IB Economics - Balance of Payments (Detail)

The Balance of Payments (BOP) is a comprehensive record of a country's economic transactions with the rest of the world over a specific period, usually a year. It includes the flow of goods, services, income, and financial assets. The BOP is crucial for understanding a country’s economic position and its interactions in the global economy.

Structure of the Balance of Payments

The BOP consists of three main accounts:

1. Current Account: Records the trade in goods and services, primary income (income from investments and employment), and secondary income (transfers like remittances and aid).
2. Capital Account: Captures capital transfers and the acquisition/disposal of non-produced, non-financial assets (like patents).
3. Financial Account: Records investment flows, including direct investment (e.g., purchasing businesses abroad), portfolio investment (e.g., stocks and bonds), and other investments (e.g., loans).

Relationships Between the Accounts

• Current Account = Capital Account + Financial Account

  This equation must balance, as every international transaction is mirrored somewhere within the BOP. For example:

  • If a country runs a current account deficit (spending more on imports than earning from exports), it must finance this by attracting foreign capital—reflected in the financial account.
  • A current account surplus indicates that a country is a net lender to the rest of the world, and this surplus will be mirrored in the financial account as outflows of capital.

Interdependence of Current Account and Financial Account

• A deficit in the current account often coincides with a surplus in the financial account because the country needs to borrow from or attract investment from abroad to finance its excess of imports over exports.
• Conversely, a surplus in the current account typically means the country is investing abroad, leading to financial account deficits.

Real-World Example:

• United States: The U.S. often runs a current account deficit, importing more than it exports. This deficit is financed by attracting substantial foreign investment, such as foreign purchases of U.S. Treasury securities, which appears as a surplus in the financial account.

The Relationship Between the Current Account and Exchange Rates

Current Account Deficit and Exchange Rates

• A current account deficit can exert downward pressure on the currency’s exchange rate. Here’s why:
  • A deficit implies higher demand for foreign currencies (to pay for imports) relative to demand for the domestic currency.
  • This increased demand for foreign currencies typically leads to a depreciation of the domestic currency.
• Depreciation makes exports cheaper and imports more expensive, potentially helping to correct the current account deficit over time.

Real-World Example:

• Turkey: In recent years, Turkey has faced persistent current account deficits, contributing to a weakening of the Turkish lira. The currency depreciation was partly due to high import demand and reliance on foreign capital to finance the deficit.

Implications of a Persistent Current Account Deficit (HL ONLY)

Key Implications:

1. Foreign Ownership of Domestic Assets:
   • A persistent deficit means that a country increasingly relies on foreign capital, leading to more foreign ownership of domestic assets like companies, real estate, and government debt.
   • This can lead to a loss of economic sovereignty and increased vulnerability to foreign investor sentiment.
2. Exchange Rates:
   • Continued deficits may cause long-term depreciation of the domestic currency, leading to inflationary pressures as import prices rise.
   • For countries that rely on imports for essential goods (like energy), this can severely impact the cost of living and economic stability.
3. Interest Rates:
   • To attract the foreign capital needed to finance a deficit, a country may have to offer higher interest rates.
   • Higher interest rates can stifle domestic investment and economic growth.
4. Indebtedness:
   • A sustained deficit often results in increased borrowing from abroad, raising the country’s external debt.
   • High levels of external debt can lead to a debt crisis if the country cannot meet its repayment obligations, as seen in Argentina’s recurrent debt crises.
5. International Credit Ratings:
   • Credit rating agencies may downgrade the country's rating if deficits are deemed unsustainable, raising borrowing costs further.
   • For example, South Africa’s recurrent deficits and economic instability have led to downgrades by major credit rating agencies.
6. Demand Management:
   • Governments might resort to fiscal or monetary policies to curb deficits, such as tightening fiscal policy to reduce imports or implementing currency controls.
   • However, these measures can lead to slower economic growth or reduced investor confidence.

Real-World Example:

• Argentina: Persistent current account deficits, combined with high debt levels, led to repeated financial crises. In 2020, Argentina defaulted on its debt yet again, illustrating the potential consequences of sustained deficits on a country's economy.

Glossary of Key Terms

• Balance of Payments (BOP): A record of all economic transactions between residents of a country and the rest of the world.
• Capital Account: Part of the BOP that records capital transfers and the acquisition/disposal of non-produced, non-financial assets.
• Current Account: Part of the BOP that includes trade in goods and services, primary income, and secondary income.
• Current Account Deficit: Occurs when a country imports more goods, services, and capital than it exports.
• Current Account Surplus: Occurs when a country exports more goods, services, and capital than it imports.
• Depreciation: A decrease in the value of a currency relative to other currencies.
• Financial Account: Part of the BOP that records investment flows including direct, portfolio, and other investments.
• Indebtedness: The state of owing money, often referring to a country’s external debt.
• International Credit Ratings: Evaluations of a country’s creditworthiness by agencies like Moody’s, S&P, and Fitch.
• Primary Income: Income earned from investments or employment abroad, such as dividends or wages.
• Secondary Income: Transfers such as remittances or foreign aid that do not involve a quid pro quo transaction.

Possible IB Economics Essay-Style Questions

1. Discuss the implications of a persistent current account deficit for an economy.
2. Evaluate the relationship between a country’s current account balance and its exchange rate.
3. Analyze the reasons why a current account deficit may lead to depreciation of a country's currency.
4. To what extent can government intervention manage a persistent current account deficit?

Recent Real-World Data and Examples

• United States (2022): The U.S. current account deficit widened to $947.2 billion, or 4.8% of GDP, driven by strong import demand and a high level of foreign investment in U.S. assets.
• Japan (2022): Japan experienced a current account surplus of $122 billion, attributed to robust exports and significant returns on overseas investments.

Retrieval Questions for A-Level Students

1. What are the three main accounts of the Balance of Payments?
2. How is a current account deficit typically financed?
3. Why might a persistent current account deficit lead to a depreciation of the domestic currency?
4. What are the potential risks of high foreign ownership of domestic assets?
5. How do international credit ratings relate to a country’s balance of payments?

This structured and in-depth guide aims to provide a comprehensive understanding of the Balance of Payments, emphasizing the interconnectedness of the accounts, the impact on exchange rates, and the broader economic implications of persistent current account deficits. Use this guide as a basis for further study and application in real-world contexts.