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What factors can affect the current account balance?

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What factors can affect the current account balance?

Value of the pound

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Movements in the value of the pound can impact the UK’s current account balance.

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

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When a country experiences strong economic growth, consumers typically have more money to spend. This can mean higher imports as people buy more goods and services from abroad, such as foreign cars, electronics, or luxury items. Businesses might also import raw materials or machinery to meet growing production needs.

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

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Being internationally competitive can lead to a current account surplus.

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?

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In theory, these parts should balance each other out perfectly, but in reality, they rarely do. Let’s discuss why:

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.