It is a ticking time bomb. We don't know when it is going to explode, but it cannot continue the way the White House describes it.¹ (Bernard Baumohl, year unknown).
Do you know what Mr Bernard Baumohl was referring to? Current account imbalances. In this article, you will learn about current accounts, the causes of their imbalances, and the reason why Mr Baumohl was so worried.
The current account is the record of a country’s sum of net trade (export - imports), the net income flows, and net current transfers.
What is the current account?
The current account indicates a country’s economic activity. It records the transactions of a country’s trade, payments to foreign investors, and other monetary transfers. The current account measures the country’s net income over a certain period. It can either be in a surplus or deficit.
The current account consists of money received and paid out for goods, services, investments, salaries, pension payments to foreign workers, and money sent by workers to family members abroad.
What are the components of the current account?
The basic four components of the current are goods, services, primary income, and secondary income.
Trade-in goods
Trade-in goods are the biggest component of current accounts. It refers to the trade of tangible goods. A country’s trade capacity depends on its productivity.
As productivity increases, the number of goods the country can export increases. An increase in productivity helps reduce the cost of production. This means that if a country’s exports become more price-competitive, it exports more.
Trade-in services
Trade-in services refer to the trade of intangibles such as tourism, banking, shipping, and likewise. When the volume of exports of all goods and services exceed the volume of imports of all goods and services result in a current account surplus. If the country’s revenue from exports exceeds the amount of money spent on imports, it experiences a surplus.
Primary income
Payments like wages, investment incomes, etc. are recorded under this component. It is the net flow of income in the form of profits, interest, or dividends from investments in other countries. The interest that a country pays to a foreigner holding a bank account in the country is listed as a debit, whereas, the dividends paid on a foreign share by the native of the country is listed as a credit item.
Secondary income
Government transactions, such as payments to the European Union (EU) or the United Nations (UN) are recorded under this component. Additionally, remittance transfers from foreign workers, which is a one-sided transaction, would be recorded here. However, the one-sided nature makes accounting for it difficult.
Remittance, commonly known as international money transfer, is the money sent by migrant workers, usually to their families in their native countries.
What is the formula to calculate a current account?
The formula for the calculation of the current account is as follows:
Current Account Balance =
Where:
X = Exports of goods and services
M = Imports of goods and services
NY = Net income from abroad
NCT = Net current transfers
Table 1 shows an example of an economy experiencing a current account deficit.
| Particulars | Amount |
| Current Account | |
| Export of goods | £225,000.00 |
| Import of goods | -£350,000.00 |
| Balance of goods trade | -£125,000.00 |
| Export of services | £95,000.00 |
| Import of services | -£125,000.00 |
| Balance of services trade | -£30,000.00 |
| Balance of goods and services trade (X - M) | -£155,000.00 |
| Income FDIs | £120,000.00 |
| Employee compensations | £80,000.00 |
| Net income from abroad (NY) | £200,000.00 |
| Government transfers | -£170,000.00 |
| Other transfers | -£75,000.00 |
| Net current transfers (NCT) | -£245,000.00 |
| Balance of Current Account | -£200,000.00 |
Table 1. Example of a current account deficit - StudySmarter.
Balance of current account =
Balance of goods trade = Export of goods + Import of goods £225,000.00 + -£350,000.00 = -£125,000.00
Balance of services trade = Export of services + Import of services £95,000.00 + -£125,000.00 = -£30,000.00
Balance of goods and services trade (X - M) = Balance of goods trade + Balance of services trade
(X-M) = -£125,000.00 + -£30,000.00 = -£155,000.00
Net income from abroad (NY) = Income FDIs + Employee compensations £120,000.00 + £80,000.00 = £200,000.00Net current transfers (NCT) = Government transfers + Other transfers -£170,000.00 + -£75,000.00 = - £245,000.00
Balance of Current Account = -£155,000.00 + £200,000.00 + - £245,000.00 = -£200,000.00
Table 2 shows an example of an economy experiencing a current account surplus.
| Particulars | Amount |
| Current Account | |
| Export of goods | £425,000.00 |
| Import of goods | -£350,000.00 |
| Balance of goods trade | -£75,000.00 |
| Export of services | £235,000.00 |
| Import of services | -£125,000.00 |
| Balance of services trade | £110,000.00 |
| Balance of goods and services trade (X - M) | £35,000.00 |
| Income FDIs | £120,000.00 |
| Employee compensations | £80,000.00 |
| Net income from abroad (NY) | £200,000.00 |
| Government transfers | -£70,000.00 |
| Other transfers | -£75,000.00 |
| Net current transfers (NCT) | -£145,000.00 |
| Balance of Current Account | £90,000.00 |
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Table 2. Example of current account surplus - StudySmarter.
