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.