4.1.7 Balance of payments – Edexcel Economics A notes

Contents

What are the components of the balance of payments?

The balance of payments is a record of all cross-border transactions.

There are three main components of the balance of payments:

• Current account
  • Current account = exports and imports of goods and services + net primary income + net secondary income.
  • Net primary income includes rent, profit and interest income coming from abroad.
  • Net secondary income includes gifts, remittances, foreign aid and pensions.
• Financial account
  • The financial account includes foreign direct investment, portfolio investment, central bank foreign exchange reserves and government borrowing from abroad.
  • 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.
• Capital account
  • The capital account includes so-called “capital transfers” such as debt forgiveness.
  • It also includes the transfer of other assets (“non-produced non-financial assets”) such as rights to water or minerals.

What causes a current account deficit or surplus?

A current account deficit occurs when the outgoings on the current account exceed the incoming items.

Causes of a current account deficit in the UK can include:

• Increasing real incomes domestically relative to other economies
  • This leads to higher consumer spending on imports, leading to a growing current account deficit.
• Stronger pound
  • Remember the SPICED acronym (Stronger pound imports cheaper exports dearer).
  • A stronger pound makes exports dearer. So there is less export demand, so current account deficit expands.
• 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 deficit grows.
• 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.
  • In this case, the current account deficit will expand.
• Low productivity growth relative to other economies.
  • In this case, production costs are higher relative to other countries. This could be measured using “unit labour costs” – the cost of labour required to produce one unit of a good.
  • So export prices are higher domestically, so domestic exports become less competitive. This reduces export demand, leading to a current account deficit.
  • In other words, we expect countries with higher unit labour costs (relative to other economies) to have current account deficits.

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.

Briefly, the causes of a current account surplus are the opposite. For instance, lower inflation relative to inflation rates abroad or higher productivity relative to other economies.

About the UK’s current account deficit

In 2023, the UK’s current account deficit was 3.3% 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.

What measures can reduce 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.

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. Instead there is often a floating exchange rate, where the exchange rate is determined by supply of and demand for the currency, rather than by central bank intervention.

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.
• This reduces the size of the current account deficit.

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.
• This reduces net exports and moving the current account further into deficit.

Whether higher interest rates reduce the size of the current account deficit depends on which of these effects outweighs the other.

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. There can be significant time lags, for instance with education spending where it takes time to learn and apply the skills taught.

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.

• Lower government spending reduces aggregate demand, as G is a component of AD. So AD shifts left.
• So there is a lower price level, so exports become more price competitive, so export demand rises.
• This increase export revenues, so the current account deficit is reduced, moving closer to balance.

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, critically 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 above.
  • 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 by other countries.
  • 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.

What are the consequences of global trade imbalances?

What are the consequences of current account deficits at a national level?

On the one hand, a current account deficit can harm the domestic economy:

• Lower net exports → lower AD, as X is a component of AD → lower growth, employment.
• There may also be a negative multiplier effect.
• Imports being high may reflect an overreliance on imports from other countries. This creates a risk of being cut off from imports, such as energy, during conflict or when there are global supply shortages.
• A current account deficit suggests there may be a financial account surplus to balance the balance of payments.
  • This means there is likely to be a net inflow of investment into the country.
  • However this means increased foreign ownership of domestic assets, such as factories and businesses.
  • This means the future income (rent, interest, profits) generated by these assets is likely to leak abroad, rather than staying in the domestic economy.
  • There is also a reliance on foreign inward investment into the country. This investment could dry up if there is a global downturn.
  • This foreign direct investment could dry up if there is a global downturn. This could make running a current account deficit, supported by a financial account surplus, unsustainable.
  • An example of where investment from abroad dried up would be the 2008 financial crisis.
• Changes to the current account balance, whether deficits or surpluses, influence supply and demand for currencies.
  • This can create currency volatility, which may increase uncertainty for businesses operating across borders.

However a current account deficit may not be so disadvantageous:

• Imports being high may be desirable for consumers
  • High imports may suggest the imported goods are higher quality than domestic products.
  • Importing more could therefore increase living standards.
• A current account deficit can be supported with a financial account surplus:
  • The balance of payments has to balance. So when there is a current account deficit, the currency to pay for extra imports must come from a financial account surplus.
  • The financial account surplus suggests that there is likely to be a net inflow of investment into the country.
  • This boosts aggregate demand.
  • Also the investment may fund new, higher quality capital, boosting productive capacity and LRAS.
• Current account deficits may correct themselves, when there is a floating exchange rate:
  • An increase in the size of the current account deficit may suggest higher importing and reduced exports.
  • This reduces demand for the domestic currency. So demand for the currency (e.g. the pound) shifts left.
  • This leads to currency depreciation → exports become cheaper, imports dearer → export demand rises and import demand falls → CA deficit is reduced in size.

Note the consequences of a current account deficit may depend on the cause of the current account deficit:

• If caused by low relative productivity growth, this suggests economic growth will be slower in the long run. This is likely to slow the growth of real incomes over time, making people worse off.
• Instead if the current account deficit is caused by high incomes leading to high importing, then the current account deficit reflects the success of the economy and its high growth. In this case, if consumers are choosing to spend their high incomes on buying imports, they may be increasing their standard of living.

The effects of current account surpluses

Note these points may also apply in reverse for countries with current account surpluses. This includes countries such as Germany and Vietnam.

For example, a current account surplus boosts aggregate demand, raising the economic growth rate and real GDP.

However this exposes the country to a risk of a global downturn, which may reduce global incomes and lower export demand.

Also the current account surplus may reflect low importing or producing too many goods for export rather than consuming some of those goods domestically. So a current account surplus could lead to lower living standards for consumers than under current account balance.

Similarly there may be a financial account deficit to balance the balance of payments. This leakage of foreign direct investment funds abroad could have benefitted the domestic economy.

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