[2.1.1d] Balance of Payments
The Current Account of 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 given period. It has several components, of which the current account is the most closely monitored.
The current account records the flow of money from trade in goods and services, plus income flows and transfers. A current account surplus means a country earns more from abroad than it pays out; a current account deficit means it pays out more than it earns — it is in net debt to the rest of the world on current transactions.
Trade in Goods and Services
Visible trade (trade in goods) covers physical products exported and imported — cars, electronics, food, clothing, oil, machinery. When the value of goods exported exceeds goods imported, there is a trade in goods surplus. When imports exceed exports, there is a trade in goods deficit.
Many developed economies, including the UK, run persistent trade in goods deficits — they import more manufactured goods than they export, partially offset by strong service exports.
Invisible trade (trade in services) covers financial services, insurance, tourism, education, legal services and other intangibles. When service exports exceed service imports, there is a trade in services surplus.
The UK has historically run a surplus in services — particularly financial and professional services centred on the City of London — which has partly offset its goods deficit.
Reasons for Current Account Deficits and Surpluses
| Factor | Effect on Current Account |
|---|---|
| Quality of domestic goods | High quality increases export demand (improving the balance); low quality reduces it (worsening the balance) |
| Quality of foreign goods | High quality of imports attracts consumers away from domestic goods, increasing imports and worsening the balance |
| Price of domestic goods | Lower domestic prices make exports more competitive — improving the balance; high prices reduce export competitiveness |
| Price of foreign goods | Cheaper imports increase import demand, worsening the balance; expensive foreign goods reduce import demand |
| Exchange rates | Currency appreciation makes exports more expensive and imports cheaper — worsening the balance; depreciation has the opposite effect (covered further in benchmark 1354–1355) |
Current Account and Exchange Rates
The current account and the exchange rate are closely linked through supply and demand for the currency:
- A current account surplus means foreigners are buying more of the country's currency (to pay for its exports) than domestic residents are selling (to pay for imports). This increases demand for the currency, tending to appreciate it.
- A current account deficit means more currency is being sold (to pay for imports) than bought (from export earnings). This increases supply of the currency, tending to depreciate it.
In practice, capital flows (investment, speculation) often dwarf trade flows in determining exchange rates, so the relationship is imperfect in the short run.
Impact of a Current Account Deficit
- Leakage from the economy: spending on imports is a withdrawal from the circular flow of income — money flows out of the domestic economy to foreign producers, reducing domestic aggregate demand and the multiplier effect.
- Inflationary pressure if foreign prices rise: a deficit country that depends heavily on imports faces imported inflation when foreign prices rise — higher import costs feed through to domestic prices, raising the CPI.
- Low demand for exports: a persistent deficit often reflects weak export performance — either from poor competitiveness or weak demand in trading partner economies — which limits growth and employment in export industries.
- Problems funding the deficit: a deficit must be financed — either by borrowing from abroad (attracting foreign investment) or by running down foreign currency reserves. If reserves are insufficient and foreign investors lose confidence, the country may struggle to fund the deficit, potentially triggering a currency crisis.
Key Takeaways
- The current account records trade in goods (visibles) and services (invisibles), plus income and transfers.
- A deficit = more paid out than earned from abroad; a surplus = more earned than paid out.
- Deficits and surpluses are determined by: quality and price of domestic and foreign goods, and exchange rates.
- A deficit causes leakages from the circular flow, potential imported inflation, weak export demand and financing challenges.
- Current account surpluses tend to appreciate the currency; deficits tend to depreciate it.