4.6 Balance of payments

The balance of payments records transactions between residents and the rest of the world. The current account covers trade in goods and services, primary income and secondary income; the capital and financial accounts record transfers of capital and changes in financial assets and liabilities.

Because each transaction is recorded twice, the accounts balance in accounting terms. A current-account deficit therefore has a counterpart in capital or financial flows, reserve changes or both; it is not the same as a government budget deficit.

A credit records a receipt from abroad or increase in external liabilities; a debit records a payment abroad or acquisition of external assets. For each account, calculate $\text{balance}=\text{credits}-\text{debits}$: a positive result is a surplus and a negative result a deficit. Example: exports of 120, imports of 150, net income of -10 and net current transfers of +5 give current-account balance $120-150-10+5=-35$, a deficit of 35 currency units. Keep the sign convention and period explicit.

The current account shows whether exports and income received exceed imports and income paid. The financial account records flows such as direct investment, portfolio investment and reserve assets; the capital account is smaller but still part of the accounting structure.

Classify a transaction by asking what is being exchanged: a good or service, an income payment, a transfer, or ownership of a financial asset. Do not treat every capital inflow as export revenue.

Use the full classification: current account = trade in goods + trade in services + income + current transfers; capital account = capital transfers + transactions in non-produced, non-financial assets; financial account = FDI + portfolio investment + reserve assets + official borrowing. A dividend received from abroad is current-account income, purchase of a foreign company is outward FDI, a patent sale is a non-produced non-financial asset transaction, and a central-bank reserve change belongs to the financial account.

A current-account deficit can be financed by borrowing from abroad or selling domestic assets, while a surplus can fund investment abroad or add to reserves. The accounts are interdependent because the external position changes both spending flows and the claims held by foreigners.

The same financing flow can have different implications: foreign direct investment may build productive capacity, whereas short-term portfolio flows can reverse quickly. Trace the identity first, then evaluate sustainability.

A persistent current-account deficit increases the economy’s need for foreign financing. If investors reduce their willingness to supply that finance, demand for the currency may fall and depreciation can make imports dearer and exports more competitive.

The response is not automatic: capital inflows can support the currency, and the trade balance reacts according to elasticities, capacity and time. Separate the accounting identity from the causal story about confidence and exchange-rate adjustment.

Current-account transactions directly enter the currency market: foreign buyers of exports create demand for the domestic currency, while domestic buyers of imports create its supply. A larger deficit caused by import demand or weaker exports tends, other things equal, to shift currency supply right or demand left and depreciate a floating rate; a surplus tends toward appreciation. Draw the relevant demand/supply shift, but allow financial inflows, reserves or policy to offset it, so an accounting deficit alone does not mechanically determine the rate.

An inward financial flow—such as foreign direct investment, portfolio investment or official borrowing—normally requires purchase of the domestic currency, shifting its demand right and supporting appreciation. An outward investment flow requires residents to supply domestic currency for foreign currency, shifting supply right and supporting depreciation. Reserve transactions can offset market pressure: a central bank selling foreign reserves buys domestic currency, while accumulating reserves supplies domestic currency. Interest-rate differentials, expected asset returns, risk and exchange-rate expectations determine the size and reversibility of flows. A financial-account surplus may finance a current-account deficit, but volatile portfolio inflows are less stable than long-term productive FDI; always identify direction, asset type and currency transaction before predicting the rate.

A deficit can reflect productive investment, temporary import demand or a strong currency that makes imports attractive. It becomes more concerning when it is persistent, finances consumption rather than capacity, or depends on short-term borrowing that can suddenly stop.

Evaluation should track the financing source, debt service, exchange-rate exposure, domestic employment and the economy’s ability to export later. “Deficit” alone is not a diagnosis.

Persistent deficits may depreciate the currency, raise interest rates needed to attract finance, increase foreign ownership of domestic assets, accumulate external debt and weaken credit ratings; demand reduction used to correct them may slow growth. Expenditure-switching policies redirect demand toward domestic output through depreciation or trade measures; expenditure-reducing monetary or fiscal policy lowers total demand and imports; supply-side policy improves productivity and export competitiveness. Evaluate elasticities, spare capacity, inflation, retaliation, time lags, debt currency and whether finance builds future capacity.

After a depreciation, import prices rise immediately while quantities adjust more slowly, so the trade balance may worsen before it improves—the J-curve. The balance improves in the longer run only if the absolute price elasticities of export and import demand sum to more than one (the Marshall–Lerner condition).

Capacity, contracts and the composition of trade determine whether the condition is plausible; never infer it from the exchange-rate movement alone.

Draw the J-curve with time horizontally and the current-account balance vertically, crossing a zero-balance line. Immediately after depreciation, contracted quantities adjust slowly while import prices rise, so the balance can fall; later, export volumes rise and import volumes fall. Long-run improvement requires $|PED_x|+|PED_m|>1$. The condition concerns demand elasticities, not the size of depreciation, and the curve's depth and timing depend on contracts, capacity and substitution.

A surplus can reflect strong export competitiveness, high saving, weak domestic demand or an exchange rate that keeps exports relatively cheap. It may build foreign assets, but it can also signal under-consumption at home and place adjustment pressure on trading partners.

Judge the surplus by productivity, distribution, domestic investment and how long it can persist—not by treating a positive balance as automatically healthy.

A persistent surplus can suppress domestic consumption or investment when saving is high, create appreciation pressure, and restrain imported inflation while export-led demand supports employment. If authorities resist appreciation, reserve accumulation and stronger domestic liquidity may add inflation. Appreciation can eventually weaken export competitiveness and employment in traded sectors; continued undervaluation can shift adjustment pressure onto deficit partners. Evaluate whether the surplus reflects productivity and sustainable saving or weak domestic demand and underinvestment, plus distributional and international consequences.