The balance of payments and the CAD - TCE Economics (Tasmania)
“Explain the structure of the balance of payments and evaluate the causes and significance of Australia's current account deficit.”
The balance of payments records all transactions between Australia and the rest of the world, split into the current account and the capital and financial account. A current account deficit, financed by capital inflow, reflects Australia importing more capital than it lends and is not automatically a problem.
What this dot point is asking
This dot point goes beyond a one-line definition. It asks you to set out the structure of the balance of payments, explain the causes of Australia's persistent current account deficit (CAD), and evaluate whether that deficit matters, using the accounting relationship between the two accounts.
The structure of the balance of payments
The balance of payments is a record of all transactions between Australia and the rest of the world over a period, compiled by the Australian Bureau of Statistics. It has two main accounts.
The current account records the day-to-day flows:
- The balance on goods and services (the trade balance): exports minus imports of goods and services.
- Primary income: income earned on investments, such as the interest and dividends Australians pay to and receive from foreigners.
- Secondary income: transfers with no quid pro quo, such as foreign aid.
The capital and financial account records the flows of investment and borrowing:
- Direct, portfolio and other investment flowing into and out of Australia.
- Lending and borrowing between Australia and the rest of the world.
A situation in the balance of payments where the outflows on the current account (imports, income paid abroad and transfers out) exceed the inflows (exports, income received and transfers in) over a period.
Why the two accounts mirror each other
The balance of payments must balance overall. A deficit on the current account is matched by a surplus on the capital and financial account, and vice versa. Intuitively, if Australia spends more on imports, income and transfers than it earns, it must fund the gap by attracting foreign capital, either by borrowing from abroad or by selling assets to foreigners. The current account deficit therefore equals the net capital inflow.
A current account deficit is financed by an equal capital and financial account surplus. Australia's CAD reflects its long history of importing foreign savings to fund investment that exceeds domestic saving.
Why Australia runs a current account deficit
Australia has run persistent current account deficits for much of its modern history. The structural reasons are tied to the savings-investment gap: Australia has long invested more than it saves domestically, so it imports capital to fund the difference. This shows up as a large net primary income deficit, because servicing past foreign borrowing and paying dividends to foreign owners of Australian assets sends income abroad every year. The trade balance itself swings between surplus and deficit with the terms of trade. During commodity booms, high export prices can push the trade balance and even the current account into surplus, before reverting as prices fall.
Step 1: Find the balance on goods and services
Exports of goods and services are billion and imports are billion, so the trade balance is billion (a surplus).
Step 2: Add the net primary income balance
Australia pays more interest, profit and dividends abroad than it receives, giving a net primary income balance of billion.
Step 3: Add net secondary income
Net transfers such as aid give a net secondary income balance of billion.
Step 4: Sum to the current account balance
billion: a current account deficit of billion. Notice how the large net income deficit outweighs the trade surplus, which is exactly why Australia's CAD persists even when the trade balance is positive.
Is the CAD a problem?
The significance of the CAD is genuinely debated. On the concern side, a large deficit means rising net foreign liabilities, higher future income payments abroad, and potential vulnerability if foreign lenders lose confidence and demand higher returns. On the reassuring side, the Pitchford thesis argues that if the deficit results from private sector borrowing for productive investment, it is sustainable: private borrowers bear the risk and the investment should generate the returns to service the debt. What matters is whether borrowed funds are invested productively and whether the deficit is sustainable relative to GDP.
Students often assume a current account deficit is simply living beyond our means and must be bad. A deficit can reflect productive investment funded by foreign capital, which can be sustainable and even beneficial. Evaluate the cause and what the borrowed funds are used for, not just the existence of the deficit.
A strong answer maps the two accounts, explains why a current account deficit is mirrored by capital inflow, identifies the savings-investment gap and net income payments as the structural causes of Australia's CAD, and evaluates its significance by weighing the risks of rising foreign liabilities against the case that productive private borrowing is sustainable.
Exam-style questions
Questions in the style of TASC exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
PracticeWhat is the Balance of Payments as it applies to Australia? What is the relationship between the two (2) main components of the Balance of Payments?Show worked answer →
Definition. The Balance of Payments (BoP) is the record of all transactions between Australia and the rest of the world over a period of time, compiled by the ABS.
Its two main components:
- The current account records trade in goods and services (the balance on goods and services), plus the primary income account (interest, profits and dividends) and secondary income. Australia typically runs a current account deficit, driven largely by a net primary income deficit from servicing foreign liabilities.
- The capital and financial account records flows of capital and financial assets, such as foreign investment in Australia and Australian investment abroad.
Relationship. The two accounts are mirror images and, in principle, sum to zero (ignoring the balancing item). A deficit on the current account must be financed by a matching net inflow on the capital and financial account, that is, by borrowing from or selling assets to the rest of the world. So a current account deficit is offset by a capital and financial account surplus.
PracticeExplain the meaning of 'current account deficit' and how such a deficit comes about.Show worked answer →
Meaning. A current account deficit (CAD) occurs when the total debits on the current account exceed the total credits over a period, that is, the money flowing out for imports, and for income paid to foreigners, is greater than the money flowing in from exports and income received.
How it comes about. The current account combines:
- The balance on goods and services (exports minus imports). A deficit here arises if Australia imports more goods and services than it exports.
- The net primary income balance (income earned by foreigners on their Australian assets, such as interest, profits and dividends, minus income Australians earn abroad). Because Australia has large net foreign liabilities, it pays out more income than it receives, producing a persistent primary income deficit.
For Australia the main driver of the CAD has historically been this net primary income deficit, the cost of servicing the foreign borrowing and investment used to fund domestic investment that exceeds national saving. A complete answer links the CAD to the saving-investment gap.