4.1.7 - Balance of payments
The balance of payments is the UK's running record of what it buys, sells, earns, pays, borrows and invests with the rest of the world. For exams, the key is not just knowing that this record exists, but understanding what goes into each account, why current account imbalances can persist, and why some imbalances are manageable while others become risky.
What the Balance of Payments Records
The balance of payments records all transactions between residents of one country and the rest of the world over a period of time, usually a quarter or a year. Transactions that bring money into the country are recorded as credits, while transactions that involve money leaving the country are recorded as debits.
Definition: Balance of payments
The record of all financial transactions between residents of a country and the rest of the world over a period of time.
The balance of payments is split into three main accounts:
- the current account
- the financial account
- the capital account
The current account is usually the main focus in exams because it shows whether the country is earning more from trade and income flows than it is paying out.
Definition: Current account
The part of the balance of payments that records trade in goods and services, primary income, and secondary income.
The current account has four main parts:
| Component | What counts as a credit | What counts as a debit |
|---|---|---|
| Trade in goods (visible trade) | Exports of goods such as cars, machinery or oil | Imports of goods such as clothing, electronics or food |
| Trade in services (invisible trade) | Exports of services such as tourism, finance or education | Imports of services such as foreign holidays, insurance or transport |
| Primary income | Income received from assets owned abroad, such as profits, dividends or interest, and wages earned by UK residents working abroad for short periods | Income paid to foreign owners of UK assets, and wages paid to non-resident workers employed in the UK for short periods |
| Secondary income | Transfers received, such as remittances or aid | Transfers paid abroad, such as remittances or government contributions |
So the current account balance can be written as:
Here, means net trade in goods and services.
In UK data, this often means a deficit on trade in goods is partly offset by stronger exports of services. The City of London is a good example: banking, insurance and legal services bring export earnings into the UK even when the country is importing large volumes of manufactured goods.
Financial, Capital and Balancing
The current account is only one part of the story. A country also buys and sells assets across borders, and those flows are recorded separately.
Definition: Financial account
The part of the balance of payments that records transactions involving changes in ownership of financial assets between residents and the rest of the world.
The financial account includes:
- foreign direct investment (FDI), where the investor gains significant control, usually associated with owning at least 10% of voting shares
- portfolio investment, where investors buy shares or bonds without gaining control
- other investment, such as bank loans, deposits, trade credit and currency flows
- reserve assets, which are changes in the central bank's holdings of foreign currency and gold
If Nissan expands production in Sunderland using overseas funds, that is an inward financial account flow. If a UK investor buys US government bonds, that is an outward financial account flow.
Definition: Capital account
The part of the balance of payments that records transfers of non-produced, non-financial assets and capital transfers between residents and the rest of the world.
The capital account is much smaller. It includes transfers of non-produced, non-financial assets such as patents and copyrights, debt forgiveness, and transfers of assets linked to migration.
In accounting terms, the balance of payments must balance:
That does not mean every account is individually balanced. It means a deficit in one part must be matched by a surplus elsewhere. The logic is that the pounds paid out for extra imports do not disappear: foreigners use them to buy UK assets or lend to UK residents, which is recorded as a financial account inflow. If the UK runs a current account deficit, it must be financed by selling assets to foreigners, attracting inward investment, borrowing from abroad, or using reserves. In published data there is also usually a balancing item called errors and omissions, because real-world transactions are not measured perfectly.
Why Deficits and Surpluses Persist
Some current account imbalances are short-term and cyclical. Others are structural and can last for years.
In the short run, a current account deficit often worsens when domestic demand rises quickly. If household incomes and spending grow, imports usually rise. In a country such as the UK, where many consumer goods and manufactured inputs are imported, strong growth can therefore increase the trade deficit. This is especially likely when imports have a high income elasticity of demand.
A strong exchange rate can also worsen the current account because exports become more expensive to foreign buyers while imports become cheaper to domestic consumers. High relative inflation has a similar effect: if UK costs and prices rise faster than those of competing countries, UK goods and services become less competitive.
Some causes are medium-term or structural. Countries can lose comparative advantage as rival economies industrialise and become more efficient. Western economies have faced this in manufacturing as countries such as China expanded lower-cost industrial production.
Persistent deficits are often linked to supply-side weaknesses:
- low productivity, which raises unit costs
- weak capital investment, which leaves firms with less efficient equipment and technology
- deindustrialisation, which can reduce the capacity to export goods
- skills shortages, especially in technical and vocational areas
- poor infrastructure, which raises business costs
- institutional weaknesses, such as regulation or corruption in some economies, which make firms less competitive
Application
The UK has often run a deficit in trade in goods while keeping a stronger position in services. That pattern reflects the structure of the economy: financial and professional services are internationally competitive, but UK households and firms still import large volumes of consumer goods, components and energy.
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