The balance of payments
The balance of payments records all transactions between a country and the rest of the world. It must always balance, but its parts tell an important story.
The current account
The current account records trade in goods and services, plus primary income (such as earnings on foreign investments and wages earned abroad) and secondary income (transfers such as remittances and foreign aid). A current account deficit means a country is spending more abroad than it earns from abroad.
The trade balance
The trade balance is exports minus imports of goods and services; it is the largest part of the current account for most countries. The US has run large trade deficits for decades, while Germany, China, and several oil exporters have often run surpluses.
The financial account
The financial account records cross-border purchases of assets: foreign direct investment (buying firms or building factories abroad), portfolio investment (shares and bonds), and changes in reserves. If foreigners buy more of a country's assets than its residents buy abroad, there is a financial account inflow.
Why the accounts balance
Every transaction has two sides. If a country imports more than it exports (a current account deficit), it must pay for the excess by selling assets or borrowing from abroad (a financial account surplus). Apart from statistical errors, the current account and the capital-plus-financial account sum to zero.
Saving, investment, and the current account
A country's current account balance equals national saving minus domestic investment. A country that invests more than it saves must borrow from abroad, running a current account deficit. This means trade deficits reflect macroeconomic saving patterns, not just trade policies or competitiveness.
Are deficits bad?
Current account deficits are not necessarily harmful. A fast-growing country may borrow to fund productive investment, as the US did in the 19th century. But large, persistent deficits financed by short-term borrowing can make countries vulnerable to sudden stops in capital inflows, as in some emerging market crises.
Remittances
Remittances, money sent home by migrants, are a major source of income for many developing countries, sometimes exceeding 20% of GDP, as in Tajikistan, Tonga, and Nepal at times. Globally, remittances to low- and middle-income countries exceed official foreign aid.
Worked example
A country exports 500 billion dollars of goods and services and imports 600 billion, with net primary and secondary income of zero. Its current account deficit is 100 billion. It must be financed by a net inflow of 100 billion, for example foreigners buying its government bonds or investing in its companies.
Key takeaways
The current account records trade, primary income, and transfers; the trade balance is its main part. The financial account records cross-border asset purchases. The two balance: a current account deficit is financed by financial inflows. The current account equals saving minus investment. Deficits can fund investment but can create vulnerability. Remittances are vital for many developing countries.
Flashcard
Record of all international transactions
Check your understanding
A country invests more than it saves. What must be true of its current account?