A Practical Guide to the Balance of Payments

What is the balance of payments?

The balance of payments is a record of all cross-border transactions in a given time frame.

There are three components to the balance of payments.

1) The current account includes 

• Exports and imports of goods and services 
• Net primary income (rent, interest and profits from abroad) 
• Net secondary income (gifts, remittances, foreign aid and pensions) 

2) The Financial account includes:

• Foreign direct investment (FDI) – investment in productive facilities e.g. factories.
• Portfolio investment – investments in e.g. stocks and bonds.
• Reserve assets – foreign currency reserves of the central bank.
• Official borrowing – government borrowing from abroad.

3) The capital account includes capital transfers (debt forgiveness, investment grants) and non-produced non-financial assets (natural resources that have not been produced e.g water, mineral rights).

A current account deficit means that the current account is negative – there are more outflows of money than inflows on this account.

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Contents

Is a current account deficit a bad thing?

Many countries have a current account deficit, for example the UK and US.

But is this a bad thing or a good thing?

Aggregate Demand Impact

• Bad – low export income relative to spending on imports, so net exports fall and aggregate demand shifts left. Net exports fall. We can also use the circular flow of income and multiplier effect to strengthen this argument. 
• Good – more imports, possibly cheaper than domestic equivalent, higher living standards. Higher quality and variety – seasonal goods from abroad.

Financial Account 

• Not so bad – a current account deficit can be supported with a financial account surplus. In the UK lots of inward investment might mean it’s less of a problem.
• Bad – a financial account surplus means increased foreign ownership of domestic assets, meaning a greater proportion of the income streams from those assets (interest, dividends etc.) are heading abroad rather than remaining in the domestic economy.

Other Considerations

• Bad – if the current account deficit reflects low productivity, it is probably a bad thing. Low productivity means slower economic growth, so lower real GDP/income.
• Mixed – A current account deficit can lead to a depreciation [see the explanation at the bottom of this page]. This may improve export competitiveness and hence the current account deficit may self-correct somewhat. However it makes imports more expensive and could raise inflation.

Whether a current account deficit is undesirable depends on:

• Whether the current account deficit is temporary or permanent.
• The cause of the current account deficit, in particular whether the cause is weak productivity performance or rising real incomes.
• The size of any current account deficit.

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What can cause a current account deficit?

When it comes to causes of a current account deficit, a good way to think about this is to consider: what causes high imports or low exports.

Causes of a current account deficit can include:

• Stronger pound: remember the SPICED acronym (Stronger pound imports cheaper exports dearer). Exports dearer so less export demand, so current account deficit worsens.
• High inflation in the UK relative to inflation abroad. If Exports are dearer in the UK, then there is less export demand, so the current account worsens.
• Quality of exports relative to the quality of other countries’ exports – if domestic exports are lower quality compared to competitors, then obviously there will be less demand for domestic exports.
• Low productivity relative to other  economies, so production costs are higher, so export prices are higher, so domestic exports become less competitive.
• Increasing real incomes relative to other economies leading to higher consumer spending on imports.

The key in these causes is that they are all “relative”. For example the UK’s productivity does not matter in isolation. But what is more important is how it compares to other countries’ productivity levels.

One could argue increasing globalisation has contributed to the UK’s budget deficit. Cheaper labour abroad has led to offshoring of production and greater imports. For more about globalisation, check out the blue button below:

The UK’s current account deficit

In 2021, the UK’s current account deficit was 2.6% of GDP. The UK has consistently run an annual current account deficit since the mid 1980s.

Why has the UK had a current account deficit for so long? 

The fact the current account deficit has been around so long likely reflects low productivity in the UK relative to other competitor nations, particularly when it comes to goods.

There are likely other factors behind the UK’s current account deficit too. In particular in recent years, the UK has also been in deficit in terms of net primary and net secondary income, two other key components of the current account.

For the most recent data on the UK’s current account, I recommend two links:

• Data on the UK’s current account deficit relative to GDP from Trading Economics here.
• A breakdown of the balance of payments from the Office for National Statistics here.

Policies to correct a current account deficit

There are three types of policies to correct a current account deficit:

The first type is “expenditure-switching” policies, switching spending away from imports and towards domestic products. Policies here include depreciation / devaluation of the currency and protectionism.

