The balance of payments

In the previous chapter, we focused on the domestic economy and briefly introduced the international economy. You may have come across exports as part of domestic economic activity, but we didn’t explore them in detail. Now that the focus shifts to the international side of the economy, a good starting point is the balance of payments.

A helpful way to think about the balance of payments is to treat a country like a company that does business with others (in this case, other countries). If a business spends more than it receives, it makes a loss. If it receives more than it spends, it makes a profit.

Using the same idea, when a country’s exports (sales to other countries) are greater than its imports (spending on foreign goods and services), the balance of payments shows a surplus. When imports are greater than exports, the balance of payments shows a deficit.

Components of balance of payments

Current Account

If you studied BA3, you may already recognize the word current. If you haven’t, the key idea is simple: in business and accounting, current usually refers to the short term (things happening “now” or within a short period).

Keep in mind, though, that the current account discussed here is not the same as the “current account” you might have studied in BA3.

Trade types

Definitions

Visible trade

Visible trade is the trade of physical goods between countries.

• For example, South Africa is well known on the African continent for brewing alcohol, and this is one of its major exports.

Invisible trade

Invisible trade is the trade or movement of intangible goods and services. This can include items such as investment income. It also includes many everyday international payments. For example, if you receive money from an overseas friend through PayPal (or a similar service), that transaction is part of invisible trade under the current account.

Capital account

The capital account represents long-term investment flows into and out of a country.

In this syllabus, you’ll treat:

• Investment coming into the country as positive (for example, foreign investors investing locally)
• Investment leaving the country as negative (for example, local investors investing overseas)

Investments can take different forms:

• A portfolio investment is when an investor buys financial assets such as shares. For example, if an investor in New York buys shares in a company abroad, that’s a portfolio investment.
• A direct foreign investment is when a company invests in real productive capacity in another country. For example, when a company moves its factories to another country (as many developed countries have done by moving production facilities to parts of Asia), that’s direct foreign investment.

The government can also play a fundamental role through its purchase or sale of reserves. Much of this concept will be covered in chapters 6 and 7.

Financial account

According to the International Monetary Fund organization, financial account is, “The financial account records transactions that involve financial assets and liabilities and that take place between residents and non-residents. The financial account indicates the functional categories, sectors, instruments, and maturities used for net international financing transactions”.

Much of this section will also be covered in future chapters.

Example

What does the term equilibrium point mean under the balance of payments?

Solution:

For the sake of your exam, we will focus on current account imbalances, the causes, and how they can be corrected.

Causes of current account imbalances

Rise in imported goods

Countries with stronger currencies are often more attractive to exporters. This means countries like the USA, the Eurozone, and Great Britain may struggle to keep imports down.

Here’s the basic mechanism:

• When a currency is strong, imports can feel cheaper to local residents.
• Local residents may then buy more foreign goods.
• The country sends more money abroad to pay for imports.
• If import spending rises relative to export earnings, the current account moves toward a deficit.

Another cause of import penetration can be a lack of trust in local brands.

During the time this publication was being written, the US-based corporation Apple Inc. released its new iPhone 16 range. Many consumers expressed dissatisfaction on social media, mainly because they felt there were no major changes compared with recent ranges. Some consumers began considering alternatives such as the Chinese brand Huawei. If this trend continues, the US could import more phones from other countries, which would worsen the balance of payments.

Other reasons include:

• Imports are more premium than local products (South Africans prefer iPhones to the locally produced Android phones)
• Currency being deliberately undervalued (explored more in chapter 7)

Decrease in exports

A current account deficit can also happen when exports fall. This is similar to a company losing customers: if an economy’s goods and services become less appealing to the rest of the world, export earnings decline.

This could be because of:

• Stronger domestic currency
• Unlimited demand in the domestic market, leaving less or no to export
• Stagflation

How can a government respond to such a situation?

Do nothing policy

A “do nothing” policy means the government expects the imbalance to correct itself over time. This approach is most likely to work in economies with a floating exchange rate.

A floating exchange rate is mainly determined by supply and demand for the currency.

• If foreign consumers buy more of our exports, demand for our currency rises, and the currency strengthens.
• A stronger currency tends to make exports more expensive to foreigners and imports cheaper to local residents.
• If imports rise and exports fall, the currency can become oversupplied and start to weaken.
• When the currency weakens, exports become cheaper and imports become more expensive.

At that point, the current account can begin to correct itself. As exports rise again, demand for the currency rises, the currency strengthens, and the cycle can repeat.

Protectionism

Tariffs and quotas can be introduced to make imports more expensive or to limit the quantity of imports entering a country. More of this was explored earlier in this chapter.

Depreciating the home currency

A government may try to weaken (depreciate) its currency to make it more attractive internationally.

• A weaker currency makes exports cheaper to foreign buyers.
• A weaker currency makes imports more expensive for local residents.

One way to weaken the currency is by buying reserves from other countries. This increases the supply of the home currency, which can reduce its value.

Other methods include deflationary policies such as tightening fiscal and monetary policy. This is mainly applicable to large economies with excessive demand. By reducing domestic expenditure, consumption falls. However, in an open economy, this may be less effective because consumers may switch to imported goods, especially with the growth of online trading.

Another approach is improving the supply side of an economy, using the supply-side factors mentioned in previous chapters. The result is higher output, which can increase the amount available for export.