A country buying more from abroad than it sells must be paying for the difference somehow: borrowing, selling assets, or running down reserves. There is no other possibility, because every transaction has two sides. That accounting truth is the whole of the balance of payments, and it is why a current account deficit is never a standalone fact. It always has a counterpart, and the interesting question is what that counterpart is and whether it can continue.
Balance of payments
A record of all financial transactions between the residents of a country and the rest of the world over a period of time, usually a year.
The current account has four components and questions expect all four. Trade in goods records exports and imports of physical products, sometimes called visible trade. Trade in services records exports and imports of services such as tourism, banking, insurance and shipping, sometimes called invisible trade. Primary income records wages, interest, profits and dividends flowing in and out, so a country whose firms own assets abroad receives inflows here. Secondary income records transfers with nothing given in return, such as foreign aid and money sent home by workers abroad.
Data-response questions routinely give the four components and ask for the current account balance, or give three and the total and ask for the missing one. Set them out in a column with signs, inflows positive and outflows negative, and add. The commonest error is treating the trade in goods balance as the current account balance, when it is only one of four parts and a country with a goods deficit can have a current account surplus.
Calculating the current account balance from its components
A country records: exports of goods $180bn, imports of goods $220bn, exports of services $95bn, imports of services $60bn, net primary income minus $12bn, net secondary income plus $8bn. Calculate the trade in goods balance, the trade in services balance and the overall current account balance.
A current account deficit arises for identifiable reasons. Domestic goods may be uncompetitive because costs or prices are high, quality is poor, or the exchange rate is strong. Rapid domestic growth pulls in imports as incomes rise. A recession in export markets reduces demand for what the country sells. Structural weakness, such as a narrow export base or dependence on a single commodity, leaves a country exposed. And high domestic inflation relative to competitors erodes competitiveness year after year.
A persistent deficit matters, though not always urgently. It must be financed by borrowing from abroad or by selling domestic assets, and both create future obligations: interest to be paid or profits to be repatriated, which worsen the primary income balance later. It can indicate a loss of competitiveness that will cost jobs in export industries. It may put downward pressure on the currency. And if lenders lose confidence, financing can stop suddenly. Against that, a deficit caused by importing capital equipment for investment builds future capacity, and a deficit financed by long-term inward investment is far safer than one financed by short-term borrowing.
A current account deficit or surplus also affects the rest of the economy. A deficit means more spending leaks abroad on imports than comes in from exports, which reduces total demand, so GDP and employment are lower than they would otherwise be, but it also eases inflation, since imports add to the supply of goods. A persistent deficit tends to push the exchange rate down. A surplus works the other way: higher demand for exports raises GDP and employment, but can add to inflationary pressure and push the exchange rate up, which eventually makes exports less competitive. A surplus also means the country is lending to or investing in the rest of the world, and a very large one means its own people are consuming less than they produce.
Governments have several policies to achieve a more stable current account. Contractionary fiscal and monetary policy reduce total spending, including spending on imports, but at the cost of lower growth and higher unemployment. Protection, such as tariffs and quotas, reduces imports directly, but raises prices and invites retaliation. A fall in the exchange rate, whether allowed or encouraged, makes exports cheaper and imports dearer. Supply-side policies that raise productivity and quality make the country's goods more competitive, which is the only lasting answer to a deficit caused by weak competitiveness, but they take years to work.
A country has a deficit on trade in goods of $50bn and a surplus on trade in services of $70bn. Net primary and secondary income are both zero. The current account is:
Which situation makes a current account deficit least worrying?
The accounts and why they balance
The balance of payments as a whole always balances, as an accounting identity rather than an economic result. The current account records trade and income. The capital account is small and records transfers of capital assets such as debt forgiveness. The financial account records transactions in assets: direct investment, portfolio investment, other investment such as bank lending, and changes in official reserves. A current account deficit means a country is spending more abroad than it earns, so it must be receiving a net inflow of finance in return, which appears as a financial account surplus of the same size. The two are two views of the same set of transactions, which is why any residual is called a balancing item and reflects measurement error rather than a genuine gap.
That identity has a consequence worth stating explicitly, because it reframes most deficit questions. A current account deficit is necessarily matched by a financial account surplus, meaning foreigners are acquiring claims on the domestic economy. Whether that is benign or dangerous depends entirely on the composition. Long-term foreign direct investment building factories is very different from short-term portfolio flows that can reverse in days, even though both finance the same deficit. Judging a deficit by its size alone, without asking how it is financed, is the commonest weakness in answers on this topic.
Policies to correct a deficit fall into three families and each has a characteristic cost. Expenditure switching aims to shift spending from foreign to domestic goods, through depreciation, tariffs or quotas, or supply-side measures improving competitiveness. Expenditure reducing aims to cut total spending, through contractionary fiscal or monetary policy, so that imports fall along with everything else. Supply-side policy raises productivity and quality so that domestic goods compete better, which is the only approach that does not require either a weaker currency or lower domestic demand. The first two work faster and the third is the only one that addresses the cause.
Why deflating the economy corrects a deficit at a high price
- The government raises taxes or interest rates to reduce aggregate demand.
- Household disposable income and firms' investment both fall, so total spending declines.
- Since a proportion of all spending goes on imports, import volumes fall as spending falls.
- The current account improves, because imports have dropped while exports are unaffected in the short run.
- But the fall in demand also reduces demand for domestically produced goods, so output falls.
- Firms respond by cutting output and employment, and unemployment rises.
- The deficit has been reduced by making the country poorer rather than by making it more competitive, so the improvement disappears as soon as demand recovers.
Step 7 is the evaluation. Expenditure reducing treats the symptom: it works reliably and quickly, and it does nothing about the underlying competitiveness that caused the deficit. That is why it is a stabilisation measure rather than a solution.
Practise this chain →Draw an AD/AS diagram showing contractionary policy shifting AD left, and mark the fall in real output and the price level. Beside it, draw a foreign exchange market showing a depreciation. Annotate which components of the current account each policy affects and by what route.
Drawing both together makes the trade-off visible. Deflation improves the current account by suppressing imports through lower income, at the cost of output and jobs. Depreciation improves it by changing relative prices, at the cost of higher import prices and therefore inflation. Neither is free, and identifying which cost matters more in the circumstances given is the judgement examiners want.
A country runs a current account deficit of $30bn. Assuming the capital account is zero and measurement is accurate, the financial account must show: