International Trade & Globalisation – Current Account of the Balance of Payments

1. The Balance of Payments (BoP) – a quick recap

The BoP records every economic transaction between residents of a country and the rest of the world during a given period (normally one year). It is divided into two main accounts:

• Current account – records transactions that affect a country’s income, expenditure and transfers.
• Capital & financial account – records transactions that involve changes in ownership of assets (foreign direct investment, portfolio investment, loans, etc.).

2. Structure of the Current Account

The current account consists of four inter‑related components (Cambridge syllabus 6.4):

1. Trade in goods – exports and imports of tangible products.
2. Trade in services – exports and imports of services such as tourism, transport, insurance and financial services.
3. Primary income – factor‑income receipts and payments (interest, dividends, wages and profits earned abroad or paid to foreign residents).
4. Secondary income – unrequited transfers (remittances, aid, pensions, insurance claims, gifts, etc.).

The overall current‑account balance (CAB) is therefore:

CAB = (X‑M)_goods + (X‑M)_services + (Primary‑income) + (Secondary‑income)

3. Primary Income

Primary income records factor‑service flows that arise from the ownership of foreign assets or the provision of labour abroad.

• Receipts (credits): interest earned on foreign bonds, dividends from overseas shareholdings, wages earned by residents working abroad, profits earned by domestic firms from foreign subsidiaries.
• Payments (debits): interest paid on foreign loans, dividends paid to foreign shareholders, wages paid to non‑resident workers, profits repatriated to foreign parent companies.

3.1 Secondary Income – definition and scope

Secondary income (also called unrequited transfers) consists of one‑way flows of money that are not exchanged for goods, services or factor services.

• Receipts (credits) – money received from abroad.
• Payments (debits) – money sent abroad.

3.2 Types of secondary income

3.3 Recording secondary income in the BoP

• Each receipt is entered as a credit (inflow) in the current‑account column.
• Each payment is entered as a debit (outflow).

3.4 Net secondary income

Net secondary income is the difference between total receipts and total payments:

Net secondary income = Secondary‑income receipts – Secondary‑income payments

4. Calculating the Current‑Account Balance – Worked Example (including primary income)

Interpretation: The goods deficit is partly offset by a surplus in services, a net primary‑income inflow, and a net secondary‑income inflow, leaving an overall current‑account deficit of £5 bn.

5. Causes of Current‑Account Surpluses and Deficits

5.1 Factors that can create a surplus

• High export competitiveness (low production costs, strong foreign demand).
• Large inflows of secondary income (remittances, foreign aid).
• Export‑oriented services (tourism, shipping, financial services).
• Weak domestic demand for imports (high tariffs, low consumer confidence).
• Exchange‑rate appreciation that makes imports cheaper but also raises the value of overseas earnings.
• Government policies that promote exports (export subsidies, trade agreements) or restrict imports (import quotas, high duties).

5.2 Factors that can create a deficit

• Import‑led growth (strong consumer demand for foreign goods).
• Large outflows of secondary income (substantial foreign aid, pension payments abroad).
• Low export earnings (loss of competitiveness, real‑exchange‑rate appreciation).
• Service imports exceeding service exports (e.g., reliance on foreign education or health services).
• Exchange‑rate depreciation that makes imports more expensive and reduces the value of foreign‑source income.
• Government policies that encourage consumption of imported goods (e.g., low import duties, subsidies for foreign products).

6. Consequences of Current‑Account Imbalances (Cambridge 6.4.4)

• Exchange‑rate movements – A surplus tends to cause appreciation of the domestic currency; a deficit can lead to depreciation.
• National income (GDP) – The trade balance component of GDP is positive with a surplus and negative with a deficit.
• Employment – Export‑oriented surpluses usually create jobs; persistent deficits may threaten domestic employment, especially in manufacturing.
• Inflation – Currency appreciation (from a surplus) can lower import prices and ease inflation; depreciation (from a deficit) can raise import prices and fuel inflation.
• External‑debt sustainability – Persistent deficits must be financed by borrowing, increasing external debt and vulnerability to external shocks.
• Balance‑of‑payments stability – Large, sustained imbalances can lead to BoP crises, forcing a country to seek IMF assistance or to impose capital controls.
• Government macro‑economic aims – Deficits may conflict with fiscal consolidation or monetary‑policy targets, while surpluses can limit inflationary pressure but may also reduce export‑sector growth.

7. Why Secondary Income Matters

• For many developing economies, remittances and aid exceed export earnings, providing vital foreign‑exchange earnings.
• Large inflows can improve the current‑account balance, support government budgets and reduce the need for external borrowing.
• Policy relevance – governments may lower transaction costs, negotiate tax treaties, or promote diaspora investment to maximise inflows.
• Social dimension – secondary income reflects migration patterns, demographic ageing and international solidarity.

8. Policy Toolkit for Achieving Balance‑of‑Payments Stability

Cambridge expects candidates to be able to discuss a range of policies that can influence the current account and the overall BoP.

• Exchange‑rate policy:
  • Intervention in foreign‑exchange markets to curb excessive appreciation (when large secondary‑income inflows threaten export competitiveness).
  • Adopting a more flexible (floating) exchange rate to allow automatic adjustment.
• Import controls: tariffs, quotas, import licensing, or voluntary export restraints to reduce import volume.
• Export promotion: export subsidies, tax incentives for exporters, trade‑mission programmes, and improving transport infrastructure.
• Fiscal and monetary coordination:
  • Using fiscal policy (e.g., reducing public‑sector consumption) to lower import demand.
  • Monetary tightening (higher interest rates) to curb domestic demand and reduce import‑led growth.
• Policies to encourage secondary‑income inflows:
  • Reducing remittance fees, establishing diaspora bonds, improving banking and mobile‑money access.
  • Negotiating favourable tax treaties to avoid double taxation of overseas earnings.
• Managing secondary‑income outflows:
  • Evaluating the effectiveness of foreign aid programmes and targeting aid more efficiently.
  • Negotiating better terms on overseas pension liabilities or insurance contracts.
• Environmental & sustainability considerations:
  • Using trade restrictions or conditional aid to promote environmentally‑friendly production (e.g., “green” tariffs).
  • Encouraging foreign investment in renewable‑energy projects that generate exportable services.

9. Key Definitions (Floating exchange‑rate regime)

• Floating exchange rate: the value of a currency is determined by market forces of supply and demand without a fixed parity to another currency or commodity.
• Appreciation: a rise in the value of the domestic currency relative to foreign currencies (one unit of domestic currency buys more foreign currency).
• Depreciation: a fall in the value of the domestic currency relative to foreign currencies (one unit of domestic currency buys less foreign currency).

10. Common Examination Questions (AO1–AO3)

1. Define secondary income and give two examples of inflows and two examples of outflows.
2. Explain how a rise in remittance inflows would affect a country’s current‑account balance and the likely impact on the exchange rate.
3. Using the CAB formula, show how a substantial increase in foreign‑aid payments (outflows) could turn a current‑account surplus into a deficit. (Include a brief calculation.)
4. Analyse the possible consequences for employment and inflation of a persistent current‑account deficit financed by borrowing.
5. Evaluate the policy options a government could adopt to maximise the benefits of remittance inflows while minimising any adverse macro‑economic effects.

11. Suggested Diagram