- What is the Balance of Payments (BOP)?
- Current Accounts
- Capital Accounts
- Financial Accounts
- What factors can affect the current account balance?
- Value of the pound
- Growth rate
- International Competitiveness
- So why does the Balance of Payments rarely balance?
- Recent trends in the UK’s balance of payments
- What does a current account surplus look like?
- While current account deficits are a common economic challenge, there are several different ways in which can be employed to address them:
- What methods have the UK implemented?
- Knowledge Checkpoint
What is the Balance of Payments (BOP)?
The BOP has 3 main parts (these will be discussed further later on):
- Current Account: This tracks the trade of goods and services
- Capital Account: This records transfers of money and assets
- Financial Account: This keeps tabs on investments going in and out of the country
Countries use the BOP to see if they’re spending more money internationally than they’re bringing in (a deficit), or if they’re earning more than they’re spending (a surplus). It helps governments and economist understand a country’s economic health and its relationships with other nations.
Ideally, all the money coming in and going out should balance perfectly, but in real life there’s usually a bit of a difference. That’s why it’s called a “balance” of payments - we’re always trying to keep things as balanced as possible!
Current Accounts
The Current Account is a crucial part of a country’s Balance of Payments. Think of it as a country’s financial report card for its dealings with the rest of the world. The Current Account focuses on 3 main components:
- Trade Account
- Goods - Physical items a country buys from or sells to other countries, like cars, clothes or food
- Services - Things you can’t touch but still pay for, such as tourism, transportation, or business services
- Primary Income Account
- Investment income - Earnings from foreign investments (e.g., profits, dividends, interest payments)
- Compensation of employees - Wages and salaries paid to workers who are employed in a country different from where they live (e.g., cross-border workers or seasonal foreign labourers)
- Other primary income - Earnings from rent, taxes, and subsidies on production and imports
- Secondary Income Account
- Transfer - Provision of economic value without a direct counterpart, including:
- Remittances (money sent home by people working abroad)
- Foreign aid given or received
- Government transfers (e.g., contributions to international organisations)
The difference between the total credits and debits across these accounts determines the current account balance. A country can have either a Current Account surplus or deficit.
- Surplus: Overall credits exceed debits
- Deficit: Overall debits exceed credits
For example, in the second quarter of 2023, the United States had a Current Account deficit of $212.1 billion, indicating it was importing more than it was exporting (US Bureau of Economic Analysis).
Capital Accounts
It includes transactions like buying or selling land in other nations, transferring ownership of valuable resources like mines, and tracking the wealth that moves when people immigrate or emigrate. Furthermore, it covers things like debt forgiveness between countries and large cross-border gifts or inheritances.
This is important because it helps economists and policymakers understand:
- How attractive the country is to foreign investors
- The country’s overall financial health and stability
- Potential impacts on exchange rates
The Capital Account works in tandem with the Current Account. Often, they balance each other out. For example, if a country has a trade deficit in its Current Account (meaning it’s importing more goods and services than it’s exporting), it might have a surplus in its Capital Account. This could mean that while the country is buying more goods from abroad, it’s also attracting a lot of foreign investment.
Financial Accounts
The financial account covers several types of international financial transactions:
- Direct Investment - Ownership of foreign businesses
- Portfolio Investment - Stocks and bonds in foreign markets
- Other Investments - Bank deposits and loans across countries
- Reserve Assets - Foreign currencies and gold held by central banks
When money or assets enter your country from abroad, it’s an inflow, recorded as a positive value. When they leave your country, it’s an outflow, recorded as a negative value.
By analysing the Financial Account, we can gauge foreign investor confidence in our economy and how our own investors view opportunities abroad.
What factors can affect the current account balance?
Value of the pound
Movements
When a currency depreciates, it makes domestic goods and services cheaper for foreign buyers, potentially boosting exports. Simultaneously, it makes imports more expensive for domestic consumers, likely reducing import demand.
These two effects work together to improve currency into the country:
- increased exports brings more foreign currency into the country
- Decreased imports mean less domestic currency leaves the country
Using this theory, an appreciation should worsen the current account.
🥲 However, in the real world this isn’t always as straightforward
- Elasticity of demand - If demand for UK exports isn’t very responsive to price change, a weaker pound might not boost exports much.
- Time lag - It takes time for businesses and consumers to adjust to new exchange rates. This can create a J-curve effect, where the current account might worsen before it improves after a depreciation
For a reminder of price elasticity of demand (PED), click the link to go back to the chapter.
