Tuesday, April 26, 2011

Surplus on Current Account Balance of Payments

Readers Question: I can't seem to understand why a surplus on a BOP of an economy might be a problem ? The negative effects of a deficit on Current account BOP are obvious but why would economies be better off with a balance of zero compared to a surplus ?

A surplus on the current account component of the Balance of payments indicates that the country is exporting more goods and services than importing. This means they are gaining foreign currency they can use to buy foreign assets such as government bonds and invest in foreign factories.

It is not clear that a surplus on the current account is a bad thing. It has certain advantages such as being able to invest in foreign countries and build up foreign exchange reserves. It may also indicate that the country is quite competitive relative to other countries.

Countries with Large Current Account Surplus
  • Japan - 3.4% of GDP
  • China - 6.1% of GDP
  • Germany - 5.1% of GDP
  • Switzerland - 11.9% of GDP
However, a large current account surplus may indicate an unbalanced economy. For example, it may indicate the country is relying too heavily on exports and consumer spending is relatively too low. For example, during the lost decade of Japan in 90s and early 00s, they mainly had a large current account surplus.

I don't think economists would be concerned with a current account surplus per se. However, they may be concerned with policies which are generating such a big imbalance.

For example, in the case of China, one reason for large current account surplus is their decision to keep their currency undervalued. This makes their exports more competitive and imports more expensive, increasing domestic demand. However, this undervaluation of the currency is arguably contributing to inflation. China is at risk of allowing their economy to grow too quickly and cause a boom and bust.

If China allowed its currency to appreciate, this would slow down growth and reduce inflationary pressures. It would also help to reduce the size of their current account surplus.

(Of course, other countries like US would like a stronger Chinese currency as this would help their domestic industries be more competitive)

Another issue with China's large current account surplus is that they are using the foreign currency to buy a significant quantities of US and other securities. This is a mixed blessing. On the one hand, it is a contribution to financing the US debt and enables the US to keep interest rates lower.

However, if there are huge imbalances in the world economy, it could artificially keep interest rates too low in countries with current account deficits. For example, in the boom period the large inflow of funds from the East, kept interest rates on US securities low, contributing to a boom in lending. This boom in lending later proved unsustainable.

In summary, it is quite complicated. You can't say surplus bad, surplus good. However, there are definite advantages to avoiding imbalances which could create long term problems.



RAJ said...

I think current account surplus is not a bad thing , actually it is good thing
for countries specially which do not have enough natural resources like Japan or
Germany. Due to limited resources their economy is not complete and trade surplus help them marinating
Good level of employment.

Anonymous said...

CA surplus brings instability to the global financial landscape through as you mentioned FX reserves building and inflation. And Reserve building has significant costs. To some extreme (think commodity producers) it can bring chaos and the ultimate "Dutch disease", although that is very extreme

Anonymous said...

No I don't agree with you Raj ........

Sam said...

CA Surplus has got both its pros and cons, I just discovered it right now ! Thanks Mr. Author for the wonderful piece of article!