The balance of payments (BoP) is a comprehensive record of a country’s economic transactions with the rest of the world, detailing trade, income flows, and investment transfers.
The structure of the balance of payments
The balance of payments is a national accounting framework used to record all economic transactions between the residents of a country and the global economy during a specific time period, usually quarterly or annually. It provides vital insights into a nation’s economic relationships with other countries and its position in the global marketplace.
The BoP is divided into three primary components:
The current account,
The capital account,
The financial account.
While the capital and financial accounts are often grouped together due to their smaller relative size and nature, all three components must, in theory, balance overall. Any deficit or surplus in the current account is offset by an equivalent movement in the capital and financial accounts.
The current account
The current account covers flows of goods, services, income, and current transfers. It is the most closely monitored part of the BoP and a crucial indicator of a country’s international economic performance.
1. Trade in goods (visible trade)
Exports and imports of physical goods such as cars, food, oil, and electronics.
When export revenues exceed import expenditure, there is a trade surplus; if imports exceed exports, a trade deficit occurs.
2. Trade in services (invisible trade)
Covers intangible products, such as tourism, financial services, education, insurance, and transport.
The UK, particularly London, often runs a surplus in services due to its strength in financial markets.
3. Primary income
Refers to income from ownership of assets abroad. This includes:
Dividends from foreign shares,
Profits earned by domestic firms from foreign subsidiaries,
Interest received from loans made to foreign borrowers.
It also includes income paid to foreign investors in domestic enterprises.
4. Secondary income (transfers)
Comprises unilateral transfers with no corresponding exchange. Examples include:
Remittances sent home by foreign workers,
Government contributions to international institutions (e.g., the UN or former EU budget contributions),
Overseas aid,
Pensions received from or paid to another country.
A current account surplus implies that a country earns more from its transactions with the rest of the world than it spends. In contrast, a current account deficit shows that a country is spending more on foreign goods, services, and income flows than it earns.
The capital and financial account
The capital and financial account records transactions that relate to the acquisition or disposal of financial and non-produced, non-financial assets. It reflects how a country funds a current account deficit or uses the surplus.
The capital account
The capital account is relatively minor in scale and records capital transfers and acquisition or disposal of non-produced, non-financial assets. Examples include:
Debt forgiveness, where one government cancels a foreign debt,
Transfer of ownership of fixed assets, such as land,
Migrant transfers, i.e. movement of personal capital when individuals emigrate or immigrate.
The financial account
The financial account is far larger and captures cross-border flows of financial capital. It consists of:
1. Direct investment
Involves long-term investment in tangible assets such as factories or businesses abroad.
For example, a UK firm setting up a subsidiary in India, or a US firm buying a British company.
2. Portfolio investment
Includes short-term investments such as purchasing shares, bonds, or other financial instruments issued in another country.
Foreign investors buying UK government bonds is an example.
3. Other investment
Encompasses loans, deposits, and trade credits.
This category reflects general cross-border lending or borrowing by banks, firms, and governments.
4. Reserve assets
These are official reserves held by the central bank, including:
Foreign currencies,
Special Drawing Rights (SDRs),
Gold reserves,
International Monetary Fund (IMF) reserve positions.
Used to manage exchange rate stability and intervene in currency markets when necessary.
Since all payments and receipts must balance overall, the BoP identity holds:
Current Account + Capital Account + Financial Account = 0
(Errors and omissions are included to ensure balance in practice.)
Causes of current account surpluses and deficits
Several factors can explain why some countries run consistent surpluses while others face persistent deficits. These causes can be structural or cyclical in nature.
1. Consumption patterns
When households and governments in a country consume more than they produce, demand for imports increases.
High levels of household spending, especially on imported goods, lead to trade deficits.
Countries with low savings ratios and high marginal propensity to import are prone to current account deficits.
2. Exchange rate fluctuations
An appreciated exchange rate makes imports cheaper and exports less competitive, widening the current account deficit.
A depreciated exchange rate improves export competitiveness and raises the domestic price of imports, which can reduce a deficit or generate a surplus.
Currency misalignment can lead to long-term imbalances. For example, if a country maintains an artificially low exchange rate, it may achieve a persistent surplus.
3. International competitiveness
Countries that are efficient and productive often enjoy a comparative advantage in high-value exports.
Wage levels, regulation, infrastructure, and innovation capacity affect competitiveness.
A loss of competitiveness may cause firms to lose market share abroad, increasing reliance on imports and worsening the current account.
