4.6.

1 Components of The
Balance Of Payments
An Introduction to the Balance of Payments

• The Balance of Payments (BoP) for a country is a record of all the financial
transactions that occur between it and the rest of the world

• The BoP has two main sections:

o The current account: all transactions related to goods/services along
with payments related to the transfer of income
o The financial and capital account: all transactions related to savings,
investment and currency stabilisation

• Money flowing into an account is recorded in the relevant account as a credit

(+) and money flowing out as a debit (-)
o If more money flows into an account than out of it, there is a surplus in
the account
o If more money flows out of an account than into it, there is a deficit in
the account

The Current Account

• The Current Account is often considered to be the most important

account in the BoP
• This account records the net income that an economy gains from
international transactions

An Example of the UK Current Account Balance for 2017

Component 2017
Balance of trade in goods (exports - imports) £-32.9bn
Balance of trade in services (exports - imports) £27.9bn
Sub-total trade in goods/services £-5bn
Net income (interest, profits and dividends) £-2.1bn
Current transfers £-3.6bn
Total Current Account Balance £-10.7bn
Current Account as a % of GDP 3.7%
• Goods are also referred to as visible exports/imports
• Services are also referred to as invisible exports/imports
• Net income consists of income transfers by citizens and corporations
o Credits are received from UK citizens who are abroad and
send remittances home
o Debits are sent by foreigners working in the UK back to their
countries
• Current transfers are typically payments at government level between
countries e.g. contributions to the World Bank

The Capital Account

• The Capital Account records small capital flows between countries and is
relatively inconsequential
• The capital account is made up of two sections:

1. Capital transfers
Smaller flows of money between countries
E.g. Debt forgiveness payments by the government toward developing
countries
E.g. Capital transfers by migrants as they emigrate and immigrate

2. Transactions in non-produced, non-financial assets

Small payments are usually associated with royalties or copyright e.g. royalty
payments by record labels to foreign artists

The Financial Account

• The Financial Account records the flow of all transactions associated with
changes of ownership of the country’s foreign financial assets and liabilities

• It includes the following sub-sections

1. Foreign Direct Investment (FDI)

Flows of money to purchase a controlling interest (10% or more) in a foreign
firm. Money flowing in is recorded as a credit (+) and money flowing out is a
debit (-)

2. Portfolio Investment
Flows of money to purchase foreign company shares and debt
securities (government and corporate bonds). Money flowing in is recorded
as a credit (+) and money flowing out is a debit (-)

3. Official Borrowing
Government borrowing from other countries or institutions outside of their own
economy e.g. loans from the International Monetary Fund (IMF) or foreign
banks. When the money is received, it is recorded as a credit (+) and when
the money (or interest payments) are repaid, it is recorded as a debit (-)
4. Reserve Assets
These are assets controlled by the Central Bank and available for use in
achieving the goals of monetary policy. They include gold, foreign currency
positions at the International Monetary Fund (IMF) and foreign exchange held
by the Central Bank (USD, Euros etc.)

Interdependence Between the Accounts

• It is called the BoP as the current account should balance with the capital
and financial account and be equal to zero
o If the current account balance is positive, then the capital/financial
account balance is negative (and vice versa)
o In reality, it never balances perfectly and the difference is called 'net
error and omissions'

• If there is a current account deficit, there must be a surplus in the capital

and financial account
o The excess spending on imports (current account deficit) has to be
financed from money flowing into the country from the sale of
assets (financial account surplus)

• If there is a current account surplus, there must be a deficit in the capital

and financial account
o The excess income from exports (current account surplus) is
financing the purchase of assets (financial account deficit) in other
countries
4.6.2 Exchange Rates & the
Balance Of Payments
The Relationship Between the Current Account & the Exchange rate

• The relationship between the current account and the exchange rate is dynamic
o Factors such as trade policies, capital flows, global economic conditions and
investor sentiment can influence both the current account and the exchange
rate

• The current account and the exchange rate are closely linked in international trade
o The current account records the value of a country's trade in goods/services
and transfers with the rest of the world
o The exchange rate determines the price of a country's currency in relation to
other currencies