Price elasticity ofdemand (PED)- Economic conditions - Global economic health and domestic growth rates can override exchange rate effects. For example, during a global recession, even a weaker pound might not boost exports significantly.
- Business decisions - Companies might choose to keep prices stable and adjust profit margins instead of changing prices immediately after exchange rate shifts.
For example, after the 1992 devaluation of the pound, the UK’s current account improved. The reason being the recession of 1990-92 and the slowdown in consumer spending. On the other hand, following the 2016 Brexit vote and subsequent pound depreciation, the current account didn’t improve as expected.
While exchange rates are important, they’re just one factor affecting the current account balance. Economic conditions, global demand, and how businesses and consumers respond to price changes all play crucial roles.
Growth rate
- If the increase in imports outpaces any growth in exports, the current account balance will likely worsen, leading to a deficit.
However, the nature of economic growth plays a crucial role
- If growth is driven primarily by domestic consumption and falling savings rates, it’s more likely to cause a current account deficit
- If economic growth is fuelled by capital investment and export demand, it can actually led to a current account surplus
- Countries like Germany and China have managed to maintain strong economic growth alongside current account surpluses due to their focus on exports
International Competitiveness
- A competitive nation produces goods and services that are highly desirable in global markets, often due to a combination of quality, innovation, and attractive pricing
- This typically boosts exports - foreign buyers are more likely to purchase these, increasing the inflow of foreign currency and at the same time locally produced goods can effectively meet domestic demand
- A competitive economy often attracts foreign investment, further contributing to a positive current account
Policymakers often seek a balance between fostering competitiveness and maintaining sustainable trade relationships.
So why does the Balance of Payments rarely balance?
Statistical Discrepancies
- It’s hard to count every single transaction a country makes with the rest of the world. Imagine trying to keep track of every item bought or sold across borders - it’s a massive task!
- Different countries might record the same transactions at different times
- Currency values are always changing. A deal worth 100 euros today might be worth a different amount in dollars tomorrow
- Some transactions, like illegal trade or tax evasion, might not get reported at all
Interplay between different accounts
- Imagine a country sells a big factory it owns in another country.
- At first, when the country bought that factory, it was recorded as money going out (in the capital account)
- But when they sell it, the money coming in is recorded as money earned from an investment (in the current account)
- This transaction effectively funds the current account deficit
- When a country is running a current account deficit, they might use money from its capital account to cover this gap. It is essentially like using your savings to pay for extra shopping!
- If a country needs to borrow money to cover this deficit, it shows up as money coming in from other countries - this might look good on paper, but it means the country is taking on debt
All these connections between different parts of the balance of payments, plus the difficulties in measuring and recording everything accurately, making it really challenging to get a perfect balance.
Recent trends in the UK’s balance of payments
The UK has maintained a current account deficit since the mid-1980s, which means the country has been consistently spending more on imports and foreign investments than it earns from exports and overseas income. In Q3 2019, the UK current account deficit was £15.9 billion, or 2.8% of GDP (ONS). This persistent deficit is deeply rooted in structural changes in the UK economy:
- Deindustrialization - Since the 1980s, the UK has seen a significant decline in its manufacturing sector. This shift has reduced the country’s capacity to produce goods for exports, while domestic demand for foreign manufactured goods remained high, contributing the the trade deficit.
- Rise of Service Economy - The UK economy has pivoted towards services (see figure below), particularly financial and business services. While the UK excels in these areas, this surplus in services isn’t large enough to offset the goods deficit. In addition, physical goods often have higher transaction values than services.
- Consumer Behaviour - The UK has a culture of relatively high consumer spending and low saving rate compared to some other developed economies. This tendency towards consumption often translates into higher demand for imported goods, especially consumer electronics, clothing, and vehicles which the UK doesn’t produce in sufficient quantities domestically.
- Global Events
- There is a significant drop around 2008, when the global financial crisis properly hit the global markets. The financial account shows heightened volatility, which mirrors the turbulence in global financial markets during the crisis.
- In this course you aren’t required to know any details of the 2008 Global Financial Crisis as it is quite complex, but if you would like to learn about it some more check out this video:
- There are sharp fluctuations in the financial and current account around 2020, coinciding with the onset of the COVID-19 pandemic. This volatility is likely reflecting the initial capital inflows as investors sought safe havens and the changes in trade patterns during the early stages of global uncertainty.
