Components of the balance of payments

The balance of payments (BOP) is a record of all monetary transactions between a country and the rest of the world over a specific period. For the UK, the BOP consists of three main parts: the current account, the capital account, and the financial account.

Sections of the current account

The current account is divided into four key sections.

Trade in goods

This section tracks visible trade, which includes physical items:

• Exports of goods - Sales of UK-produced items abroad.
• Imports of goods - Purchases of foreign items.

Trade in services

This covers invisible trade, involving non-physical items:

• Exports of services - UK strengths include financial services like banking and insurance.
• Imports of services - Common examples are travel-related spending, such as overseas holidays.

Investment and employment income (primary income)

This records earnings from investments and work abroad:

• Inflows (credits) - Include interest from overseas bank deposits, profits from UK-owned foreign businesses, dividends from shares in international companies, and wages earned by UK residents working abroad.
• Outflows (debits) - Payments made to foreign investors or workers in the UK.

Transfers (secondary income)

These are one-way movements of money not linked to trade or investment:

• Inflows (credits) - Aid received from abroad or remittances from UK citizens overseas.
• Outflows (debits) - Foreign aid given by the UK or money sent to family members in other countries.

Calculating the current account balance

The overall current account balance is found by adding the balances from all four sections. Recent UK data shows a persistent deficit since 1984.

Causes and consequences of surpluses and deficits

Imbalances in the current account can arise from various economic factors and have significant effects on a country's economy.

Causes of a current account deficit

• High consumer spending and low savings - During growth periods, demand for imports rises, especially if income elasticity for imports is high.
• Lack of international competitiveness:
  • Rising production costs (e.g., higher wages or inefficiencies) make exports less attractive and imports cheaper.
  • Currency appreciation increases export prices and reduces import costs.
  • High inflation makes domestic goods less competitive.
• External shocks - Sudden increases in global raw material prices (e.g., oil), economic slumps in trading partners, or new trade barriers can boost import costs or cut export demand.

Causes of a current account surplus

• Economic recession - Reduced domestic spending lowers imports, while firms push exports to compensate.
• Low currency value - Makes exports cheaper and imports more expensive.
• High interest rates - Encourage saving over spending, reducing imports.

Consequences of a current account deficit

A current account deficit indicates potential uncompetitiveness. It can allow higher living standards through access to affordable imports, but long-term deficits may devalue the currency, raise import prices, cause inflation, and increase unemployment.

Consequences of a current account surplus

A current account surplus signals strong competitiveness but can lead to economic stagnation if domestic demand is low, resulting in slow growth and high unemployment. It may stem from overreliance on exports or an undervalued currency, which can fuel inflation through higher import costs for production materials.

Government policies to correct imbalances

Governments often intervene to address BOP imbalances.

Policies to correct a deficit

• Supply-side measures - Reduce production costs by tackling issues like labour immobility, boosting productivity and export competitiveness.
• Import restrictions - Tariffs or quotas make foreign goods more expensive, encouraging domestic purchases.
• Currency adjustment - Devaluation (in fixed systems) or depreciation (in floating systems) cheapens exports and raises import prices, effective if Marshall-Lerner conditions (elastic demand for exports and imports) apply.
• Demand management - Fiscal or monetary policies cut overall spending to lower imports.

Policies to correct a surplus

Currency revaluation increases the currency's value, making exports costlier and imports cheaper.

Global impacts of these policies

• Successful supply-side reforms - Can boost world trade and efficiency.
• Import barriers - May reduce global trade and hurt developing economies by limiting their exports, leading to higher unemployment and slower growth there.

Details of the capital and financial accounts

The capital and financial accounts record asset transfers and investments.

Capital account

The capital account focuses on non-produced, non-financial assets. The main flows are assets transferred by migrants (e.g., property or savings when someone moves to or from the UK).

Financial account

The financial account tracks movements of financial assets.

Key components:

• Foreign direct investment (FDI) - Long-term investments like building factories abroad.
• Portfolio investment - Buying shares or bonds in foreign companies.
• Financial derivatives - Contracts tied to asset values, such as currency options.
• Reserve assets - Holdings by the central bank (e.g., Bank of England) for economic stability.

Income from these (e.g., interest) appears in the current account.

Short-term and long-term flows

• Long-term flows - Predictable investments like FDI, often linked to comparative advantages developing over time.
• Short-term flows (hot money) - Speculative movements chasing quick profits, such as shifting funds between currencies based on expected exchange rate changes.