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Capital exports in 2006

Capital imports in 2006

The current account of the balance of payments is the sum of the balance of trade (exports minus imports of goods and services), net factor incomes (such as interest and dividends) and net transfer payments (such as foreign aid). A current account surplus increases a country's net foreign assets by the corresponding amount, and a current account deficit does the reverse. Both government and private payments are included in the calculation. The balance of trade is typically the most important part of the current account. This means that changes in the patterns of trade are key drivers in the current accounts of most of the world's economies. However, for the few countries with substantial overseas assets or liabilities, net factor payments may be significant. Together with Net Capital Outflow, they are a major metric of how much a nation invests or is invested in.

The current account and the capital and financial account and change in official reserves each sum up to an offsetting equality (are opposite in sign but same in magnitude) after errors and omissions are taken into account. This is a result of a floating exchange rate system, where demand for a currency is equal to supply for a currency. This result can be proven with simple algebra:

Demand for a Currency = Supply for a Currency

Exports + Income and Current Transfer Credits + Capital Inflow = Imports + Income and Current Transfer Debits + Capital Outflow

ie. EX + IT Credits + Ki = IM + IT Debits + Ko (EX - IM) + (IT Credits - IT Debits) = Ko - Ki

Alternatively,

A deficit on the current account = A surplus in the capital account

Or in the other case,

A surplus on the current account = A deficit on the capital account

This sum is known as the balance of payments. Typically, the changes in official reserves is very small.

Action to reduce a substantial current account deficit usually involves increasing exports or decreasing imports. This may be accomplished directly through import restrictions, quotas, or duties (though these may indirectly limit exports as well), or subsidizing exports. Influencing the exchange rate to make exports cheaper for foreign buyers will indirectly affect the balance of payments. This can be accomplished by increasing domestic inflation (e.g. by cutting interest rates), loosening monetary policy (making more money available), or adjusting government spending to favor domestic suppliers.

Less obvious but more effective methods to reduce a current account deficit include measures that increase domestic savings (or reduced domestic borrowing), including a reduction in borrowing by the national government.

It should be noted that a current account deficit is not always a problem. The "Pitchford Thesis" states that a current account deficit does not matter if it is driven by the private sector. Some feel that this theory has held true for the Australian economy, which has had a persistent current account deficit, yet has experienced economic growth for the past 16 years (1991-2007). Others argue that Australia is accumulating a substantial foreign debt that could become problematic, especially if interest rates increase. A deficit in the current account also implies that the country is a net capital importer.

Absent changes in official reserves, the current account is the mirror image of the sum of the capital and financial accounts. One might then ask: Is the current account driven by the capital and financial accounts or is it vice versa? The traditional response is that the current account is the main causal factor, with capital and financial accounts simply reflecting financing of a deficit or investment of funds arising as a result of a surplus. However, more recently some observers have suggested that the opposite causal relationship may be important in some cases. In particular, it has controversially been suggested that the United States current account deficit is driven by the desire of international investors to acquire U.S. assets (See Ben Bernanke, William Poole links below). However, the main viewpoint undoubtedly remains that the causative factor is the current account and that the positive financial account reflects the need to finance the country's current account deficit.

• Balance of payments
• Service sector
• U.S. public debt
• List of countries by current account balance