We have already had a look at who the UK trade with and what they trade in the imports and exports chapter 👇🏻
Imports and ExportsThis figure below highlights the difference in trade balances of goods and services in the UK. The trade surplus services create isn’t enough to offset the large trade deficit the UK has in goods. As mentioned above, this is a key factor that could explain the consistent current account deficit the UK has.
- This includes things like buildings, machinery, equipment, and infrastructure, but excludes land purchases
- GCFC is a key indicator of economic health, as it shows how much is being invested in the country’s future productive capacity.
This graph highlights how volatile the UK investments are to both domestic and global economic conditions.
- As highlighted, major events like the Global Financial Crisis, Brexit Referendum and COVID-19 pandemic have caused significant fluctuations in investment
- While not highlighted in the graph, the UK officially left the EU (customs union and single market) in Q1 2020, coinciding with the start of the COVID-19 pandemic
- This means we can’t necessarily isolate the impact of Brexit on investment by itself
While the UK has seen an fairly consistent upward trend in investment over the mid 2000s - early 2020s, this paints a slightly misleading picture. This figure shows that the UK is investing more in absolute terms compared to 1997 but it doesn’t tell us how investment is growing relative to the rest of the economy.
If we look at the overall investment rate (GFCF) as a % of GDP, it has fallen considerably since the 1980s. Measuring investment as a percentage of GDP gives us a different perspective as it shows how much of the country’s total economic output is being reinvested. If GDP is growing faster than investment, the investment rate as a percentage of GDP will fall, even if the absolute amount of investment is increasing.
In the late 80s investment was around 23% of GDP and from 2000s onwards hasn’t reached higher than 18%, nearly three-quarters of its previous share.
As we can see, the UK’s rate is consistently lower than all the other G7 countries who have maintained rates in the 20-25% range, apart from Italy briefly but they have since returned to that range in recent years. While investment has been growing, it hasn’t kept pace with overall economic growth, leading to a lower investment rate compared to other G7 countries.
What does a current account surplus look like?
A few key reasons why China has remained in a surplus is:
- China has maintained a substantial goods trade surplus, which has more than doubled since the pandemic, reaching around $900 billion annually
- China has amassed considerable foreign assets, including over $3 trillion in foreign exchange reserves and substantial overseas investments by state banks and policy banks, generating significant interest income
- China’s economic policies have generally favoured export-led growth and capital controls, helping to maintain the surplus position over time
This contrast can helps you understand the real-world implications of different trade positions and their effects on a country’s balance of payments.
While current account deficits are a common economic challenge, there are several different ways in which can be employed to address them:
- Devaluation - Lowering the value of the pound can make exports cheaper and imports more expensive. This can potentially increase export demand and reduce import demand.
- Deflationary policies - Can help reduce a current account deficit by cooling down the economy and reducing spending on imports. These policies mainly involve monetary and fiscal approaches:
- Monetary - This involves controlling money through interest rates. When the central bank raises interest rates, borrowing become more expensive reducing spending on imports. While this can make the UK exports more competitive, it can also attract foreign investment, strengthening the pound and potentially making exports more expensive
- Fiscal - This is about government management of taxes and spending. Increasing taxes or reducing government spending leaves people with less money, potentially reducing import purchases. While this doesn’t directly affect exchange rates, it can slow economic growth and job creation, making it a challenging decision for government.
- Supply-side policies - Improving the economy’s competitiveness through measures like privatisation or deregulation can boost exports over time. These polices aim to increase efficiency and reduce production costs.
- Wage reduction - Lowering wages, particularly in the public sector, can reduce production costs and improve export competitiveness. However, this approach may lead to lower aggregate demand.
- Protectionism - Implementing tariffs or quotas on imports can directly reduce the volume of imports.
What methods have the UK implemented?
- Fiscal targets - Set fiscal rules to manage public finances, including targets for government borrowing and debt
- The current rules aim to have public sector net debt falling as a % of GDP by the fifth year of the forecast period
- Additionally, keep public sector new borrowing below 3% of GDP in the same timeframe
- Monetary policy - The Bank of England has used interest rate adjustments to influence spending and investment.
- Welfare cap - The government has implemented a cap on certain welfare spending to control expenditure
While the fiscal targets are currently being met according to the Office for Budget Responsibility (OBR), the margin for success is narrow.
As we have seen, the current account deficit has persisted since the mid-1980s, suggesting that these policies have not fully addressed the underlying issues.