Balance of Payments and Development

The current account

The balance of payments records all the money flowing into and out of a country. The current account is the part that records trade and income.

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Remittances matter enormously for many developing countries, and they are often what a data question is really testing.

Current account balance = money flowing in − money flowing out.

• Deficit: more money flowing out than in. Imports exceed exports.
• Surplus: more money flowing in than out.

Causes of a deficit:

• Loss of competitiveness: domestic inflation higher than trading partners', or low productivity.
• A strong exchange rate, making exports dear and imports cheap.
• Strong economic growth at home, so richer consumers buy more imports.
• Poor quality or design of domestic goods.
• Dependence on imports of energy, food or machinery the country cannot produce.

Consequences of a deficit:

• Money leaves the country, so demand for domestic output falls, lower output and higher unemployment.
• The country must borrow from abroad or sell assets to pay for the gap, creating future interest payments.
• Under a floating system the currency tends to fall, which is partly self-correcting because it makes exports cheaper.

But a deficit is not automatically bad. A deficit caused by importing machinery and equipment builds future productive capacity, very different from one caused by borrowing to buy consumer goods. Making that distinction is a reliable evaluation point.

Economic development

Economic growth is an increase in real GDP, a purely quantitative measure.

Economic development is an improvement in living standards and quality of life, a broader idea including health, education, and freedom from poverty.

Growth usually helps development, because it raises incomes and the tax revenue that funds schools and hospitals. But growth without development is possible: if the gains from an oil boom go to a small elite, GDP rises while most people's lives do not improve.

Opening with this distinction frames any answer on this topic.

Measuring development

GDP per capita is the starting point but a poor measure of welfare:

• It is an average, so it hides inequality, a country can have a high average income and widespread poverty.
• It ignores unpaid work such as childcare and subsistence farming.
• It ignores the informal economy, which is very large in many developing countries.
• It ignores pollution, and cleaning pollution up actually adds to GDP.
• Comparisons are distorted by exchange rates and price differences, which is why economists adjust using purchasing power parity (PPP).

The Human Development Index (HDI) was created because income alone is too narrow. It combines three dimensions into a single figure between 0 and 1, the closer to 1, the higher the level of development.

Strengths: broader than income alone; captures the outcomes that income is supposed to buy; comparable across countries and over time.

Limitations: still an average, so it hides inequality within a country; ignores the environment; ignores political freedom and human rights; ignores gender inequality unless a separate index is used.

Other indicators: literacy rates, infant and maternal mortality, access to clean water and sanitation, doctors per thousand people, and internet access. Using several indicators together gives a fuller picture than any one alone, a good closing point.

Factors influencing development

• Education and healthcare: better-educated, healthier workers are more productive.
• Investment and infrastructure: roads, ports, power and broadband lower costs for every firm.
• The savings gap: poor households cannot save, so there is little money to lend for investment. This is the poverty cycle: low income → no saving → no investment → low productivity → low income again.
• Population growth: if population grows faster than output, GDP per head falls.
• Dependence on primary products, whose world prices are volatile, making export earnings unpredictable.
• Debt, where interest payments absorb money that could fund development.
• Corruption and political instability, which deter investment.
• Foreign direct investment (FDI): brings capital, technology and jobs, but profits are sent abroad.
• Aid: can fund schools and infrastructure, but may create dependency or be misused.
• Trade barriers in richer countries limiting access to their markets.

Worked example

A low-income country relies on exporting one primary product, coffee.

1. Its export earnings depend on a single world price
2. that price is volatile, so revenue swings sharply from year to year
3. the government cannot plan long-term spending on schools and hospitals
4. development stalls.

A bad harvest, disease or drought could wipe out most of the country's export earnings in a single season.

What could the country do, and what is wrong with each option?

• Diversify into manufacturing and services, so it is no longer dependent on one crop. This is the real long-term solution, but it needs capital, skills and infrastructure the country does not yet have, and takes a decade or more.
• Attract foreign direct investment to supply the capital and technology quickly. But the profits are sent abroad, jobs may be low-skilled, and the firm can leave.
• Invest in education and healthcare to raise productivity, attacking the root cause. But the payoff is a generation away, and the money must come from borrowing or aid.

Evaluation. These work best together. FDI is far more likely to arrive, and to bring better jobs, where the workforce is educated and the infrastructure works. Education without capital tends to produce emigration; capital without education produces low-skilled assembly work.

Judgement: diversification is the goal, but it must be financed and staffed first. The sensible order is education and infrastructure to build capacity, FDI to supply capital in the meantime, with diversification as the destination rather than the starting point.

Common exam mistakes

• Treating growth and development as the same thing.
• Forgetting primary and secondary income in the current account, especially remittances.
• Saying GDP per capita measures living standards accurately.
• Naming only two HDI components, or saying HDI uses GDP, it uses GNI per capita at PPP.
• Treating a current account deficit as automatically harmful, without asking what is causing it.
• Presenting aid or FDI as entirely good, without the drawbacks.
• Forgetting population growth when discussing living standards.

Exam technique

Name the four sections of the current account when asked about its structure; that is usually four marks, one each.

For HDI questions, give all three dimensions and their indicators, and remember it is GNI per capita at PPP.

Open development answers by distinguishing growth from development, then group the factors into economic (savings gap, primary dependence, debt), social, education, health, population, and political (corruption, instability).

For evaluation, ask how long each strategy takes and who captures the gains, those two questions separate a top answer from a list.

Quick revision

• Current account: trade in goods, trade in services, primary income, secondary income.
• Deficit = imports exceed exports; surplus = the reverse.
• A deficit's significance depends on what is causing it, importing machinery differs from funding consumption.
• Growth = more real GDP. Development = better living standards. Growth without development is possible.
• GDP per capita ignores distribution, unpaid work, the informal economy and pollution; use PPP to compare countries.
• HDI = life expectancy + schooling (mean and expected) + GNI per capita at PPP, scored 0 to 1.
• HDI ignores inequality within a country, the environment and political freedom.
• Factors: education, health, investment, infrastructure, the savings gap and poverty cycle, population growth, primary product dependence, debt, corruption, FDI, aid.

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