Balance of current account =
Balance of goods trade = Export of goods + Import of goods £425,000.00 + -£350,000.00 = -£75,000.00
Balance of services trade = Export of services + Import of services £235,000.00 + -£125,000.00 = -£110,000.00
Balance of goods and services trade (X - M) = Balance of goods trade + Balance of services trade
(X-M) = -£75,000.00 + -£110,000.00 = £35,000.00
Net income from abroad (NY) = Income FDIs + Employee compensations £120,000.00 + £80,000.00 = £200,000.00
Net current transfers (NCT) = Government transfers + Other transfers -£70,000.00 + -£75,000.00 = - £145,000.00
Balance of Current Account = -£35,000.00 + £200,000.00 + - £145,000.00 = -£90,000.00
What causes current account deficit and surplus?
The world’s total current account is always balanced, but that of an individual nation is not. It usually experiences a surplus or a deficit. But from the world’s current account perspective, the total current account deficits are balanced by the total current account surpluses.
Imbalances can be caused due to several factors.
Some of the causes of current account deficits are:
- High inflation. If inflation rises at a faster rate than competitors, the country will have less competitive exports. There will be fewer volumes of exports demanded and sold, and imports are cheaper to buy, thereby deteriorating the country’s current account.
- The decline in competitiveness of the export sector. The UK’s export sector has failed to compete with the exports of other major countries. The UK’s current account has deteriorated primarily due to this reason.
- Economic growth. During periods of economic growth, consumers spend more money and the demand for goods and services increases. If domestic firms can’t keep up with the rising demand, the goods and services will have to be imported from other countries.
- Recession in other countries. The US is the UK’s top trading partner. If the US experiences a recession, the UK will experience a current account deficit because the US will demand fewer UK exports due to negative economic growth.
Some common causes of a current account surplus are:
- Low inflation and low exchange rate. These factors allow exports to become more price-competitive, causing a country to export more. This leads to a current account surplus.
- Economic growth among trading partners. If the UK’s trading partners such as Germany and China were to grow economically, they are more likely to buy more of the UK’s exports, thereby allowing the UK to experience a current account surplus.
- High inflation in a trading country will add value to the exports from the UK, making their exports competitive and improving the current account status as a result.
Reversing the causes of the current account deficit will also lead to a current account surplus.
What are the consequences of current account deficit and current account surplus?
A current account deficit implies that a country is spending more money on imports than it receives from its exports.
When a country experiences deficiency in its current accounts, the demand for goods and services also decreases, as people have less money to spend. This will slow down economic growth and can result in unemployment.
Depreciating the value is sometimes necessary to balance trade. This is known as overvalued currency. When the currency is overvalued, imports become cheaper, allowing higher volumes of imports. This results in uncompetitive exports, and the volume of exports decrease.
When there is a current account deficit, implying lower exports than imports, it means that there is a lower demand for domestic goods. This lack of demand for domestic goods leads to a decrease in domestic employment opportunities. A decrease in employment means that many people in the economy have less spending capacity, which in turn slows down economic growth.
Certain countries’ deficits, though, can have a large impact on the global economy. This is certainly the case with the USA.
The USA has a large influence on the global economy, and it has the biggest current account deficit in the world. It imports more than it exports. It mainly imports from China and also from other countries.
However, when the US experienced a recession as it did in 2008–09, the countries that exported to the US also suffered a loss of the export market. Therefore, the growth and decline of the US economy affect other economies as well.
When a country is experiencing a current account surplus, they are receiving more revenue from its exports compared to the money spent to import foreign goods and services. A country’s net assets increase by its amount of surplus. But, with the increased supply of money, the country may experience inflationary pressure. This will lead to low wage growth, like in Japan.
BOP: Current Account - Key takeaways
- The current account indicates whether a country is in a surplus or deficit.
- The basic four components of the current account are trade-in goods, trade-in services, primary income, and secondary income.
Investment and employee income are collectively known as primary income.
Current Account Balance = ( X − M ) + ( NY + NCT )
Some of the causes of current account deficits include high inflation, a decline in the competitiveness/export sector, economic growth, and recession in other countries.
The common causes of a current account surplus are low inflation and low exchange rate, economic growth, and high inflation.
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