The second type is “expenditure-reducing” policies. By reducing overall expenditure, import spending will fall and thus the current account improves. This includes contractionary fiscal and monetary policy.

Supply-side policies can also be used though I consider these to belong to their own separate category.

Depreciations / Devaluations

Consider a depreciation of the currency (also known as a devaluation in the case of a fixed exchange rate regime). 

This makes exports cheaper and imports dearer and hence should raise exports, reduce imports and improve net exports and the current account.

Particularly in a floating exchange rate regime, currency fluctuations can automatically correct for current account imbalances.

But there are caveats:

• The Marshall-Lerner and J-curve conditions come into play. In short, a depreciation may not always improve net exports and the current account. I will cover this in more detail in a separate exchange rate article.
• In most developed economies, the exchange rate is not targeted nor is it used as an instrument or policy tool.

Monetary Policy

Increasing interest rates will have two contrasting effects:

First, higher interest rates mean increased reward for saving and increased cost of borrowing. So there is lower consumption, reduced aggregate demand and hence a lower price level in equilibrium. In theory this acts as an expenditure-reducing policy, reducing spending on imports and improving the current account. Also because the price level has fallen, domestic exports will become more price-competitive, increasing export demand.

However, higher interest rates can lead to an appreciation of the currency. Higher interest rates generate hot money inflows into the country from investors seeking higher returns. This means higher demand for the domestic currency to invest or save in the domestic economy, hence an appreciation. An appreciation makes exports dearer and imports cheaper, reducing export demand and increasing import demand, reducing net exports and moving the current account further into deficit.

Supply-side Policies

Supply-side policies can include the market-based policies (e.g. privatisation or deregulation) and the interventionist policies (e.g. infrastructure or education spending).

These supply-side policies generate an increase in productivity, so the LRAS shifts right as in the diagram. This means a lower price level, increased competitiveness of UK exports and hence an improved current account. 

However many supply-side policies can take time to implement.

Increasing productivity is not sufficient to reduce the size of the current account deficit. Productivity needs to increase relative to productivity in competing economies. If other countries are improving their productivity as well and if a gap remains between UK and competitor nations’ productivity, then maybe export demand will not increase as much. For example the UK has about 30% lower productivity (output per hour) compared to the US.

For more on supply side policies, check out the article below:

Fiscal Policy

Contractionary fiscal policy could include increasing taxes or cutting government spending. Higher taxes, for example income taxes, reduces disposable income for consumers, which reduces consumption. Also AD shifts left. Similarly for cutting government spending, as G is a component of AD, AD shifts left too. So there is a lower price level, so exports become more price competitive, so export demand rises. The current account improves. 

An example of this is Greece. Following the 2008 financial crisis, Greece had to cut spending to receive loans from IMF/European Commissions. The goal of cutting spending was to improve competitiveness of Greece, as well as to help reduce budget deficit. Specific policies included cutting public sector workers’ pay and privatising the port of Piraeus.

One big issue with contractionary fiscal policy is the tradeoff with other macroeconomic objectives. Contractionary fiscal policy is likely to reduce real GDP and domestic employment, harming living standards.

The ability of contractionary fiscal policy to improve the current account  depends on:

• The marginal propensity to import (MPI). If high, then lower real income/GDP means import spending falls more, improving the current account to a greater degree
• Also the state of economy, crucially how near the economy is to full capacity. Use a Keynesian (long-run) aggregate supply curve. If the economy is near full capacity, contractionary fiscal policy mainly lowers the price level without reducing real GDP as much. However if spare capacity is high (or there is already a deep recession), contractionary fiscal policy could worsen a recession. In the example of the policies in Greece, Greek youth unemployment rose to the extremely high rate of 50%.

