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The Balance of Payments
Money flowing into the domestic economy is a credit, if it flows out it is a debit. Components of the balance of payments are the current account, the financial account and the capital account. Each component can be positive or negative but the overall balance of payments will equal zero as everything has to be paid for.

The current account shows transactions in goods and services (imports and exports), incomes payments and international transfers. Visible trade is the trade in goods whilst invisible trade is the trade in services. Income payments consist of the earnings of domestic nationals from employment abroad as well as payments of investment income (profits, dividends and interest). Transfers are the transactions between governments as well as bilateral aid and any social security payments that are paid abroad. It can also be expressed as the difference between national (i.e. private and public) savings and investment.

The financial account is the transaction of financial assets such as investments flows and government transfers in foreign exchange reserves. If an economy runs a current account deficit then it must run a financial account surplus to fund the imported goods and services. This occurs because the economy is selling assets and debt to foreign investors in order to pay for their consumption of foreign goods. Foreign direct investment would be included in the financial account. A high interest rate is likely to lead to a surplus in the financial account as domestic savers save at home (rather than abroad) and foreign savers may chose to send their money here.

The capital account includes capital transfers which is usually associated with migrants, for example if they because a domestic citizen then there assets become domestically owned.

Because it is hard to accurately measure every single item that goes into the balance of payments a net error and omissions section is also included which is a small number to ensure that the balance of payments equal zero, effectively cancelling out any sampling errors.

Current Account Surplus
A current account may be in surplus for a variety of different reasons. The first is due to export led growth. An economy may focus on exporting goods abroad in order to make money. The problem with this is that consumers in the domestic economy don’t benefit from the goods they produce, however they do make money from it which could be spent in the future of consumer goods. This may be exacerbated by FDI. A developing country which is considered to have good prospects or may have plenty of a factor of production may have high levels of foreign direct investment. This boosts exports as capital stock is being produced.

The second reason is due to an undervalued exchange rate. A country can artificially devaluate its currency in order to boost its competitiveness. A low exchange rate means the currency is weak and therefore foreigners can purchase more goods which are exported. One way in which this can be achieved is by selling one’s currency abroad and buying foreign currency. However this makes imports more expensive and therefore may lead to inflation.

If a country has a high domestic savings rate then it is unlikely to be spending much money on foreign goods, therefore this will contribute to a current account surplus. A country may also have expensive tariffs or excessive non-tariff barriers which prevent imports whilst benefiting domestic exporters.

Current Account Deficits
Is running a current account deficit a bad thing for the economy? A current account deficit isn’t a bad thing in the short run. The balance of payments will always equal zero, so in order to finance a current account deficit the financial account must be in surplus. This must mean that the country is borrowing money (issuing debt) from foreigners as well as selling assets in order to fund the purchase of these goods. In the long run this could be considered unsustainable as eventually foreign investors may worry about the debt burden of the debtor country and its ability to repay. If the government is no longer seen as solvent and there is a risk that it may default (refuse to pay its debt and hence consider it invalid) then investors may be hesitant to lend to the country. This will raise the interest payments that the country has to pay making it more expensive to borrow as well as adding to the debt burden, therefore it won’t be able to borrow indefinitely. Interest rates on government debt should usually be below the rate of GDP increase (growth) for it to be considered sustainable. Also if there is inflation in an economy then this will reduce some of the real value of the debt.

In the short run a current account deficit may persist in order for the country to purchase capital stock which will allow it to run a current account surplus in the future by exporting goods made with the capital stock. A deficit is also likely to raise the standard of living of citizens if they are importing goods.

It could be argued that current account deficits are irrelevant due to auto corrections in the exchange rate and the business cycle. If a country purchases a lot of foreign goods then it must sell the domestic currency in order to purchase it, by doing this they are weakening their currency making it more expensive to buy goods in the future and also leading to a growth in the import sector. However it is important to note that the UK economy is unlikely to benefit much from a weak currency as our export elasticity is rather inelastic. This means that the price of our exports doesn’t really alter the quantity demanded because our exported goods are usually high quality, expensive and durable. We would also experience high inflation due to a weak currency as imports (which we rely on a lot) would be more expensive. Similarly there may be a correction in the business cycle, as heavy spending on imports will lead to high debts, eventually these will have to be paid off and people will stop buying foreign goods in order to save. Therefore during a recession we would expect to see a trade deficit fall.

