Current Account and Balance of Payments

A current account deficit occurs when the value of a country's imports and other outflows exceeds the value of its exports and inflows on the current account (1) — that is, the country spends more on trade, income and transfers with the rest of the world than it earns (1).

Balance on trade in goods = exports − imports = $400bn −$500bn = **−$100bn** (a goods deficit) (2). Balance on trade in **services** =$150bn − $90bn = +$60bn (a services surplus). Overall trade balance (goods + services) = −$100bn +$60bn = **−$40bn** (a deficit of$40bn) (2).

Rapid economic growth raises households' incomes, and as people become better off they spend more on goods and services — including imported ones such as cars, electronics and foreign holidays. Because a portion of every extra dollar of income is spent on imports (the marginal propensity to import), faster growth tends to pull in more imports. At the same time, if the country's trading partners are growing more slowly, demand for its exports may not rise as quickly, so imports grow faster than exports. This widening gap between imports and exports worsens the trade balance and pushes the current account towards deficit. Strong domestic demand can also create inflationary pressure, raising domestic prices and making exports less competitive, which reinforces the deficit. So rapid growth can cause a deficit because rising incomes suck in imports faster than exports grow.

A large, persistent current account deficit means a country is continually spending more abroad than it earns, and this has several consequences. First, it must be financed: the country has to borrow from abroad or sell domestic assets to foreigners, which builds up external debt and future interest payments. Second, pressure on the currency: persistent excess demand for foreign currency (to buy imports) tends to cause the currency to depreciate under a floating system, or drain foreign-exchange reserves. Third, effects on output and jobs: if residents are buying imports instead of domestic goods, demand for home-produced output falls, which can reduce growth and employment. Fourth, loss of confidence: foreign lenders and investors may lose confidence in the economy, making it harder or more expensive to borrow. So a large persistent deficit can lead to rising debt, currency pressure and weaker confidence — though a small or temporary deficit need not be harmful.

A depreciation can reduce a current account deficit, but whether it is the best way is debatable. Why it works: a weaker currency makes exports cheaper abroad and imports dearer at home (WPIDEC), so exports rise and imports fall, improving the trade balance; it can be brought about relatively quickly. Drawbacks and alternatives: the improvement depends on price elasticities — if demand for exports and imports is inelastic, the balance may not improve and could even worsen at first (the J-curve); a depreciation also causes imported inflation (dearer raw materials and energy), which raises costs and can erode the competitiveness gain; and it lowers living standards by making imports dearer. Alternatives include demand-side restraint (higher taxes/interest rates to cut import spending — but this slows growth and raises unemployment) and supply-side policies (training, infrastructure, technology to raise competitiveness lastingly — but these are slow). Judgement: a depreciation can be an effective and quick way to reduce a deficit when demand is price-elastic, but it is not always the best because of imported inflation and the elasticity condition. For a lasting improvement, supply-side policies that raise genuine competitiveness are often better, even though they take longer. So the best policy depends on elasticities and the time horizon, and a combination is often used.

It is tempting to assume a surplus is always the goal, but this is debatable. Why aiming for a surplus seems sensible: a surplus means exports exceed imports, so there is strong demand for domestic goods, supporting output and jobs; the country earns more than it spends abroad, building up reserves and foreign assets; and it signals competitiveness. Why a surplus should not always be the aim: a large surplus often means a country is consuming less than it could — exporting goods rather than letting its own citizens enjoy them — so current living standards may be lower; persistent surpluses cause the currency to appreciate, which makes future exports dearer and erodes competitiveness; they can provoke trade tensions and retaliation from deficit partners; and a deficit is not always bad — a temporary deficit that imports capital goods can raise future growth, so aiming relentlessly for a surplus may sacrifice useful investment and consumption. Judgement: a country should generally aim for a sustainable balance rather than always a surplus — a moderate surplus or a small, well-financed deficit can both be healthy. A large surplus is not automatically the best outcome because of the cost to living standards and the risk of currency appreciation and trade friction. So the aim should be balance and sustainability, not a surplus at all costs.