Balance of Payments Equilibrium

A country’s balance of payments is the net of its current and capital accounts. The current account measures the inflows and outflows of capital for the following purposes: export and import of goods and services, transfers of capital by tourists, and foreign governments using the host country’s currency to operate a presence in the host country. In all but the rarest of cases, the current account is dominated by transfers from cross-border exchanges of goods and services. A positive current account balance means that the country is exporting more goods and services than it is importing. A negative current account balance means that a country is importing more than it is exporting.

As a result of bilateral trade imbalance, a country with a positive current account balance with respect to another country should also experience an appreciation of its currency as against its deficit trading partner. Why? The surplus country needs less of its trading partner’s currency to buy the trading partner’s goods. Applying the axiomatic law of supply and demand, the decreased demand for the currency equates into decreased price for the same currency. As for the converse, the deficit trader needs more of its trading partner’s currency. The increased demand translates into a higher price for the surplus country’s currency.

With respect to developing or emerging economies, a current account deficit demonstrates the strength of an economy in that its economy is growing faster than can be supported by domestic savings. However, a current account deficit can also signal a severe and disproportionate imbalance between domestic investment and savings and foreign generated debts, such that those debts cannot be serviced by the current level of domestic output.

It is not always easy to see what is driving a current account deficit. An imbalance in-and-of-itself is not a bad thing. If the imbalance is driven by consumption, then that should worry policymakers. Why? Because this consumption does not generate the ability to pay back the current account deficit. By contrast, purchases of imported goods that are used to create new goods or services can generate future revenue streams. This new revenue can then be used to service the past current account deficits. As a rule of thumb, a current account deficit should begin to worry policymakers when it approaches five percent of GDP, though large current account deficits can be tolerated if economic growth is high.

The capital account measures the value of the flow of capital for "capital transactions." A capital transaction involves the sale or purchase of real property, buildings, stocks, and bonds. Current account deficits are often balanced by capital account surpluses. The net of the two accounts is the "balance of payment."

Policymakers must be on the watch for the composition of capital flows used to offset the current account deficit. Simply because the capital account is running a surplus does not mean that the policymakers should be unconcerned. Short-term capital flows are more dangerous than long-term flows because they are more likely to suddenly flow outward and destabilize the country’s macroeconomic picture. So, as an example, if a country running a current account deficit has a capital account surplus composed predominantly of foreign direct investment (the direct purchase of assets in the host country), or FDI, then the deficit is more sustainable than if the capital account was composed of short-term portfolio investments.