3.2.6.3 - The balance of payments

Accounts and current-account components

The balance of payments records transactions between residents of an economy and the rest of the world over a period.

The current account records trade in goods, trade in services, primary income and secondary income. Credits are receipts from abroad; debits are payments abroad. Each component's balance is credits minus debits.

Primary income includes investment income and compensation of employees across borders. Secondary income consists of current transfers without a corresponding good, service or asset received; distinguish a remittance from payment for work. A foreign visitor's spending on UK accommodation is a service export even though the service is consumed in the UK.

The capital account has capital transfers, such as qualifying debt forgiveness, and transactions in non-produced non-financial assets. It is not the general account for international investment. The financial account records transactions in financial assets and liabilities, including direct and portfolio investment, loans and reserve assets. Only a general appreciation of these other accounts is needed; detailed classification and sign conventions are not the main learning demand.

In an illustrative year, goods receipts/payments are £240bn/£320bn, services £180bn/£130bn, primary income £70bn/£85bn and secondary income £10bn/£15bn. Balances are −80, +50, −15 and −5, giving a current-account balance of −£50bn. A deficit means current payments exceed receipts; a surplus means receipts exceed payments. The −£30bn trade balance is only goods plus services, not the whole current account. Neither balance is the government's budget deficit.

Financial flows provide the counterpart to net borrowing/lending, with the capital account and statistical discrepancies also relevant. A current-account deficit need not equal a published financial inflow in a rounded table. The accounting relationship does not establish why spending or investment changed. Also distinguish these flows from the stock of external assets and liabilities measured at a date.

Competitiveness, demand and income

Current-account outcomes depend on both a country's ability to sell abroad and its demand for foreign goods, services and income-bearing assets.

Higher productivity can reduce unit labour costs if output per worker rises faster than pay. Lower relative costs may improve export prices and import-competing firms' competitiveness; better quality, reliability and design improve non-price competitiveness. By contrast, persistently higher inflation than competitors can raise relative prices if the exchange rate does not offset it. The relevant comparison is relative prices and quality, not the domestic inflation rate alone.

A depreciation lowers a currency's foreign-currency price. It can make domestic exports cheaper to overseas buyers and imports more expensive to residents. Whether export receipts rise and import spending falls depends on demand responsiveness, contracts and time. Initially, import quantities may change little while their domestic-currency price rises, worsening the trade balance. Later, substitution and production adjustment may improve it. A price movement does not guarantee an immediate volume response; price elasticities link individual purchasing decisions with the macroeconomic balance.

Strong domestic income growth increases demand for imports, depending on consumers' and firms' purchasing patterns. Foreign growth can increase demand for exports. Energy dependence, supply constraints and firms' use of imported components also matter. A weak current account can therefore reflect strong investment/import demand as well as weak export competitiveness. Primary income depends on the size and returns of external assets and liabilities: a better trade balance can be offset by larger payments to overseas investors.

Compare explanations with evidence. Price data and volumes help separate a fuel-price shock from a surge in demand; productivity and order data help investigate competitiveness. A correlation between growth and imports alone does not establish which mechanism caused a change.

Investment flows and their consequences

Investment can finance an imbalance and change future capacity, income flows and vulnerability.

Foreign direct investment (FDI) establishes a lasting interest with control or significant influence in an overseas business, such as building a subsidiary or acquiring an influential ownership stake. Portfolio investment buys financial securities such as shares and bonds without that direct-investment relationship. FDI can include acquisitions, not just new factories; portfolio investment is not defined by a rule that it is always short term.

Inward investment can fund productive machinery, jobs, training and supplier networks, increasing future output and exports. Buying an existing business instead changes ownership immediately and need not add equivalent new productive capacity. Profits earned by foreign owners create future primary-income payments abroad. Outward FDI can support foreign market access and generate income receipts, though it may relocate some domestic activity.

Portfolio inflows can lower financing costs and help businesses or government obtain funds. Mobile investors can also sell assets suddenly when expected returns or confidence change. A deficit financed by stable productive investment may be more sustainable than one dependent on repeatedly renewed short-term borrowing. Currency, maturity, returns and investor confidence matter; a deficit is neither proof of crisis nor proof that finance will remain available.

The original purchase of a foreign bond is in the financial account; its later interest payment is primary income in the current account. Keeping transaction and income distinct prevents double-counting and clarifies how today's financing can affect tomorrow's balance.

Correcting deficits and surpluses

A corrective policy should match the source of an imbalance rather than target a headline number alone.