The balance of payments (BOP) is the place where countries record their monetary transactions with the rest of the world. Examining the current account portion of a country's BOP can give us a good idea of its economic activity. It includes activity around a country's industries, capital market, services, and the money entering the country from other governments or through remittances.
Calculating a country's current account balance (CAB) will tell us if it has a deficit or a surplus. If there is a deficit, does that mean the economy is weak? Does a surplus automatically mean that the economy is strong? Not necessarily. It's important to look at all of the factors involved when analyzing the current account on a country's BOP.
Basic Components of a Current Account
When looking at a country's current account, it's important to understand the four basic components that factor into it: goods, services, income, and current transfers.
Current Account Deficit
- Goods: These are movable and physical in nature, and for a transaction to be recorded under "goods," a change of ownership from or to a resident (of the local country) to or from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in), and an import is noted as a debit (money going out).
- Services: These transactions result from an intangible action such as transportation, business services, tourism, royalties, or licensing. If money is being paid for a service, it's recorded like an import (a debit). If money is received, it's recorded like an export (credit).
- Income: Income is money going in (credit) or out (debit) of a country from salaries, 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 fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production.
The Formula for Current Account Balance
Now that we've covered the four basic components, we need to look at the mathematical equation that allows us to determine the CAB. It tells us whether the current account is in deficit or surplus (whether it has more credit or debit). This will help us understand where any discrepancies may stem from and how resources may be restructured in order to allow for a better functioning economy.
X = Exports of goods and services
M = Imports of goods and services
NY = Net income abroad
NCT = Net current transfers
What Does It Mean?
Theoretically, the CAB should be zero, but in the real world, this is improbable. If the current account has a surplus or a deficit it tells us something about the government and state of the economy in question, both on its own and in comparison to other world markets.
A surplus is indicative of an economy that is a net creditor to the rest of the world. What this means is that the country is likely providing an abundance of resources to other economies and is owed money in return. By providing these resources abroad, a country with a CAB surplus gives other economies the chance to increase their productivity while running a deficit. This is referred to as financing a deficit.
A CAB deficit reflects government and an economy that is a net debtor to the rest of the world. It is investing more than it is saving and is using resources from other economies to meet its domestic consumption and investment requirements.
For example, let's say an economy decides that it needs to invest for the future to receive investment income in the long run. Instead of saving, it sends the money abroad into an investment project. This would be marked as a debit in the financial account of the balance of payments at that period, but when future returns are made, they would be entered as investment income (a credit) in the current account under the income section.
A current account deficit is usually accompanied by depletion in foreign exchange assets because those reserves would be used for investment abroad. The deficit could also signify increased foreign investment in the local market, in which case the local economy is liable to pay the foreign economy investment income in the future.
Analyzing the Current Account
It's important to understand where a CAB deficit or surplus is coming from. When analyzing it, be sure to examine what is fueling the extra credit or debit and what is being done to counter the effects.
Depending on the nation's stage of economic growth, its goals, 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 financed by a donation may not be the most prudent way to run an economy.
A deficit between exports and imports of goods and services combined—otherwise known as a balance of trade (BOT) deficit—could mean that the country is importing more to increase its productivity and to eventually churn out more exports. This, in turn, could ultimately finance and alleviate the deficit.
A deficit could also stem from a rise in investments from abroad and increased obligations by the local economy to pay investment income (a debit under income in the current account). Investments from abroad usually have a positive effect on the local economy because, if used wisely, they provide for increased market value and production for that economy in the future. This can allow the local economy eventually to increase exports and, again, reverse its deficit.
So, a deficit is not necessarily a bad thing for an economy—especially for an economy in the developing stages or under 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 through a combination of means that will help reduce external liabilities and increase credits from abroad.
For example, a current account deficit that is financed by short-term portfolio investment or borrowing is likely riskier. That's because a sudden failure in an emerging capital market or an unexpected suspension of foreign government assistance, perhaps due to political tensions, will result in an immediate cessation of credit in the current account.