Current Account and Balance of Payments

Balance of payments (BoP). A record of all economic transactions between residents of one country and residents of the rest of the world over a given period (usually a year).

Two main accounts:

1. Current account.

The 'flow' of trade and income transactions. Four sub-components:

• Trade in goods (visible trade). Exports and imports of physical goods — cars, clothing, electronics, food.
• Trade in services (invisible trade). Exports and imports of services — banking, tourism, education, IT.
• Primary income. Income earned on FOREIGN ASSETS — interest, dividends, profits — minus payments to foreigners on assets they hold here.
• Secondary income / transfers. Payments without anything received in return — foreign aid, remittances from migrant workers, gifts.

2. Capital / financial account.

The 'flow' of investment transactions:

• Foreign direct investment (FDI) inflows and outflows.
• Portfolio investment (buying foreign shares/bonds).
• Other investment flows.
• Changes in foreign exchange reserves.

Why the BoP balances overall. Every transaction is recorded twice (double-entry bookkeeping). A current account DEFICIT is offset by a capital/financial account SURPLUS, and vice versa.

Worked example. UK runs a £80bn current account deficit. To pay for it, foreigners must invest £80bn in the UK (FDI, buying UK assets, etc.). The capital account shows a £80bn surplus.

Cambridge tip. Mark schemes for "components of the current account" expect ALL FOUR. Memorise: trade goods, trade services, primary income, secondary income.

Current account deficit. When imports + outflows exceed exports + inflows on the current account.

Possible causes:

1. Overvalued exchange rate (SPICED in reverse — strong currency makes exports expensive and imports cheap).
2. High domestic demand (strong growth → more imports).
3. Loss of competitiveness (higher domestic costs vs foreign).
4. Structural change (decline of export industries; growth of import-heavy industries).

Possible consequences:

• Currency pressure. Persistent deficit → currency depreciates over time (under floating) or reserves drain (under fixed).
• Foreign borrowing. Deficit must be financed by foreign capital — government and firms borrow from abroad.
• Loss of confidence. Foreign creditors may eventually balk.
• Debt accumulation. Persistent deficits build up foreign debt.

Are deficits always bad?

NO — short-term deficits can be sustainable, especially if:

• Capital flows in to finance them (FDI, foreign investment in productive capacity).
• The economy is growing rapidly (deficit reflects investment, not consumption).

USA has run persistent deficits for decades — financed by foreigners willing to hold dollars.

Current account surplus. When exports + inflows exceed imports + outflows.

Possible causes:

• Undervalued currency (SPICED — weak currency boosts exports).
• High savings rate (consumers save, less domestic spending → fewer imports).
• Strong export industries.

Possible consequences:

• Currency appreciation pressure (eventually erodes export advantage).
• Trade tensions with deficit countries (China's surpluses ↔ US's deficits = US-China trade tensions).

Are surpluses always good?

NO — large persistent surpluses can:

• Indicate underconsumption / weak domestic demand.
• Provoke retaliation from deficit countries.
• Indicate excessive saving / low investment.

Cambridge tip. Mark schemes for evaluation questions expect candidates to AVOID one-sided framing. Deficit ≠ bad; surplus ≠ good. Persistent imbalances are the issue.

1. Currency depreciation / devaluation.

Make exports cheaper and imports dearer (SPICED in reverse — weak pound = imports dearer, exports cheaper).

Effect: trade balance improves over time.

Limitation: raises inflation (imports more expensive). Effect can be slow (J-curve effect — deficit gets worse before better).

2. Demand-side restraint.

Tighter fiscal / monetary policy → slows economy → less consumer spending → fewer imports.

Effect: import demand falls; trade balance improves.

Limitation: slows growth, raises unemployment. The trade-off is real.

3. Supply-side measures.

Long-term improvement in productivity through education, infrastructure, R&D, deregulation.

Effect: export competitiveness rises in the long run; imports may fall as domestic alternatives improve.

Limitation: very slow (years to decades). Doesn't help with short-term crisis.

4. Direct trade controls (protectionism).

Tariffs and quotas reduce imports.

Effect: improves trade balance directly.

Limitation: invites retaliation, raises consumer prices, breaks international trade rules (WTO).

Choosing the right policy depends on:

• Cause of the deficit (overvalued currency? structural? cyclical?).
• Time horizon (short or long-run focus).
• Other macroeconomic conditions (growth, unemployment, inflation).

Cambridge tip. Top-band evaluation questions expect 2-3 policy options PLUS trade-offs for each. The mark scheme rewards candidates who acknowledge that no policy is costless.