Definition of the current account balance
What is the current account balance?
The balance of payments (BOP) is where countries record their monetary transactions with the rest of the world. Examining the current account (CAB) of a country’s balance of payments can give a good idea of ââits economic activity. It includes activity around a country’s industries, capital market, services, and money entering the country from other governments or through remittances.
Key points to remember
- The current account of the balance of payments comprises the key activity of a country, such as capital markets and services.
- The current account balance should theoretically be zero, which is impossible, so in reality it will tell whether a country is in surplus or in deficit.
- A surplus is indicative of an economy that is a net creditor of the rest of the world. A deficit reflects a government and an economy that owe a net debt to the rest of the world.
- The four main components of a current account are goods, services, income and current transfers.
Understanding the current account balance
Calculating a country’s current account (CAB) balance will show whether it has a deficit or a surplus. If there is a deficit, does that mean the economy is weak? Does a surplus automatically mean the economy is strong? Not necessarily.
It is important to consider all the factors involved when analyzing the current account on a country’s balance of payments. When looking at a country’s current account, it is important to understand the four basic components that account for it: goods, services, income and current transfers.
Components of the current account balance
These are of a movable and physical nature, and for a transaction to be recorded under the heading “goods”, a change of ownership from or to a resident (of the local country) to or from a non-resident (in a country foreign) must take place. Movable property includes general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money in) and an import is marked as a debit (money out).
These transactions result from an intangible action, such as transport, business services, tourism, royalties or licenses. If money is paid for a service, it is recorded as an import (a debit). If money is received, it is recorded as an export (credit).
Income is money entering (credited) or leaving (debit) a country from wages, portfolio investments (in the form of dividends, for example), direct investments, or any other type of investment. Together, goods, services and income provide an economy with the fuel it needs to function. This means that the items in these categories are real resources that are transferred to and from a country for the purpose of economic production.
Transfers in progress
Current transfers are unilateral transfers with nothing received in return. These include workers’ remittances, donations, aid and subsidies, public aid and pensions. Due to their nature, current transfers are not considered to be real resources affecting economic production.
The formula for the current account balance
The mathematical equation that allows us to determine the current account balance tells us whether the current account is in deficit or in surplus (if it has more credit or debit). This will help to understand where the gaps may come from and how resources can be restructured to make the economy work better.
VSAB=(X–M)+(NOTYes+NOTVST)or:X=Exports of goods and servicesM=Imports of goods and servicesNOTYes=Net income abroadNOTVST=Net current transfers??
What does the current account balance tell you?
Theoretically, the CAB should be zero, but, in the real world, this is unlikely. Whether the current account shows a surplus or a deficit, it informs about the government and the state of the economy in question, both alone and in relation to other world markets.
A surplus is indicative of an economy that is a net creditor of the rest of the world. This means that the country is probably providing an abundance of resources to other economies and that it owes money in return. By providing these resources abroad, a country with a CAB surplus gives other economies the opportunity to increase their productivity while running a deficit. This is called deficit financing.
A current account deficit reflects a government and an economy that are net debtors to the rest of the world. It invests more than it saves and uses the resources of other economies to meet its domestic consumption and investment needs.
For example, an economy decides that it must invest for the future in order to receive long-term investment income. Instead of saving, he sends the money abroad for an investment project. This would be marked as a debit in the balance of payments financial account for that period, but, when future returns are made, they would be recorded as investment income (a credit) in the current account in the income section.
A current account deficit is usually accompanied by a depletion of foreign currency assets, as these reserves would be used for investments abroad. The deficit could also mean an increase in foreign investment in the local market, in which case the local economy is likely to pay the investment income of the foreign economy in the future.
Analyze the current account balance
It is important to understand where a current account deficit or surplus comes from. When analyzing, be sure to consider what is feeding the additional credit or debit and what is being done to counter the effects.
Depending on the stage of economic growth of the nation, its objectives and, of course, the implementation of its economic program, the state of the current account is relative to the characteristics of the country in question. For example, a surplus funded by a donation may not be the safest way to run an economy.
A deficit between exports and imports of goods and services combined, otherwise known as the trade balance deficit (BOT), could mean that the country is importing more to increase its productivity and possibly produce more exports. This, in turn, could ultimately finance and mitigate the deficit.
A deficit could also arise from an increase in investment from abroad and an increased obligation of the local economy to pay investment income (a debit under current account income). Foreign investments generally have a positive effect on the local economy because, if used wisely, they increase the market value and output of that economy in the future. This can allow the local economy to increase its exports and, again, reverse its deficit.
So a deficit is not necessarily bad for an economy; especially for an economy in the development phase or undergoing reform. Sometimes an economy has to spend money to make money, so it runs a deficit intentionally. However, an economy must be prepared to finance this deficit by a combination of means which will make it possible to reduce external commitments and increase foreign credits.
For example, a current account deficit financed by short-term portfolio investments or borrowing is likely to be riskier. Indeed, a sudden failure of an emerging capital market or an unexpected suspension of assistance from a foreign government, perhaps due to political tensions, will result in an immediate termination of current account credit.