The Balance of Payments and Correcting Imbalances

Structure

The balance of payments records all transactions between residents of a country and the rest of the world over a year. The current account contains trade in goods (visible balance), trade in services, primary income (wages, interest, profits and dividends flowing between countries) and secondary income (transfers such as remittances and aid). The capital account is small (capital transfers, sale of non-produced assets). The financial account records foreign direct investment, portfolio investment, other investment such as bank loans, and changes in official reserves. Because every transaction has two sides, the accounts must sum to zero once net errors and omissions are included: a current account deficit is matched by a net inflow on the financial account, i.e. borrowing from abroad or selling assets to foreigners.

Causes and consequences of a current account deficit

Causes: an overvalued exchange rate, high domestic inflation reducing competitiveness, low productivity and poor non-price competitiveness, a consumer boom that sucks in imports (high marginal propensity to import), a deteriorating terms of trade for commodity exporters, and structural decline of key industries. A deficit financed by FDI may be benign; a persistent deficit financed by short-term borrowing raises external debt, puts downward pressure on the currency, may require higher interest rates and represents a leakage from the circular flow.

Policies to correct a deficit

Expenditure-switching policies change the relative price of imports and exports: devaluation or depreciation, tariffs and quotas. Expenditure-reducing policies cut aggregate demand and hence imports: contractionary fiscal or monetary policy, at the cost of lower output and higher unemployment. Supply-side policies raise long-run competitiveness but act slowly. A depreciation improves the current account only if the Marshall-Lerner condition holds:

Because elasticities are low in the short run (contracts, search costs), the balance worsens first and improves later: the J-curve. Depreciation also raises import prices and may feed inflation, eroding the gain.