The Balance of Payments
In one line. The balance of payments records all transactions between a country and the rest of the world. The current account covers trade in goods and services and primary and secondary income; the capital and financial account covers flows of assets. A current account deficit must be financed by financial inflows, and its desirability depends on its cause. This is H2 only.
Exam relevance: a core A Level Economics topic, on ETG analysis of the last ten years. Taught the way an economics tutor who wrote the answer keys teaches it.
01What the balance of payments is
The balance of payments is the full record of a country's transactions with the rest of the world, and it is an H2 only topic that frames the external side of every open economy answer.
The balance of payments is a record of all economic transactions between the residents of a country and the rest of the world over a given period. It is divided into the current account and the capital and financial account.
This theme is H2 only: H1 candidates do not study the balance of payments. The two accounts together capture every cross border flow, whether it is a good leaving the country, a service sold abroad, income earned on a foreign asset, or an investment moving in or out. Because every transaction is recorded twice, once as a credit and once as a debit, the balance of payments as a whole always balances; what students analyse is the balance on each individual account.
02The current account
The current account records trade in goods and services together with the income flows that cross borders, and it is the part most macro answers focus on.
Trade in goods. Visible trade: exports and imports of physical goods.
Trade in services. Invisible trade: exports and imports of services such as finance, shipping and tourism.
Primary income. Income from the cross border ownership of factors: profits, interest, dividends and wages earned abroad.
Secondary income. Transfers without a corresponding flow of goods or services, such as foreign aid and remittances.
The balance of trade in goods and services is the largest component for most economies, which is why a trade deficit and a current account deficit are often discussed together, though they are not identical.
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03The capital and financial account
The capital and financial account records flows of financial assets and investment between a country and the rest of the world, and it is the mirror image of the current account.
Where the current account records flows of goods, services and income, the financial account records flows of assets: foreign direct investment, portfolio investment in shares and bonds, and other flows of capital and reserves. A country running a current account deficit, paying out more than it receives on goods, services and income, must finance that deficit by attracting offsetting inflows on the financial account, through borrowing or by selling assets to foreigners. This is why the two accounts are linked: a deficit on one is matched by a surplus on the other.
04Deficit against surplus
A current account deficit and a surplus describe the net position on the current account, and each has a clear meaning for how a country stands against the rest of the world.
- A current account deficit means a country pays out more on the current account than it receives, usually because imports of goods and services exceed exports. It must be financed by inflows on the financial account, that is by borrowing or by selling assets to foreigners.
- A current account surplus means receipts exceed payments, so the country is a net lender to the rest of the world, accumulating foreign assets or reserves.
Neither is automatically good or bad. A deficit can reflect strong investment and growth as easily as overspending, and a surplus can reflect weak domestic demand as easily as competitiveness.
05Causes and consequences of an imbalance
A persistent current account imbalance has identifiable causes and consequences, and a strong answer traces both rather than treating a deficit as simply a problem.
A persistent deficit can arise from a loss of price or non price competitiveness, an overvalued exchange rate, or strong domestic demand pulling in imports. Its consequences include rising external debt, downward pressure on the currency, and a dependence on continued financial inflows that can reverse suddenly. A persistent surplus can arise from high competitiveness or weak domestic demand and high saving, and its consequences include upward pressure on the currency and accumulated reserves, but also the criticism that it reflects demand suppressed at home. The key point examiners reward is that the desirability of an imbalance depends on its cause and on whether it is sustainable.
Do not equate a current account deficit with economic weakness. Trace its cause, strong investment is very different from lost competitiveness, and judge it by whether the financing is sustainable, not by its sign alone.
06Common misconceptions
The balance of payments as a whole always balances, by construction, because every transaction is recorded as both a credit and a debit. A "balance of payments deficit" really means a deficit on a particular account, usually the current account. Be precise about which account is in deficit.
A second error is to treat the trade balance and the current account as the same thing. The trade balance is only one part of the current account, which also includes services, primary income and secondary income, so a country can run a trade deficit and still have a current account surplus.
07Test yourself
- List the four components of the current account and classify each of these: a tourist visiting Singapore, dividends paid to a foreign shareholder, an exported cargo of electronics, a remittance sent home by a migrant worker.
- Explain why a country with a current account deficit must run a surplus on its financial account.
- Explain why a persistent current account deficit is not necessarily a sign of economic weakness.
08Questions students ask
The balance of payments is a record of all economic transactions between a country's residents and the rest of the world over a period of time. It has two main parts: the current account, which records trade in goods and services and income flows, and the capital and financial account, which records flows of financial assets and investment. It is an H2 only topic.
The current account has four components: trade in goods (visible trade), trade in services (invisible trade), primary income (income from cross border ownership of assets and labour, such as profits, interest and wages), and secondary income (transfers such as foreign aid and remittances). The balance of trade in goods and services is its largest part for most economies.
A current account deficit means a country pays out more to the rest of the world on the current account than it receives, typically because imports exceed exports. A surplus is the reverse, with receipts exceeding payments. A persistent deficit must be financed by borrowing or by inflows on the financial account, while a persistent surplus reflects net lending to the rest of the world.