• A stronger exchange rate makes imports cheaper and exports more expensive
o When a country's currency appreciates, its exports become relatively more
expensive for foreign buyers, potentially leading to a decrease in export
volumes
o Conversely, imports become relatively cheaper for domestic consumers,
which may lead to an increase in import volumes

• A weaker exchange rate makes imports more expensive and exports cheaper
o When a country's currency depreciates, its exports become relatively cheaper
for foreign buyers, potentially leading to an increase in export volumes.
o At the same time, imports become relatively more expensive for domestic
consumers, which may result in a decrease in import volumes
Exam Tip
The impact of a depreciation on the current account is dependent on the price elasticity of
demand for the exports and imports (Marshall Lerner condition). See the next page of
revision notes for further explanation of this

Relationship Between the Financial Account & the Exchange Rate

• The financial account measures the inflows and outflows of financial assets,
including foreign direct investment and portfolio investment

• Changes in the financial account can impact the exchange rate

o When there is an inflow of foreign investment into a country, it increases the
demand for the country's currency, potentially leading to an appreciation of
the exchange rate
o Conversely, when there is an outflow of domestic investment to other
countries, it increases the supply of the country's currency in the foreign
exchange market, potentially leading to a depreciation of the exchange rate

• The exchange rate influences the attractiveness of a country for foreign investment
o A stronger exchange rate makes foreign investments more expensive in terms
of the investor's home currency, potentially reducing the appeal of investing
in that country.
o A weaker exchange rate can make a country's assets more affordable for
foreign investors, potentially increasing the attractiveness of investing in that
country.
 4.6.3 Persistent Current
Account Deficits

Implications of a Persistent Current Account Deficit

• A persistent current account deficit refers to a situation where a country consistently

spends more on imports than it earns from exports

The Impact of Persistent Current Account Deficits

Factor Implications of a Persistent Current Account Deficit

Depreciating Exchange Rates • A persistent current account deficit can put downward pressure (depreciate) on
a country's currency as the economy is constantly supplying its currency onto
world markets

Increasing Interest Rates • With downward pressure on the currency, the Central Bank may raise interest
rates in order to attract foreign/portfolio investment
o The raised rates will encourage demand for the currency which will help it
to stop depreciating

Increasing Foreign • A persistent current account deficit may result in increased foreign ownership of
Ownership of Domestic domestic assets
Assets o It can be driven by the need to finance the deficit through foreign capital
inflows, potentially leading to a larger share of ownership by foreign
entities

Increasing National Debt • A chronic current account deficit can contribute to the accumulation of external
debt as financing is required to fund the deficit

Worsening International • If the deficit is viewed as unsustainable or indicates weak economic

Credit Ratings fundamentals, credit rating agencies may downgrade the country's
creditworthiness, potentially raising borrowing costs
o Investors can lose confidence in a country's ability to repay any future
borrowing

Demand Management • A persistent current account deficit may necessitate adjustments in demand
Conflicts management policies and in the process create trade offs
o E.g. It may require measures to curb domestic consumption or stimulate
exports to reduce the deficit and rebalance the economy
 Impact on Long term • A chronic current account deficit can have implications for economic growth
Economic Growth o It may signal an imbalance in the economy, relying on external
financing rather than domestic productivity and competitiveness

Exam Tip
Remember that a current account deficit is different to a budget deficit. A budget deficit
refers to the situation in which government spending is higher than government revenue

Correcting a Persistent Current Account Deficit

• The Government has several options available to them in order to tackle a current
account deficit
o They could do nothing, leaving it to market forces in the foreign exchange
market to self-correct the deficit
o They could use expenditure switching policies
o They could use expenditure reducing policies
o They could use supply-side policies

• The choice of any policy - or any combination of policies generates both costs and
benefits

Costs & Benefits of Policies used to Tackle Current Account Deficits

Benefits Costs
Policy Option
Do nothing • Floating exchange rates act as a self- • There may be other external factors that
correcting mechanism. Over time a prevent the currency from depreciating. It
higher level of imports will end up may take a long time for self-correction to
depreciating the currency causing happen and many domestic industries may
imports to decrease (they are now go out of business in the interim. The
more expensive) and exports to longer it takes to self-correct, the more
increase (they are now cheaper). firms will delay investment in the economy
This improves the deficit

