Balance of Payments

Structure of the accounts

The balance of payments records all transactions between residents of a country and the rest of the world over a period of time.

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The current account

Records flows of income, in four parts:

• Balance of trade in goods: visible exports minus visible imports.
• Balance of trade in services: tourism, financial services, shipping, education.
• Primary income: income earned on assets abroad: profits, interest, dividends, and wages of workers abroad.
• Secondary income (current transfers): payments with nothing given in return: foreign aid, remittances sent home by migrant workers.

Remittances matter enormously for many developing economies and are frequently the point a stimulus question is testing.

The capital and financial accounts

• Capital account: small: debt forgiveness, transfers of non-produced assets.
• Financial account: the large one: foreign direct investment (FDI), portfolio investment (shares and bonds), other investment such as bank loans, and changes in reserve assets.

Worked example: placing the transactions

A country reports, in billions: goods −40, services +15, primary income −8, secondary income +5.

Current account balance = −40 + 15 − 8 + 5 = −\$28bn, a deficit.

By the identity below, the capital and financial accounts together must therefore show +\$28bn, the country is a net seller of assets or net borrower to that value.

Note what each line tells you. Services are in surplus while goods are in deficit, so the country's competitive strength is in services, a pattern typical of advanced economies. Negative primary income means more is paid out to foreign asset-holders than is received from abroad, which is the long-run consequence of past financial-account inflows: today's deficit financing becomes tomorrow's primary income outflow.

The accounts must balance

This is the structural idea the topic rests on:

Current account + capital account + financial account = 0 (allowing for statistical error).

A current account deficit must be financed. The money to pay for the excess imports comes from somewhere, selling assets to foreigners, borrowing abroad, attracting investment, or running down reserves. Each of those is a financial account inflow. So:

• A current account deficit is matched by a financial account surplus.
• A current account surplus is matched by a financial account deficit (the country is accumulating claims on the rest of the world).

Stating this relationship explicitly is one of the clearest ways to show understanding, and it is also the reason a deficit is not simply "bad": it is a country consuming more than it produces and financing the difference by selling assets or borrowing.

The domestic version of the same identity is worth knowing, because it reframes the whole topic: a current account deficit means domestic investment exceeds domestic saving, with the gap filled by foreign saving. That is why a deficit can be a sign of an attractive investment climate rather than of weakness, and why "spend less on imports" is not the only route to closing one.

Causes of a current account deficit

• Loss of international competitiveness: domestic inflation above trading partners', or wage growth above productivity growth.
• An overvalued exchange rate, making exports dear and imports cheap.
• Strong domestic growth, raising import demand faster than partners' growth raises export demand.
• Structural weakness: a narrow export base, or dependence on volatile primary commodities.
• High dependence on imported energy or capital goods, common in developing economies.

Consequences of a persistent deficit

• Downward pressure on the exchange rate under a floating system, since supply of the currency exceeds demand. This is partly self-correcting, the depreciation improves competitiveness, which is a key evaluation point.
• Rising external debt or foreign ownership of domestic assets, and future outflows of profit and interest, worsening the primary income balance later.
• Reserve depletion under a fixed exchange rate, since reserves must be sold to defend the rate. Reserves are finite, so this cannot continue indefinitely.
• Lower AD through negative net exports, reducing output and employment.
• Loss of confidence among international investors, raising borrowing costs.

But it depends on why. A deficit caused by importing capital goods and FDI inflows that raise future productive capacity is very different from one caused by borrowing to fund consumption. Making that distinction is the single strongest evaluative move in this topic.

A surplus is not automatically good

Questions increasingly ask this, and most answers are unprepared for it.

• Domestic consumption is being forgone. A surplus means producing more than the country consumes and lending the difference abroad. Living standards today are lower than they need to be.
• Upward pressure on the exchange rate, eroding the competitiveness that produced the surplus in the first place.
• Imported inflation risk, where the surplus reflects strong export demand adding to AD near capacity.
• Trading-partner retaliation. Every surplus is somebody else's deficit, so large persistent surpluses create political pressure and protectionist responses.
• Over-reliance on external demand, leaving the economy exposed when partners slow.

So the balanced position is that persistent imbalances in either direction signal something worth examining, and neither sign is good or bad on its own.

Policies to correct a deficit

Expenditure-switching

Shift spending from foreign to domestic goods.

• Depreciation or devaluation: exports cheaper, imports dearer. Success requires the Marshall–Lerner condition and takes time (the J-curve). It also raises imported input costs and inflation.
• Protectionism: tariffs and quotas. Fast but invites retaliation, raises consumer prices and protects inefficiency.

The Marshall–Lerner condition states that a depreciation improves the current account only if:

PEDexports + PEDimports > 1 (in absolute terms)

The reasoning is worth being able to give. A depreciation cuts the foreign-currency price of exports and raises the domestic-currency price of imports. Whether the balance improves depends on whether volumes respond enough to outweigh the worse prices. If the two elasticities sum to less than one, quantities barely move, the country simply pays more for the same imports, and the deficit widens.

