Government and Economy
2.1.1 Current account of the balance of payments
Government and the economy
The current account
Current account: where the total value of exports and imports are recorded.
Exports are goods and services sold to other countries, and imports are goods and services bought from other countries. The current account is one part of the balance of payments, a country’s record of all its transactions relating to international trade.
Trade in goods and services
- Visible trade (trade in goods): buying and selling physical goods, e.g. cars, smartphones, wheat and textiles. Visible exports minus visible imports gives the balance of trade.
- Invisible trade (trade in services): buying and selling services, e.g. tourism, banking, insurance and shipping. The current account also records income such as interest and profits flowing in from assets owned abroad, and out to foreign investors who own assets in the country.
Money flowing into the country counts as an export, even when nothing physical leaves the country. So when foreign tourists spend money on holiday in a country, this is an invisible export for that country. When its own residents go on holiday abroad, this is an invisible import.
Example: classifying trade for Kenya
- Kenyan tea sold to the UK: a visible export.
- Machinery bought from Germany: a visible import.
- American tourists on safari in Kenya: an invisible export.
- A Kenyan family on holiday in South Africa: an invisible import.
Current account deficits and surpluses
Current account surplus: When the value of exports exceeds the value of imports.
Current account deficit: when value of imports exceeds the value of exports.
The current account balance is the total value of exports minus the total value of imports, for goods and services together. A surplus means more money flows into the country from trade than flows out, so the balance is positive. A deficit means more money flows out than in, so the balance is negative.
Formula:
Current account balance = Total exports – Total imports
Always subtract imports from exports, not the other way round. Show the currency, and keep the minus sign if the answer is a deficit.
Example: a country’s current account
- Balance of trade (goods): exports $96bn – imports $120bn = –$24bn.
- Invisible balance (services and income): +$15bn.
- Current account balance: –$24bn + $15bn = –$9bn, a current account deficit.
The current account and exchange rates
Exchange rate: The price of one currency in terms of another currency.
How exchange rates and the current account affect each other:
- A stronger exchange rate: one unit of the currency buys more foreign currency. Exports become more expensive for foreign buyers and imports become cheaper, so fewer exports are sold and more imports are bought. The current account gets worse, e.g. a deficit gets bigger.
- A weaker exchange rate: exports become cheaper and imports more expensive, which can improve the current account.
- The effect in the other direction: if a country’s exports rise, foreign buyers need more of its currency to pay for them. Higher demand for the currency can push its exchange rate up.
Real-world exchange rates
Exchange rates are set by market forces, so they change whenever supply of or demand for a currency changes. For example, in June 2016, just before the UK’s vote to leave the EU, £1 bought about US$1.50. By January 2017, it had fallen to about £1 = US$1.24, a fall of around 17%. With the pound weaker, more people chose holidays in the UK, which boosted the UK’s invisible exports.
Example: A UK-made car costs £18 000. When the exchange rate is £1 = €1.15, a buyer in Europe pays £18 000 × 1.15 = €20 700.
Reasons for current account deficits and surpluses
- Quality of domestic goods: if a country’s goods have a reputation for high quality, foreign buyers want more of them and home consumers choose them over imports. Exports rise and the current account improves.
- Quality of foreign goods: if foreign goods are better, demand for imports rises and demand for home-produced goods falls. The current account gets worse.
- Price of domestic goods: if home-produced goods are expensive, e.g. because of high inflation, foreign buyers buy fewer of them, so exports fall.
- Price of foreign goods: when imports cost less than similar home-produced goods, demand for imports rises. A surplus shrinks or a deficit grows.
- Exchange rates between countries: a change in the exchange rate alters export and import prices. A weaker currency makes exports cheaper and helps the current account, while a stronger one makes it worse.
Example: Country Z makes high-quality electric bikes that sell well abroad, so its exports are strong. However, cheaper clothing from abroad floods its shops, and its currency has just risen in value. Exports of bikes help its current account, but the cheap imports and the stronger currency work against it.
The impact of a current account deficit
- Leakage from the economy: money spent on imports flows out to foreign firms instead of home businesses, so domestic output and jobs are put at risk.
- Can be inflationary if prices rise abroad: imported goods are included when the CPI is calculated. If import prices rise, the general price level rises too. The more a country relies on imports, the bigger this risk.
- Low demand for our exports: a deficit may show that the country’s goods are too expensive or not good enough. If this continues, growth may slow and unemployment may rise.
- Problems finding foreign reserves to fund the deficit: imports must be paid for in foreign currency. If the country’s reserves of foreign currency run low, it may have to borrow, and continued borrowing can cause long-term problems.
Example: A country imports most of its fuel and food and has a large current account deficit. When world oil prices rise, its fuel import bill jumps and petrol prices at home rise, adding to inflation. Its central bank’s reserves of US dollars fall, so the government has to borrow abroad to keep paying for imports.