4. Fiscal policy and budget balances
Expansionary fiscal policy (tax cuts or increased government spending) can increase domestic demand and import volumes.
Budget deficits may contribute to twin deficits – where both the fiscal and current account are in deficit.
Countries with tight fiscal policy may reduce imports and improve the current account.
Other contributing factors include:
Demographic shifts, which influence savings and investment trends,
Resource endowments, such as oil or minerals, which can generate trade surpluses,
Global trade conditions, which determine demand for exports.
Measures to reduce current account imbalances
Governments and policymakers can employ various strategies to correct unsustainable current account deficits or surpluses, depending on the underlying causes.
1. Expenditure-reducing policies
These aim to decrease domestic demand, thereby reducing imports and improving the current account balance.
Fiscal tightening:
Increasing taxes or reducing government spending to lower aggregate demand.
Monetary tightening:
Raising interest rates to discourage consumption and investment.
Benefits:
Effective in curbing import demand when the current account deficit is demand-driven.
Drawbacks:
May slow economic growth, increase unemployment, and lead to recession.
Not suitable if the deficit is caused by structural supply-side issues.
2. Expenditure-switching policies
These are designed to encourage households and firms to switch their expenditure from foreign to domestic goods.
Exchange rate adjustments:
A currency depreciation (under floating rates) makes exports more competitive and imports more expensive.
Marshall-Lerner condition:
A depreciation will improve the current account if the sum of the price elasticities of demand for exports and imports is greater than 1.
J-curve effect:
Initially, a depreciation may worsen the trade balance before improving it, as volumes adjust more slowly than prices.
Protectionist policies (covered in detail in 4.1.6) may also fall into this category but are often restricted under international agreements.
Risks:
May lead to inflationary pressures,
Potential for retaliatory action from trade partners,
Can provoke currency wars if multiple countries attempt to devalue simultaneously.
3. Supply-side policies
These aim to improve the underlying productivity and competitiveness of the domestic economy over the long term.
Examples include:
Investment in education and training to raise labour productivity,
Infrastructure development to reduce transport costs and increase efficiency,
Deregulation and labour market reforms to enhance flexibility,
Innovation support to raise product quality and technological advantage.
Advantages:
Promote sustainable export growth,
Help reduce reliance on imports,
Boost overall economic growth and employment.
Limitations:
Take time to have an impact,
Require significant public and private investment,
Results may not be guaranteed.
Significance of global imbalances
Persistent current account imbalances between major economies can have wide-reaching consequences for international stability, investment flows, and political relations.
The China–US trade imbalance
The United States has long experienced a large current account deficit, particularly with China.
China historically ran significant surpluses due to its export-led growth strategy.
Contributing factors:
High Chinese savings and limited domestic consumption,
US consumers’ reliance on cheap Chinese imports,
Accusations of currency manipulation, with China allegedly keeping the yuan undervalued to support exports.
Consequences:
Growing tensions and threats of tariffs and protectionism,
Accumulation of US Treasury bonds by China to finance the US deficit,
Risk of unsustainable debt and financial dependence.
Eurozone internal disparities
Within the Eurozone, there are significant imbalances:
Countries like Germany and the Netherlands run large surpluses,
Others like Greece, Portugal, and Spain have historically run deficits.
Causes:
Varying levels of productivity and wage growth,
Structural differences in competitiveness,
The Euro prevents deficit countries from devaluing their currency to regain competitiveness.
Effects:
Contributed to the Eurozone debt crisis,
Austerity measures in deficit countries led to social unrest,
Need for fiscal transfers and greater integration to manage the disparities.
Broader economic implications
Global imbalances can lead to:
Volatile capital flows, increasing the risk of financial crises,
Asset bubbles, particularly when surplus countries reinvest abroad,
Political tensions, with growing nationalism and protectionism.
International bodies like the International Monetary Fund (IMF) and G20 often step in to mediate and coordinate policy responses to reduce systemic risks.
FAQ
A current account surplus might indicate strong export performance or a competitive economy, but it is not always a sign of economic strength. In some cases, a surplus can result from weak domestic demand, where households and firms save excessively and consume less, dampening economic growth. It may reflect structural imbalances such as an ageing population that saves more and spends less, reducing consumption and import demand. Additionally, countries with persistently large surpluses may face international criticism for contributing to global imbalances, as their excess savings are often recycled into deficit economies, fuelling credit bubbles or financial instability. Moreover, reliance on exports makes an economy vulnerable to external shocks and changes in global demand. In the long term, a surplus may also signal underinvestment in domestic infrastructure or consumption, leading to social and economic underperformance. Thus, while surpluses can be beneficial, they are not inherently superior to balanced trade positions.
Income elasticity of demand (YED) affects how demand for imports and exports changes as national income changes. If a country’s imports have a high YED, a rise in domestic income will lead to a proportionally greater increase in import demand, worsening the current account balance. This is common in developed economies where rising incomes encourage consumption of luxury goods, many of which are imported. Conversely, if a country’s exports are income-inelastic in foreign markets, even global economic growth may not substantially boost export revenues. Developing countries that export primary commodities often face this issue, as demand for raw materials grows more slowly than income. As a result, even when global incomes rise, their trade balance may not improve significantly. On the other hand, if a country exports income-elastic goods, such as high-tech or branded products, it benefits from growing foreign demand. Therefore, income elasticity shapes how trade responds to economic cycles and affects BoP sustainability.
A current account deficit can put downward pressure on a country's currency. This is because a deficit implies that the country is importing more than it is exporting, leading to higher demand for foreign currency to pay for imports. At the same time, there is relatively less demand for the domestic currency from abroad, as fewer exports are sold. This imbalance in currency demand and supply can lead to a depreciation of the domestic currency under a floating exchange rate system. If investors perceive the deficit to be unsustainable, it may lead to capital flight or reduced foreign investment, worsening the pressure on the currency. Over time, depreciation may help correct the deficit by making exports more competitive and imports more expensive, assuming elastic demand. However, in the short run, it can also cause imported inflation and erode purchasing power. Therefore, while depreciation can be a correcting mechanism, it also introduces risks for inflation and investor confidence.
Demographic changes significantly influence long-term trends in the balance of payments. An ageing population often results in higher savings and lower consumption, particularly of imported consumer goods, which may lead to a current account surplus. Countries like Japan and Germany demonstrate this pattern. On the other hand, younger populations tend to spend more, potentially increasing demand for imports and creating a current account deficit, especially if domestic production cannot meet consumption needs. Labour force size also affects productivity and export capacity. A shrinking working-age population can reduce economic output and competitiveness, limiting a country’s ability to earn from exports. In contrast, countries with growing populations may benefit from increased human capital and productivity, enhancing export potential. Migration also plays a role, influencing remittance flows in the secondary income balance. Thus, population size, age structure, and workforce participation all have long-term implications for trade flows, investment patterns, and the sustainability of the BoP position.
Foreign exchange reserves play a crucial role in helping a country manage balance of payments problems, particularly in maintaining exchange rate stability and supporting investor confidence. When a country experiences a current account deficit, it may face downward pressure on its currency. The central bank can use its foreign exchange reserves to intervene in the currency market by selling foreign currency and buying the domestic currency, thereby supporting its value. This can prevent excessive volatility and protect against inflation caused by a depreciating currency. Reserves also provide a buffer in times of external shocks, such as sudden capital outflows or commodity price swings, allowing the central bank to meet international payment obligations without resorting to emergency borrowing. Maintaining adequate reserves can reassure foreign investors and credit rating agencies, helping preserve access to international capital markets. However, accumulating reserves often comes at a cost, including opportunity costs and potential inflationary pressures if sterilisation is not managed effectively.
Practice Questions
Explain two reasons why a country might experience a current account deficit on its balance of payments.
A country may experience a current account deficit due to a fall in international competitiveness, making exports less attractive and imports relatively cheaper, reducing net exports. Factors such as high unit labour costs, weak productivity, or poor infrastructure contribute to this. Another reason could be a strong domestic currency, which appreciates against others and makes imports cheaper and exports more expensive. This worsens the trade balance as import volumes rise and export demand falls, increasing the current account deficit. Both reasons reduce net inflows from trade, leading to a persistent imbalance on the current account.
Evaluate expenditure-switching and supply-side policies as methods of correcting a persistent current account deficit.
Expenditure-switching policies, such as currency depreciation, can improve competitiveness and reduce a current account deficit by making exports cheaper and imports dearer. However, their success depends on the Marshall-Lerner condition and may initially worsen the deficit due to the J-curve effect. Conversely, supply-side policies aim to improve long-term productivity and reduce costs through investment in education, infrastructure, and innovation. These create sustainable improvements but take time to be effective. While switching policies offer quicker results, they can cause inflation and retaliation. Therefore, supply-side reforms may be more effective in correcting structural deficits over the long term.
