The balance of payments records transactions between residents and non-residents.
Must know
- The current account includes trade and primary and secondary income.
- The capital account differs from the financial account.
- Financing identities do not establish causal behaviour.
Must know definitions
Balance of payments: a record of economic transactions between residents and non-residents over a given period.
Current account: the part of the balance of payments recording trade in goods and services, income, and current transfers.
Financial account: the part of the balance of payments recording changes in ownership of foreign financial assets and liabilities, including FDI and portfolio investment.
Financial flows: an inflow occurs when non-residents acquire domestic assets; an outflow occurs when residents acquire foreign assets. Check the sign convention: an inflow is positive in a net-inflows table, but BPM6 financial-account balances use net asset acquisition minus net liability incurrence.
Current account deficit: a situation where the value of money leaving a country (via imports, income paid out, and transfers) exceeds the value of money entering it.
Expenditure-switching policy: a policy that shifts spending from imports to domestically produced goods, e.g. tariffs or currency devaluation.
Explain and apply
Mechanism in brief: A current-account deficit can accompany investment financed from abroad. Future returns may support repayment, but short-term foreign finance can reverse quickly and create exchange-rate or refinancing pressure.
Distinguish: A current-account deficit is not a fiscal deficit; the accounting balance does not make every imbalance harmless.
Use the extract: Identify the current-account component and the financing flow separately; look for maturity and currency exposure.
Components of the balance of payments
The balance of payments is a record of all of a country's financial dealings with the rest of the world over the course of a year. Exports are a positive/inflow entry (money enters the country), while imports are a negative/outflow entry (money leaves the country).
- Current account — records trade in goods and services, income, and current transfers. The UK has historically run a surplus in services trade but a deficit in goods trade, and traditionally negative current transfers.
Balance of trade
the difference between the value of goods and services exported and imported, split into a trade in goods balance and a trade in services balance.
Primary income
earnings receivable by residents from non-residents, such as relevant employment income, interest, dividends and reinvested earnings, minus corresponding payments abroad. Residence, not citizenship, is the criterion.
Current transfers
Transfers without a direct return, such as qualifying current grants, aid and contributions to international organisations. The UK’s EU membership fees are a historical example.
Capital account — records capital transfers, such as qualifying debt forgiveness and investment grants, and transactions in non-produced non-financial assets. Ordinary purchases of foreign financial assets and FDI belong in the financial account.
Financial account — records changes in ownership of a country's foreign financial assets and liabilities; students should focus especially on FDI flows.
Direct investment
Cross-border investment establishing a lasting interest and significant influence in an enterprise, conventionally at least 10% of voting power. It can involve a wholly owned subsidiary or a joint venture; smaller holdings without significant influence are generally portfolio investment.
Portfolio investment
investment in equities and debt securities.
Financial derivatives
financial instruments whose price is based on an underlying asset, e.g. options, futures, and currency/interest rate swaps.
Reserve assets
foreign financial assets controlled by the monetary authorities (e.g. the central bank) for financing or regulating payments imbalances, such as monetary gold, Special Drawing Rights, and foreign exchange reserves.
Sign convention in these notes: financial inflows are positive and outflows negative. On that basis, current account + capital account + financial account + net errors and omissions = 0. A current-account deficit is offset by the other accounts together; official financial-account data may use the opposite sign convention.
Using this inflows-positive teaching convention, identify whether residents acquire foreign assets or non-residents acquire domestic assets. Financial-account signs should always be checked against the source.
Financial account inflow (+) — capital enters the country
a foreigner buys a domestic asset, or a domestic resident sells/repatriates a foreign asset they previously held.
Financial account outflow (−) — capital leaves the country
a domestic resident buys a foreign asset, or a foreigner sells/repatriates a domestic asset they previously held.
This is why the identity holds: if a UK exporter is paid in US dollars for goods sold abroad, the sale is a current account credit, but the dollars the exporter now holds are a UK-owned foreign asset — recorded as a financial account outflow (UK capital acquiring a foreign asset) of the same value. The two entries are simply two sides of the same transaction, described once in terms of goods and once in terms of the payment used to settle it.
