Balance of payments

AQA also says:

Spec content: Components of the balance of payments; Current account deficit and surplus; Causes and consequences of current account deficits.

Students should be able to understand: the components of the balance of payments; the meaning of current account deficit and surplus; the causes and consequences of a current account deficit; simple calculations involving the balance of payments.

What is the Balance of Payments?

The balance of payments is a record of all financial transactions between a country and the rest of the world over a period (usually one year). It has two main accounts:

  • Current account — records trade in goods and services, income flows, and current transfers. The most closely watched component.
  • Capital and financial account — records flows of investment and financial assets (foreign direct investment, portfolio investment, changes in reserves).

The overall balance of payments always balances (by accounting convention) — a current account deficit must be financed by a surplus on the capital/financial account (i.e. borrowing from abroad or selling assets to foreign investors).

The Current Account

The current account has four components:

  • Trade in goods (visible trade) — exports minus imports of physical goods. The UK typically runs a large deficit here (imports more goods than it exports).
  • Trade in services (invisible trade) — exports minus imports of services (financial services, tourism, education, insurance). The UK typically runs a surplus — London is a global financial centre.
  • Primary income — investment income flows: interest, profits, and dividends earned abroad minus those paid to foreign investors in the UK.
  • Secondary income (transfers) — government transfers (e.g. EU contributions, foreign aid) and private remittances.

Current account balance = Trade in goods + Trade in services + Primary income + Secondary income

A current account deficit means the country imports more in total (goods, services, income) than it earns from exports. A surplus means the opposite.

Causes of a Current Account Deficit

  • Strong domestic demand — a growing economy sucks in imports of consumer goods and capital equipment
  • Overvalued exchange rate — UK exports become expensive for foreign buyers; imports are cheap for UK consumers
  • Low international competitiveness — if UK productivity and quality lag behind competitors, demand for UK exports may be weak
  • High domestic inflation — makes UK exports relatively more expensive than those of lower-inflation competitors

Consequences of a Current Account Deficit

  • Must be financed by capital inflows (foreign investment, borrowing) — creates external debt obligations
  • Downward pressure on the exchange rate — demand for foreign currencies to pay for imports exceeds demand for pounds
  • May indicate weak export sector and structural competitiveness problems
  • Can be sustainable if financed by productive FDI (which builds future export capacity) but less so if financed by short-term borrowing

 Key Takeaways

  • Balance of payments = current account + capital/financial account. Overall balance always balances.
  • Current account = trade in goods + trade in services + primary income + secondary income.
  • UK typically: deficit on goods, surplus on services.
  • Causes of deficit: high demand, overvalued exchange rate, poor competitiveness, high inflation.
Students should be able to understand: the components of the balance of payments; the meaning of current account deficit and surplus; the causes and consequences of a current account deficit; simple calculations involving the balance of payments.