The range of policies available to achieve balance of payments stability and their effectiveness

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

Objective

To understand the range of policies available to achieve balance of payments stability and to evaluate their effectiveness.

1. What is the Current Account?

The current account records all transactions that involve the export or import of goods and services, income flows and unilateral transfers. It is a key component of the balance of payments (BoP) and indicates whether a country is a net lender or borrower to the rest of the world.

2. Components of the Current Account

• Trade in Goods (Merchandise) – exports and imports of physical products.
• Trade in Services – tourism, transport, financial services, royalties, etc.
• Primary Income – earnings on investments (interest, dividends) and compensation of employees.
• Secondary Income (Unilateral Transfers) – remittances, foreign aid, gifts.

3. How the Current Account Affects the Balance of Payments

The balance of payments identity can be expressed as:

\$\text{Current Account} + \text{Capital Account} + \text{Financial Account} + \text{Errors \& Omissions} = 0\$

A surplus in the current account must be offset by a deficit in the capital/financial accounts (or vice‑versa). Persistent current‑account deficits can lead to a depletion of foreign reserves and pressure on the exchange rate.

4. Policies to Achieve Balance of Payments Stability

4.1 Exchange‑Rate Policy

• Fixed (or Pegged) Exchange Rate – government or central bank intervenes to maintain a set rate.
• Managed Float – occasional intervention to smooth excessive volatility.
• Floating Rate – market‑determined; may correct imbalances automatically.

Effectiveness: A fixed rate can quickly correct a current‑account deficit by making imports more expensive and exports cheaper, but it requires large foreign‑exchange reserves and can lead to loss of monetary policy autonomy.

4.2 Fiscal Policy

• Reduce government spending or increase taxes to lower domestic demand for imported goods.
• Target subsidies for export‑oriented industries.

Effectiveness: Fiscal contraction can improve the current account, but the impact is often delayed and may cause recessionary pressures.

4.3 Monetary Policy

• Raise interest rates to attract foreign capital, strengthening the currency and reducing import demand.
• Lower rates to stimulate export‑oriented investment.

Effectiveness: Interest‑rate changes affect the exchange rate and capital flows, but the transmission to the current account can be weak if the exchange‑rate pass‑through is low.

4.4 Trade Policy

• Tariffs and import quotas – directly reduce import volumes.
• Export subsidies – encourage higher export volumes.
• Negotiating trade agreements – improve market access.

Effectiveness: Tariffs can improve the current account in the short term but may provoke retaliation, reduce consumer welfare, and distort resource allocation.

4.5 Capital Controls

• Restrictions on short‑term capital inflows/outflows.
• Limits on foreign‑currency borrowing.

Effectiveness: Can prevent sudden capital flight and protect the current account, but may deter beneficial foreign investment and be difficult to enforce.

4.6 Structural Reforms

• Improving productivity and competitiveness of export sectors.
• Investing in education, infrastructure, and technology.
• Promoting diversification away from import‑dependent goods.

Effectiveness: Long‑term solution; results appear over several years but provide sustainable current‑account improvement.

5. Comparative Summary of Policies

6. Evaluating Effectiveness – Key Considerations

1. Time Horizon – Some policies (e.g., tariffs) act quickly, while others (e.g., structural reforms) take years.
2. Economic Side‑Effects – Policies may affect inflation, employment, growth, and income distribution.
3. External Constraints – WTO rules, IMF conditionalities, and global market reactions limit policy choices.
4. Policy Mix – Combining exchange‑rate adjustments with fiscal tightening often yields a more balanced outcome.
5. Country Context – Small open economies may rely more on exchange‑rate policy, whereas larger economies may use fiscal and structural tools.

7. Conclusion

Achieving balance of payments stability requires a nuanced mix of policies. Short‑term measures such as exchange‑rate adjustments or trade barriers can provide immediate relief but may entail costs. Long‑term strategies focused on productivity and diversification are essential for sustainable current‑account improvement. Effective policy design must weigh speed, side‑effects, and the specific economic context of the country.