The J-curve is that condition playing out over time. Immediately after a depreciation, contracts are fixed and buyers have not yet switched supplier, so elasticities are low and the current account worsens. As months pass, buyers respond, elasticities rise above the threshold, and the balance improves, tracing a J shape. This is why judging a depreciation on its first-quarter effect is a mistake, and saying so is a strong evaluative point.

Expenditure-reducing

Cut total demand so import demand falls.

• Contractionary fiscal or monetary policy: reduces AD, and imports fall with it. The cost is blunt: it also reduces output and raises unemployment, so it treats the symptom by shrinking the economy.

Supply-side

Improve underlying competitiveness through productivity, education, infrastructure and innovation. This addresses the root cause rather than the symptom, but works only over years, the standard trade-off between effectiveness and speed.

Worked example

A country runs a persistent current account deficit of 6% of GDP, driven by weak export competitiveness.

Depreciation.

1. The currency depreciates
2. exports cheaper in foreign-currency terms and imports dearer domestically
3. export volumes rise and import volumes fall, provided demand is sufficiently price elastic
4. net exports improve
5. the current account moves towards balance.

The qualifications. In the short run elasticities are low, so the higher cost of the same imports dominates and the deficit worsens first, the J-curve. Dearer imports also feed cost-push inflation, which erodes the competitiveness gain over time. And if the export base is narrow, or firms lack spare capacity, exporters cannot expand to meet the cheaper-price opportunity at all.

Judgement. Depreciation may improve the deficit where the Marshall–Lerner condition holds and exporters have capacity to respond. Where the deficit is structural, a narrow export base, low productivity, depreciation buys time but does not fix the cause, and supply-side improvement is the only durable remedy despite its longer lags.

Real-world examples

• Germany has run large persistent current account surpluses, and the criticism made of it is precisely the one above: that suppressed domestic consumption and reliance on external demand impose adjustment costs on trading partners.
• The United States has run persistent deficits financed by strong demand for dollar assets, an illustration that a deficit can be sustained for decades where the financing is willingly supplied, and that the constraint is confidence rather than accounting.
• Remittance-dependent economies show the secondary income line doing the heavy lifting: inflows that finance imports without creating any repayment obligation, unlike borrowing.

Terms of trade

Terms of trade is not a numbered topic in this syllabus, but its consequences for the balance of payments are examinable and it bears directly on the barriers in 4.9, so it sits here.

Definition and calculation

The terms of trade measure the rate at which a country's exports exchange for its imports, how many units of imports a unit of exports will buy.

Terms of trade index = (index of average export prices ÷ index of average import prices) × 100

It is an index of prices, not of quantities or of the value of trade. That is the single most important thing to hold onto, because almost every error in this topic comes from forgetting it.

• Improvement: the index rises. Export prices rise relative to import prices, so a given volume of exports buys more imports.
• Deterioration: the index falls. Export prices fall relative to import prices, so a given volume of exports buys fewer imports.

The vocabulary is counter-intuitive and deliberately so: "improvement" refers only to the exchange rate between exports and imports, not to whether the country is better off overall. A country can enjoy improving terms of trade while its export industries collapse.

Causes of changes

Short-run causes

• Changes in demand for exports or imports, a global boom raises commodity prices and improves exporters' terms of trade.
• Changes in supply: a harvest failure raises the price of an agricultural export.
• Exchange rate movements. An appreciation raises export prices in foreign-currency terms and lowers import prices in domestic terms, so it improves the terms of trade, even though it usually worsens competitiveness. This apparent paradox is a favourite examiner target.
• Relative inflation rates. Higher domestic inflation raises export prices, improving the index.

Long-run causes

• Changes in world income. As global incomes rise, demand grows faster for manufactures and services (high YED) than for primary products (low YED).
• Technological change, which can reduce the raw material content of production and lower commodity demand.
• Productivity growth, which lowers the relative price of goods produced more efficiently.

The Prebisch–Singer hypothesis

The long-run argument that the terms of trade of primary-product exporters tend to deteriorate over time relative to manufactures.

The reasoning combines elasticities:

• Primary products have low YED, so as world incomes rise, demand for them grows slowly while demand for manufactures grows quickly.
• Primary products have low PED and low PES, so their prices swing sharply when either curve shifts.
• Productivity gains in primary production tend to be passed on as lower prices in competitive commodity markets, whereas gains in manufacturing are captured as higher wages and profits where market power and unions exist.

The implication is that a country specialising according to its comparative advantage in primary products may find that advantage delivering steadily less over time, a serious challenge to the standard trade argument, and the intellectual basis for diversification and import-substitution strategies.

Consequences of a change

The effect on the current account depends on elasticities, and this is where most marks are won or lost.

An improvement (export prices up relative to imports):

• Each unit of exports buys more imports, a gain in purchasing power and potentially higher living standards.
• But if demand for exports is price elastic, the higher price causes a proportionately larger fall in quantity sold, so export revenue falls and the current account worsens.
• If demand is inelastic, revenue rises and the current account improves.

A deterioration:

• Each unit of exports buys fewer imports, living standards fall for a given export volume.
• But if demand is elastic, cheaper exports raise volume enough that revenue rises.

