A country’s balance of payments (BoP) is simply a record of their economic transactions with the rest of the world.
It can look daunting but in reality is merely an application of double-entry bookkeeping to national accounts. They measure the flow of payments between one country and foreign countries. International transactions that create an inflow of domestic currency are a credit (+), because they are a source of funds. An outflow of domestic currency is a debit (–), because they are a use of funds. Therefore exports are credits (i.e. a source of foreign exchange), while imports are debits (a use of foreign exchange). The “balance” stems from the fact that the flow of goods and services across borders must be equal to the flow of financial assets/ liabilities that finance capital accumulation, and it is defined as the following:
BoP = Current Account + Capital Account (+ Financial Account)
Traditionally the BoP was simply the relationship between the current and capital accounts; however, the IMF uses a separate item. But we can merge the capital and financial accounts. A typical BoP will look similar to the following:
(1) Current account
(2) Capital account/financial account
By definition we know that 1 = 2, however, in practice they don’t always add up. Therefore there is usually a final line on a BoP called “net errors and omissions”, which is simply the difference. Looking at the current account, the first (and usually largest) item is known as the “trade balance”, or “net exports”.
Now that we are thinking about international trade, we can go back to the equation for total spending in an economy, and realize that it is still incomplete. In addition to consumption, investment and government spending, a further source of demand comes from foreigners If we export (X) more than we import (M), and have a positive trade balance, this will boost aggregate demand.
AD = C + I + G + (X – M)
If a country has a trade deficit (which implies a current account deficit), it means that they are importing more than they are exporting.
How is it possible to import more than you export? There are really two ways.
Drawing down foreign reserves.
Borrow money from overseas.
If you think of yourself as a “country”, the only way you can “import” (consume) more than you “export” (produce) is either by drawing down your savings, or by borrowing from outside sources.
The capital account shows these sources of financing.
FDI is typically viewed as being more favourable to the recipient country; because it is a more long-term, stable investment. But precisely because indirect investment is easier to reverse, this may make it more advantageous to the company doing the investing.
If a country has a trade deficit, then it is reasonable to expect that they (i) also have a current account deficit and (ii) are a net borrower on global markets. Is this a bad thing? Indeed it is typical of rich countries (such as the US and the UK) to import more goods than they export; hence they run current account deficits. But to maintain the balance of payments a current account deficit must result in a capital account surplus. You might hear commentators say the following:
“The US must borrow more than $3 billion per day from foreigners to finance its huge trade deficits.”
But the following is just as true:
“Foreigners must sell the US goods and services worth more than $3 billion per day to finance their huge purchase of US assets.”35
People often refer to the “twin deficits” of a budget deficit (when government spending > government revenue) and a trade deficit (when imports > exports). But it is important to realize that:
A current account deficit is not necessarily a debt.
If a foreign company such as Sony sells a Playstation 2 for £100 and uses that cash to buy shares in a British company such as Unilever, there is no debt.
Potential political risks are part of a deeper problem.
People may be concerned about foreigners owning large amounts of domestic assets but this gives them an incentive to maintain their value.
Budget deficits help to create current account deficits.
A trade deficit (or the inflow of foreign investment that allows for a trade deficit) offsets insufficient private (S) and government (T – G) savings. The real problem is therefore the budget deficit, and the current account deficit may just be a symptom.
The main point is that it depends on why there is a current account deficit. In a McKinsey Quarterly article, Jack Hervey and Loula Merkel provide three potential explanations for the US current account deficit.
They argue that consumption had been falling as a share of GDP, and that industrial materials are a larger share of imports than consumer goods. They also argue that in a large diversified economy such as the US “hot money” is not a realistic concern. Sudden capital withdrawals are much more dangerous for small countries with a less steady flow of capital. And most of the US capital inflows are FDI, large equity stakes and longer-dated bonds. They conclude that the source of the current account deficit is therefore more likely to be due to technological improvements, which is good news –
So current account deficits aren’t necessarily a problem. For emerging markets this might also be due to the fact that they are making lots of investments and will experience higher future growth as a result. In which case running a current account deficit may be perfectly sensible. However, if an emerging market begins to resemble a safe haven relative to other countries in the region, attracting high portfolio inflows, or if incoming funds are used as a means for increased consumption, rather than investment, there may be concerns.
If the current account deficit reflects an underlying indebtedness, then it may well be a problem. But not in and of itself.
In October 2022 there was a widespread concern that the UK was on the verge of a currency crisis, which is when a currency loses a lot of value relatively quickly. See this video for my assessment:
In his 2023 book, ‘The crisis of democratic capitalism’, Martin Wolf makes the following points (p. 70-71):
We can also use Balance of Payments data to better understand the consequences of the global financial crisis. According to Bohle and Greskovits (2012, p.225), the type of FDI had a big impact on the severity of the impact. In the Baltic states, Romania, Bulgaria, and Croatia, FDI flowed mostly to real estate and the financial sector. Their balance of payments were poor going into the crisis, and these sectors were particularly fragile. By contrast, the Czech Republic, Hungary, Poland and Slovakia (i.e. Visegrad countries) saw FDI flow into industry, which allowed them to increase exports and be less dependent on future capital inflows. (For more see Capitalist Diversity on Europe’s Periphery, Cornell University Press).
Here are three examples of Balance of Payments.
Consider the following questions: