosting the surplus.

Section 4: Consequences of Current Account Imbalances (6.4.3)

Current account imbalances have significant implications for the four main macroeconomic aims: GDP, employment, inflation, and the foreign exchange rate.

Consequences of a Current Account Deficit

1. Impact on GDP and Economic Growth:

   A deficit means money is leaving the circular flow of income (M > X). This represents a leakage, which will reduce Aggregate Demand (AD), leading to slower GDP growth.

2. Impact on Employment:

   Lower demand for domestically produced goods (as consumers buy imports) leads to lower output, which may cause unemployment in domestic industries.

3. Impact on Foreign Exchange Rate:

   To pay for the net imports, the country must supply more of its own currency to the foreign exchange market. This increase in supply causes the domestic currency to depreciate (fall in value).

4. Impact on Inflation:

   If the currency depreciates (as above), imports become more expensive. This increases the costs of raw materials and imported final goods, leading to cost-push inflation.

5. Increased Indebtedness:

   Persistent deficits must be financed, usually by borrowing from abroad or selling domestic assets. This can lead to increased national debt and future obligations.

Consequences of a Current Account Surplus

1. Impact on GDP and Economic Growth:

   A surplus means money is flowing into the circular flow (X > M). This represents an injection, boosting Aggregate Demand (AD), potentially increasing GDP and growth.

2. Impact on Employment:

   Higher demand for domestic exports leads to increased production and lower unemployment.

3. Impact on Foreign Exchange Rate:

   Foreigners demand the domestic currency to buy the country's net exports. This increased demand causes the domestic currency to appreciate (rise in value).

4. Impact on Inflation:

   The high demand for exports can put pressure on domestic resources, potentially leading to demand-pull inflation.

5. Trade Friction:

   Large, persistent surpluses (like those experienced by countries such as Germany or China) can lead to trade tensions with deficit countries.

Did you know? China’s large current account surpluses in the early 2000s resulted in massive appreciation pressure on its currency, the Yuan, which led to trade disputes with the US and Europe.

Section 5: Policies to Achieve Balance of Payments Stability (6.4.4)

Governments aim for BOP stability, meaning avoiding persistent, large deficits or surpluses. Policies generally target the trade balance.

Don't worry if this seems tricky at first—these policies are the same tools you studied in the Macroeconomics section (Chapter 4), just applied to a specific international goal!

1. Monetary Policy (Interest Rates and Exchange Rates)

If a country has a large deficit, the Central Bank might raise interest rates.

Mechanism:

1. Higher interest rates discourage borrowing and encourage saving domestically, reducing spending power.
2. Lower domestic demand means reduced demand for imports (M decreases).
3. Higher interest rates attract foreign 'hot money' investment, causing the currency to appreciate (though this is often seen as a conflict with the goal of increasing exports).

Effectiveness: This works quickly to reduce import spending, but its effect on the exchange rate can make exports even less competitive, possibly making the trade deficit worse in the long run.

2. Fiscal Policy (Taxes and Government Spending)

To combat a deficit, the government can adopt deflationary fiscal policy (increasing taxes and/or reducing government spending).

Mechanism:

1. Higher taxes or lower spending reduce the disposable income of consumers.
2. Lower income leads to reduced overall demand in the economy.
3. Reduced domestic demand means less money is spent on imports (M decreases).

Effectiveness: This is generally effective for reducing imports but carries a major drawback: it slows economic growth and risks increasing unemployment.

3. Supply-Side Policies

Supply-side policies are the most sustainable way to achieve long-term BOP stability, as they focus on improving the quality and competitiveness of domestic goods.

Measures Include:

• Education and Training: Improves the quality of the labour force, leading to higher productivity.
• Investment in Infrastructure: Better roads, ports, and communications reduce costs for exporting firms.
• Deregulation/Lower Direct Taxes: Improves incentives for firms to invest and innovate, enhancing international competitiveness.

Effectiveness: These policies increase both price and non-price competitiveness (better quality, lower cost), boosting exports (X increases) without requiring the government to slow down the economy. However, they take a very long time to implement and show results.

4. Protectionist Measures (Tariffs and Quotas)

Protectionism directly limits imports to reduce a deficit.

• Tariffs: Taxes on imported goods, making them more expensive than domestic goods.
• Quotas: Physical limits on the quantity of goods that can be imported.

Effectiveness and Drawbacks: These measures are quick, but highly controversial. While they reduce imports, they can invite retaliation from trading partners, leading to international trade wars. They also reduce consumer choice and may lead to domestic monopolies becoming inefficient due to lack of foreign competition.