Expenditure Switching • This is often successful in changing • Any protectionist policy often leads
the buying habits of to retaliation by trading partners. This may
consumers, switching consumption consist of reverse tariffs/quotas which will
on imports to consumption on decrease the level of exports. This may
domestically
 produced goods/services. This helps offset any improvement to the deficit
improve a deficit caused by the policy

Expenditure Reducing • Deflationary fiscal policy invariably • Deflationary fiscal policy also dampens
reduces discretionary income which domestic demand which can cause output
leads to a fall in the demand for to fall. When output falls, GDP growth
imported goods & improves a deficit slows & unemployment may increase

Supply-side • Improves the quality of products and • These policies tend to be long term policies
lowers the costs of production. Both so the benefits may not be seen for some
of these factors help the level of time. They usually involve government
exports to increase thus reducing the spending in the form of subsidies and this
deficit always carries an opportunity cost
4.6.4 Marshall-Lerner & J-Curve
The Marshall-Lerner Condition

• When a currency is devalued in a fixed exchange rate system or experiences

depreciation in a floating exchange rate system, it makes the country's exports
cheaper

• Depreciation of the currency causes exports to be cheaper for foreigners to buy

and imports to the UK are more expensive

• The extent to which this depreciation improves the current account

balance depends on the Marshall-Lerner condition
o This follows the revenue rule which states that in order to increase revenue,
firms should lower prices for products that are price elastic in demand
o If the combined elasticity of exports/imports is less than 1 (inelastic), a
depreciation (fall in price) will actually worsen the current account balance

The J-Curve Effect

• It is also important to recognise that there is a time lag between the depreciation of
the currency and any subsequent improvement in the current account balance

• This time lag is explained by the J-Curve effect

o It takes time for firms and consumers to respond to changes in price
o Once it becomes evident that price changes will last for a longer period of
time, firms and consumers change their patterns
o E.g. a firm in the USA has been importing electric scooters from the UK. If
the Euro depreciates, the price of scooters in France becomes relatively
cheaper. In the short-term, the USA firm will not switch immediately to
purchasing scooters from France as the exchange rate may soon bounce back.
They also have a good relationship with their UK suppliers. In the long
term they are likely to switch
 The J Curve explains what happens to a trade balance over time when the country's
currency depreciates

Diagram Analysis

• In the short run, the sum of PEDs for exports and imports was less than one /
inelastic (or the Marshall-Lerner condition was not fulfilled) so the deficit widens
• However, in the long run the Marshall-Lerner condition is met so it leads to a surplus
• With any currency depreciation/devaluation, the trade balance will initially worsen
before it improves
4.6.5 Persistent Current
Account Surpluses
Implications of a Persistent Current Account Surplus

• A persistent current account surplus occurs when a country

consistently exports more goods/services than it imports
• The implications of this occurring can be summed up as follows

1. Rising consumption and investment

• Investment increases as exporting firms are making excellent profits

• With a higher level of profits in the economy, domestic income rises leading
to an increase in consumption

2. Appreciating Exchange Rates

• With higher exports, foreigners demand more of the local currency to pay for
their goods/services leading to currency appreciation
• Appreciating exchange rates make the economy less desirable as a
destination for foreign direct investment

3. Both an inflationary and deflationary effect on price levels

 • The net effect on inflation will depend on the extent to which domestic firms
rely on imported raw materials used in their production process

4. Employment

• With rising demand for exports, unemployment usually falls as exporting

industries require more workers
• Rising profits usually result in increased investment which may mean that
even more workers are required
• Decreasing unemployment creates a higher average domestic income and
much of this income is spent domestically
o Non exporting domestic industries may also require more workers to
help meet the rising domestic demand

5. Export competitiveness

• Appreciating exchange rates associated with a persistent surplus, will

gradually erode the nation's export competitiveness over time
• The extent to which this is eroded will depend on the price elasticity of
demand for the country's exports
o if PED for their exports in inelastic, then currency appreciation will not
impact the competitiveness as much as it does when the PED for
exports is elastic