Causes of deficits and surpluses on the current account
| Cause | Effect on the current account |
|---|---|
| Relatively low productivity | Domestic goods become less price-competitive, exports fall and/or imports rise → deficit worsens |
| Appreciation/relatively high value of the currency | Exports become relatively more expensive abroad and imports become cheaper at home → deficit worsens |
| Relatively high inflation | Domestic goods become less price-competitive internationally → exports fall, imports rise → deficit worsens |
| Rapid economic growth | Rising incomes raise demand, including for imports (especially where the marginal propensity to import is high, as in the UK) → deficit worsens |
| Deindustrialisation | A shrinking domestic manufacturing base means goods once produced at home must now be imported → deficit worsens |
| Non-price factors | Poor quality, design, or reliability of exports reduces overseas demand for them → deficit worsens |
Current account surpluses tend to arise from the reverse of these factors — high productivity, a relatively weak/undervalued currency, low inflation, and internationally competitive, high-quality exports.
currency appreciates → exports relatively more expensive, imports relatively cheaper → export demand ↓, import demand ↑ → current account deficit ↑, ceteris paribus
Measures to reduce a country's imbalance on the current account
| Type of measure | Example | How it works | Limitation |
|---|---|---|---|
| Expenditure-reducing | Deflationary fiscal policy (e.g. higher income tax, lower government spending) | Lowers disposable income and AD, so spending on imports falls | Also reduces spending on domestic goods, risking lower growth and higher unemployment; effective mainly in the short term, as spending tends to revert to imports once the policy ends |
| Expenditure-switching | Tariffs, quotas, or a devaluation of the currency (under a fixed exchange rate) | Makes imports relatively more expensive, switching demand towards domestic goods | Risk of retaliation from trading partners, which could reduce export demand too, potentially leaving the deficit uncorrected |
| Monetary policy | Lower interest rates to encourage currency depreciation | Cheaper exports; but can be inflationary domestically, and "hot money" may flow out of the country as investors seek higher returns elsewhere | Difficult to control the money supply precisely in practice, and there is a significant time lag before an effect is seen |
| Supply-side policies | Spending on education/training, deregulation, privatisation | Raises productivity and international competitiveness, encouraging exports to rise, and can attract foreign investment | Significant time lag before results show, so not effective as a short-term fix; privatisation also risks creating monopolies that do not raise efficiency |
Governments could also do nothing, particularly under a floating exchange rate regime, since market forces (a depreciating currency, for example) may correct the imbalance automatically over time. Any active intervention also carries a risk of government failure, since governments often have imperfect information about the true state of the economy.
The significance of global trade imbalances
Since a country's balance of payments must always balance overall, some argue that current account imbalances are not a significant problem. However, the 2008 Global Financial Crisis highlighted that persistently large deficits can be unsustainable in the long run, since financing them relies on continued inflows of foreign investment or borrowing — if investor confidence falls (e.g. Chinese investors losing confidence in US securities), interest rates may have to rise to keep attracting funding, raising debt-repayment burdens for domestic consumers.
Persistent surpluses can also be a problem: resources are directed towards meeting export demand rather than domestic demand, potentially keeping domestic consumer choice and living standards lower than they could be (e.g. China's relatively low consumption and high saving). Trade imbalances can also make economies more interdependent — a country reliant on particular export markets is vulnerable if those markets weaken — and large, persistent imbalances risk destabilising currency fluctuations that disrupt world trade.
The problem is especially acute for fixed-exchange-rate members such as the Eurozone, since they cannot devalue their currency to restore competitiveness when a deficit builds up.
Examine what the deficit finances and the maturity and currency of liabilities. Productive investment with stable funding is more sustainable than weak-return spending dependent on volatile borrowing.
Rapid recap
The current account records trade and income flows; financing appears elsewhere in the balance of payments. An accounting balance does not make a current-account deficit harmless or necessarily harmful.
Diagram cue: trace the spending or currency channel causing the imbalance.
Related chapters: Unit 2 chapter 1 · Unit 4 chapter 7 (p. 35)