An improvement in the terms of trade does not imply an improvement in the current account. The two are different things and can move in opposite directions.

Why commodity-dependent economies are especially exposed

• Volatility. With inelastic demand and inelastic supply, any shift in either curve produces large price swings, so export revenue and government revenue fluctuate unpredictably.
• Planning difficulty. Volatile revenue makes budgeting, investment and debt servicing hard.
• Long-run deterioration if Prebisch–Singer holds, requiring ever more exports to fund the same imports.
• Debt burden. Deteriorating terms of trade make foreign-currency debt harder to service.
• Vulnerability to a single market: a demand shock in one trading partner can be devastating.

Responses: diversification into manufactures and services, buffer stock schemes to stabilise prices, commodity stabilisation funds saving windfalls for lean years, and moving up the value chain by processing raw materials domestically rather than exporting them unprocessed.

Worked example

A country's export price index rises from 100 to 110 while its import price index rises from 100 to 104.

Terms of trade = (110 ÷ 104) × 100 = 105.8

The index has risen from 100 to 105.8, so the terms of trade have improved by about 5.8%. Each unit of exports now buys roughly 5.8% more imports than before.

Does this help the current account? Not necessarily.

• If demand for the country's exports is price elastic. Say it exports manufactured goods facing close international competition, the 10% price rise causes a more than 10% fall in volume, so export revenue falls and the current account worsens despite the "improvement".
• If exports are price inelastic, a commodity with few substitutes, revenue rises and the current account improves.

Judgement. The terms of trade measure purchasing power per unit exported, not national welfare. Whether this improvement is good news depends on elasticity of demand for exports, on whether it was caused by an appreciation (which also harms competitiveness) or by stronger world demand (which does not), and on whether it persists.

Second worked example: a deterioration

A commodity exporter sees its export price index fall from 100 to 88 while import prices rise from 100 to 106.

Terms of trade = (88 ÷ 106) × 100 = 83.0

A fall from 100 to 83 is a deterioration of about 17%: the same volume of exports now buys 17% fewer imports. To import the same basket as before, the country must export roughly 20% more volume, because 100 ÷ 83 ≈ 1.20.

That last sentence is the one worth writing in an exam. It converts an index movement into the real burden it imposes: more resources committed to exporting, for no gain in what comes back. For a country servicing foreign-currency debt out of export earnings; it is also why a terms-of-trade shock and a debt crisis so often arrive together.

Real-world examples

• Commodity price cycles: oil, copper, coffee, are the standard illustration of the volatility point: exporters' terms of trade swing violently with world demand, taking government revenue with them.
• Oil importers and exporters move in opposite directions in the same event, which makes an oil price rise a useful stimulus: it improves the terms of trade of exporters and deteriorates those of importers, simultaneously.
• Sovereign wealth and stabilisation funds in resource-rich economies exist precisely to save windfalls from favourable terms of trade against the years when they reverse.

Common exam mistakes

• Confusing the balance of trade (goods and services only) with the whole current account.
• Forgetting that the accounts must sum to zero, so a current account deficit is financed by a financial account surplus.
• Treating any deficit as automatically harmful without asking what is causing it and how it is financed.
• Assuming a surplus is automatically desirable.
• Placing FDI in the current account. Investment flows go in the financial account; the income they later generate goes in primary income.
• Asserting depreciation will fix a deficit without invoking Marshall–Lerner or the J-curve.
• Stating Marshall–Lerner without explaining that it is about volumes outweighing prices.
• Ignoring the inflationary cost of depreciation.

Exam technique

Be precise with account names, examiners check whether you can place a transaction correctly. A useful test: does money change hands for goods, services or income (current account), or for assets (financial account)?

Where figures are given, add the four current-account components before saying anything else, then state what the financial account must therefore be. That single line demonstrates the identity better than a paragraph about it.

For 15-mark policy questions, structure by policy type, expenditure-switching, expenditure-reducing, supply-side, then compare speed against durability. Expenditure-reducing works fastest and costs the most in lost output; supply-side is slowest and most durable.

For evaluation: what is causing the deficit, how it is financed (productive investment versus consumption borrowing), elasticities and the J-curve, the exchange-rate regime (a floating rate is partly self-correcting; a fixed rate drains reserves), and the trade-off with domestic objectives.

Quick revision

• Current account: trade in goods, trade in services, primary income, secondary income.
• Financial account: FDI, portfolio investment, other investment, reserves.
• The accounts sum to zero, a current account deficit implies a financial account surplus.
• A deficit also means domestic investment exceeds domestic saving.
• Today's financing inflow becomes tomorrow's primary income outflow.
• Causes: lost competitiveness, overvalued currency, strong domestic growth, narrow export base.
• Consequences depend on why the deficit exists and how it is financed.
• A surplus has costs too: forgone consumption, currency appreciation, partner retaliation.
• Policies: expenditure-switching (depreciation, protection), expenditure-reducing (contractionary), supply-side (durable but slow).
• Marshall–Lerner: PEDx + PEDm > 1, because volumes must outweigh prices. The J-curve is it happening slowly.

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