Protectionism – For Example Increasing Tariffs

• Tariffs reduce price competitiveness of imports and increase price competitiveness of exports. See the tariff diagram. The tariff increases the price and reduces imports from (Q3-Q) to (Q2-Q1). A reduction in imports means a reduction in the size of the current account deficit.
• However there may be retaliatory tariffs. For example after the US raised tariffs on steel and aluminium, other countries followed with higher tariffs of their own, including the EU, leading to a trade war. Retaliatory tariffs make domestic exports less competitive and can nullify any gains from protectionism. 
• Tariffs also create welfare losses as shaded in pink in the diagram. Consumers are worse off from the higher prices 
• The success of tariffs will depend on: the degree of retaliation, the price elasticities of demand (and supply) for exports and imports; how the tariff revenue is used by the government (for example the money could go towards investing back into infrastructure to improve domestic productivity and competitiveness).

Note on policies to tackle a current account surplus, these policies will be the opposite to the policies mentioned above. For example expansionary fiscal policy, removing protectionist measures, appreciation of the currency and so on.

For more on tariffs, click the blue button below:

To learn about the theory of comparative advantage and its relation to trade, click the link below:

The implications for the global economy of a major economy or economies with imbalances deciding to take corrective action. 

Consider this example question: The US has suggested imposing tariffs on EU aluminium and steel. Consider the effect of such tariffs on the EU economy.

Supply and demand

Using the tariff diagram above, we can show the amount of imports decrease. This will harm demand for the products of UK producers. This means lower profits, wages and reduced investment.

Evaluation: how much trade do we do with the US relative to other countries. The UK trades most with the EU. While the US is the country with whom the UK does the most trade, an even greater proportion of UK trade is with the EU. Maybe the UK can rely on export demand from other countries, making this effect less significant.

Aggregate Supply / Aggregate Demand – Net Exports

AD-AS: AD shift left as UK exports to the US fall. Price level decreases, real GDP decreases. AD could shift further left because of the multiplier effect. Multiplier: change in a component of AD leads to a larger than proportionate change in national income.

Evaluation: level of spare capacity: if low spare capacity, then little fall in real GDP but large fall in price level. While the UK unemployment rate is still relatively low at 4.9%, over 11 million workers are on the furlough scheme, suggesting there may be significant spare capacity, which makes this problem worse. Therefore the fall in UK exports could be detrimental to the UK economy.

Retaliation

Retaliation – maybe the UK puts in place its own tariffs in response – mitigate damage to domestic producers. 

Then the US could raise tariffs further – lose-lose scenario for both countries. 

The effects on the UK economy of a US tariff are negative overall. The most important reason for this is because of AD shifting left having a negative effect because of significant spare capacity. [And/or retaliation would lead to a lose-lose scenario as US tariffs might go up further].

Other evaluation points to consider:

• Depends on whether the corrective action, in the form of tariffs, is short-term or permanent.
• The tariff costs may be small in comparison to other non-tariff barriers. This could include rules of origin, SPS rules for pest control and cleaning. So tariffs may be less influential on the cost of trade. 
• Depends on the number of industries covered by the tariffs.
• Another key factor is the number of industries dependent on the industry or industries facing the tariff.

Other questions

How does the balance of payments balance / equal zero? How can “disequilibrium” be corrected?

In theory the balance of payments equals zero because of currency market equilibrium. 

Consider the supply of and demand for a particular currency such as the US Dollar ($). If the balance of payments is overall negative, this would mean higher supply of currency (e.g. imports) than demand for the currency (e.g. exports).

If supply exceeds demand, there is a surplus of currency, so the price of the currency falls until supply of the currency equals demand for the currency.

A fall in the price of the currency, in other words a depreciation, means exports are cheaper and imports dearer. So there are increased exports and decreased imports, moving the balance of payments towards zero. 

Sometimes you will see the terms “credits” and “debits”. Credits refer to items that add to the balance of payments, for example exports; while debits refer to items that take away from the balance of payments like imports.

Equilibrium in the currency market means the demand for currency equals the supply of that currency, which is equivalent to saying credits are equal to debits.

Why can a current account deficit cause depreciation of the currency?

A current account deficit means outflows on the current account are greater than inflows. This is likely to mean imports exceed exports (though note there are other components to the current account – see the definitions above).

High imports relative to exports means the supply of the currency is likely to exceed demand at the current exchange rate (you can either show this as a shift right in supply or a shift left in demand). This creates a surplus of currency, leading to a depreciation until supply of and demand for the currency are equal once more.

I will cover more on exchange rates and currency in a separate article.

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