Structure of the Balance of Payments

The balance of payments (BoP) records all financial transactions between a country and the rest of the world.

It is made up of several accounts:

Current account: Records trade in goods and services, primary income, and secondary income.

Capital account: Records relatively minor capital transfers, such as debt forgiveness.

Financial account: Records flows of investment, such as FDI and portfolio investment, as well as changes in foreign exchange reserves.

Current Account Deficits and Surpluses

• A current account deficit occurs when outflows, such as imports and income paid abroad, are greater than inflows from exports and income received.
• A current account surplus occurs when inflows are greater than outflows.
• A current account deficit must be financed by a surplus on the capital and financial account, such as borrowing from abroad or selling domestic assets to foreigners.

Causes of a Current Account Deficit

• Low competitiveness: Higher relative inflation or lower productivity than trading partners can weaken exports.
• Strong exchange rate: An overvalued currency makes exports expensive and imports cheap.
• Strong domestic demand: High consumer spending can pull in more imports.
• Non-price factors: Weaknesses in quality, design, or marketing can reduce export performance.
• Structural factors: Economies may rely on imported raw materials or finished goods because of deindustrialisation.

Policies to Reduce a Current Account Deficit

Expenditure-Switching Policies

These policies attempt to shift spending away from imports and towards domestic goods, for example through currency depreciation or protectionism.

A major risk is retaliation from trading partners.

Expenditure-Reducing Policies

These policies use deflationary fiscal or monetary measures to reduce aggregate demand and therefore reduce spending on imports.

However, they may also cause lower growth and higher unemployment.

Supply-Side Policies

These policies aim to improve long-run competitiveness through investment in skills, infrastructure, and innovation.

They may be effective in the long run, but they are usually slow and costly.

Significance of Global Imbalances

Persistent deficits: These may lead to rising foreign debt, loss of domestic asset ownership, and vulnerability to sudden stops in capital flows.

Persistent surpluses: These may indicate that an economy depends too much on external demand and may contribute to international tension.

Large global imbalances between major economies can create wider financial instability.

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