There are also reasons why a deficit does matter. Firstly it can show structural weaknesses in an economy. When measured against GDP it may show a loss of competitive, a lack of investment in capital stocks (and human capital) and infrastructure or a movement in comparative advantage to other countries. Secondly a deficit shows an unbalanced economy, if a deficit persists (i.e. it’s not down to large spending on importing capital goods) then it shows that consumers are spending more than they could afford and may be taking on debts in order to do so. Obviously this can’t go on ad infinitum and so a rebalancing of the economy (fewer imports, more exports) may be necessary, this could be achieved through currency manipulation.

Large spending on imports may mean that people lose their jobs in the domestic market, particularly in the manufacturing sectors if cheap foreign goods are being imported. 

In order to finance a deficit interest rates may need to rise in order to attract foreigners to purchase debt to finance the consumption spending. Higher interest rates will dampen domestic demand and investment, if there is low investment then it is unlikely that the investment sector will benefit. As mentioned the deficit country is relying on foreign investors to continue to purchase debt, if they get frightened and stop investing then this could cause trouble for the economy.

Reducing a Current Account Deficit
A current account deficit can be reduced either through demand management, a lower exchange rate, supply-side improvements or protectionist policies. Demand management includes reducing government spending (and hence less is spent on exports and there are fewer withdrawals from the circular flow), higher interest rates (in order to reduce consumption, hopefully this will mean fewer imports, and less domestic investment). Although higher interest rates may result in an increase in hot money flows into the country and hence a stronger currency making imports cheaper and exports more expensive. Higher taxes would also have the effect of reducing consumers’ disposable income which may mean they purchase fewer imported goods.

If domestic demand is relatively low due to the policies stated above then it provides an incentive (to keep profits high and utilise spare capacity) for firms to export abroad in order to replace low spending in the domestic economy.

A lower exchange rate would improve competitiveness as it reduces the overseas price of exports and also makes imports more expensive to domestic consumers. Countries which operate a managed exchange rate may decide to intervene in Forex (foreign exchange) markets to manipulate the value of the currency to have the effect stated above.

Supply side policies which could be adopted include; raising productivity (by increasing innovation and incentives, perhaps lower taxes), encouraging business start-ups and helping entrepreneurs (state-bank or state funded lending as well as lower taxes or tax breaks), investment in education and health to increase human capital and ensure that all citizens are healthy enough to work and finally, investment in infrastructure to improve competitiveness. The problem with supply side policies is that there is a large time lag, i.e. they only really work in the long run (e.g. it takes 15 years to educate a child before they can enter the workforce). Also supply side policies can be expensive to initiate and run.

The final way in which a government could reduce the current account deficit is to introduce protectionist measures such as import quotas and higher tariffs. This makes it more expensive for consumers to purchase goods and in some cases puts a limit on the amount a country can import. However this could again lead to higher inflation and inefficiencies (allocate and productive) and foreign governments may retaliate by imposing high barriers to entry into their markets, therefore making it hard to export goods to them.

Twin-Deficit Hypothesis
The twin deficits are deficits in the current account (of the balance of payments) and in the public sector (i.e. government debt). The twin deficit hypothesis proposes that there is a strong link between a country having a current account deficit and a public sector deficit. The hypothesis therefore leads us to conclude that if a country is operating a current account deficit it must also implicitly be operating a public sector deficit at the same time, and vice versa.

The economic formula for GDP is Y = C + I + G + (X-M), this is the formula for national output, national output is the same as national income which is Y = C + S + T. Therefore C + I + G + (X-M) = C + S + T, we can cancel out the Cs: I + G + (X-M) = S + T, and rearrange in terms of (X-M): (X-M) = S + T –  I – G, this can be written as (X-M) = (S-I) + (T-G).

If (T-G) is negative then the government is running a budget deficit. In order to finance this they have to borrow money. The twin deficit theory assumes that output is constant and savings remain constant, therefore the borrowed money has to either come from investment, meaning I falls (due to crowding out theory) or net exports (X-m) must fall leading to a trade deficit.

Page last updated on 15/04/14