What the balance of payments is

The balance of payments tracks every financial exchange between a country and the rest of the world over a set period. It captures all movements of money entering and leaving the country.

The main components of the balance of payments

• Current account - Focuses on day-to-day transactions, including trade in goods and services, income from investments, and transfers of money.
• Capital account - Records transfers of capital, such as funds for development projects or the sale of non-financial assets like patents.
• Financial account - Covers investments in financial assets, including foreign direct investment, portfolio investments, and changes in reserve assets.

The structure of the current account

The current account is a key part of the balance of payments, divided into four main sections that reflect different types of international transactions.

Trade in goods

This section measures the value of physical items imported and exported:

• Exports - Goods sold abroad, such as machinery, electrical appliances, and pharmaceuticals.
• Imports - Goods bought from overseas, including machinery, electrical appliances, raw materials like natural gas, and oil-based products.

Trade in services

This covers non-physical items, focusing on intangible exchanges:

• Exports - Services provided to other countries, such as banking advice or insurance policies.
• Imports - Services received from abroad, like holidays taken overseas.

Investment and employment income (primary income)

This includes earnings from work or previous investments abroad:

• Investment income - Profits from foreign subsidiaries, dividends from shares in overseas companies, or interest from deposits in international banks.
• Employment income - Salaries earned by a country's residents working in other nations.

Transfers (secondary income)

• These are funds moved between countries without any exchange of goods, services, or investments.
• Examples include money sent to relatives living abroad (remittances) or aid provided to or received from foreign governments for development purposes.

How to calculate the current account balance

The current account balance is found by combining the results from its four sections. Each section calculates a net figure by comparing inflows (credits) and outflows (debits).

Steps to calculate the current account balance:

1. Calculate the balance for each section:
   • For trade in goods and services - Balance = exports - imports.
   • For primary income and secondary income - Balance = credits - debits.
2. Add up all section balances to get the overall current account balance.
3. Interpret the result:
   • A positive balance indicates a surplus (more money entering than leaving).
   • A negative balance shows a deficit (more money leaving than entering).

Causes of current account deficits and surpluses

A current account deficit occurs when a country spends more on imports and outflows than it earns from exports and inflows, while a surplus happens when earnings exceed spending. Various economic factors can lead to either situation.

Causes of current account deficits

Strong consumer demand and low savings:

• In periods of economic expansion, people buy more imported products.
• If imports are highly responsive to income changes (high income elasticity of demand), this accelerates the deficit.

Problems with global competitiveness:

• When a country cannot match rivals' prices or quality, exports decline.
• Higher production costs (e.g., rising wages or poor efficiency) compared to competitors increase import reliance.
• Structural issues, such as inflexible labour markets, raise domestic prices.
• A stronger currency makes exports costlier for buyers abroad and imports cheaper at home.
• Faster inflation than in other countries reduces export appeal and boosts import attractiveness.

Unexpected global events:

• Sharp rises in prices of essential imports (e.g., fuel or construction materials), especially if demand does not fall much with price increases (price inelastic), worsen the deficit.
• Downturns in key export destinations reduce demand for a country's goods.
• New trade restrictions by other nations limit export access.

Causes of current account surpluses

• Domestic economic slowdown - During recessions, reduced local demand pushes firms to sell more abroad, increasing exports.
• Currency weakening - A devaluation or depreciation lowers export prices for foreign buyers and raises import costs, encouraging a surplus.
• Elevated interest rates - These promote saving over spending, reducing imports while potentially attracting foreign investment inflows.

The UK's balance of payments situation

The UK has experienced ongoing challenges with its balance of payments, particularly in the current account. This influences broader economic strategies and decisions.

Key features of the UK's current account

• The UK maintains a substantial current account deficit, meaning outflows exceed inflows.
• This deficit has persisted without interruption since 1984.
• As a result, addressing the balance of payments deficit forms an important element of the UK's macroeconomic policies.