Current Account and Its Four Components
The current account is a country's trade balance plus net income and direct payments. The trade balance is a country's imports and exports of goods and services. The current account also measures international transfers of capital.
A current account is in balance when the country's residents have enough to fund all purchases in the country. Residents include the people, businesses, and government. Funds include income and savings.
Purchases include all consumer spending as well as business growth and government infrastructure spending.
The goal for most countries is to accumulate money by exporting more goods and services than they import. That’s called a trade surplus. It means a country will take in more earnings. A deficit occurs when a country's government, businesses, and individuals export fewer goods and services than they import. They take in less capital from foreigners than they send out.
The Four Current Account Components
1. Trade: Trade in goods and services is the largest component of the current account. Therefore, a trade deficit is enough to create a current account deficit.
That’s because a deficit in goods in services is large enough to offset any surplus in net income, direct transfers, and asset income.
2. Net Income: This is income received by the country’s residents minus income paid to foreigners. The country’s residents receive income from two sources. The first is earned on foreign assets owned by a nation's residents and businesses.
That includes interest and dividends earned on investments held overseas. The second source is income earned by a country's residents who work overseas.
Income paid to foreigners is similar. The first category is interest and dividend payments to foreigners who own assets in the country. The second is wages paid to foreigners who work in the country.
If the income received by a country's individuals, businesses, and government from foreigners is more than the income paid out, then net income is positive. If it is less, then it contributes to a deficit.
3. Direct Transfers: This includes remittances from workers to their home country. For example, Mexico receives $25 billion from abroad. Although there are no exact figures, it's probable that the majority is from immigrants living in the United States. President Trump threatened to stop those payments if Mexico did not pay for the border wall he wants to build. He would use the Patriot Act to confiscate Western Union payments. That would reduce 1 percent of Mexico's economic output. But it would double its current account deficit of $29 billion.
Direct transfers also include a government's direct foreign aid. For example, the United States spends $22 billion a year on foreign aid.
That adds to America's $502 billion current account deficit, the largest in the world.
A third direct transfer is foreign direct investments. That's when a country's residents or businesses invest in ventures overseas. To count as FDI, it has to be more than 10 percent of the foreign company's capital.
The fourth direct transfer is bank loans to foreigners.
4. Asset Income: This is composed of increases or decreases in assets like bank deposits, central bank and government reserves, securities, and real estate. For example, if a country’s assets do well, asset income will be high. U.S. assets owned by foreigners are subtracted from asset income. These include:
- A country's liabilities to foreigners such as deposits of foreign residents at the country's banks.
- Loans made by foreign banks abroad to domestic banks.
- Foreign private purchases of a country's government bonds, such as U.S. Treasury securities.
- Sales of the securities, such as stocks and bonds, made by a nation's businesses to foreigners.
- Foreign direct investment, such as reinvested earnings, equities, and debt.
- Other debts owed to foreigners.
- Assets, like those described, held by foreign governments.
- Net shipments of the country's currency to foreign governments.
Again, the opposite will add to asset income and subtract from the deficit. More specifically, this includes:
- Deposits at foreign banks.
- Bank loans to foreigners.
- Sales of foreign-based securities.
- Direct investment made in foreign countries.
- Debts owed to a country's residents and businesses by foreigners.
- Foreign assets owned by a country's government.
- A country's official reserve assets of foreign currency. (Source: "Current Account," Bureau of Economic Analysis.)
How the Current Account Is Part of the Balance of Payments
- Current Account
- Capital Account
- Financial Account