The balance of payments
Balance of payments: a systematic record of all economic transactions between one country's residents and the rest of the world over a given period.
Credit and debit: a credit (+) is a receipt of money from abroad, such as an export sale; a debit (−) is a payment abroad, such as an import purchase.
- The balance of payments records every economic transaction between residents of a country and the rest of the world over a period, usually one year.
- It is split into three linked accounts: the current account, the capital account and the financial account.
- A flow of money into the country is entered as a credit (+) and a flow out as a debit (−), so every item carries a sign.
- Because every credit is matched by a debit somewhere, the three accounts plus a balancing item always sum to zero.
- The balance of payments is far wider than the current account alone.
- Because inflows and outflows are two sides of every deal, the accounts plus errors and omissions sum to zero.
- So a current account deficit must be matched by a net surplus on the capital and financial accounts.
The current account
Primary income: net income earned from factors of production employed abroad, including profit, interest, dividends and labour income.
Secondary income: net current transfers between residents and non-residents for which nothing of economic value is received in return, such as aid and remittances.
- Trade in goods records exported physical goods (X) less imported physical goods (M), for example machinery, food or oil.
- Trade in services records exported services such as tourism, shipping and banking, less imported services.
- Primary income covers the returns to factors owned abroad, such as profit, interest, dividends and wages earned overseas.
- Secondary income covers one-way transfers such as government aid and workers' remittances.
- A country records goods exports of $400bn and goods imports of $500bn, a services balance of +$120bn, primary income of −$20bn and secondary income of −$25bn.
current account = (400 − 500) + 120 + (−20) + (−25) = −$25bn
- The current account is in deficit by $25bn, driven mainly by the −$100bn balance on trade in goods.
The capital account
Capital account: the part of the balance of payments recording capital transfers and the acquisition or disposal of non-produced, non-financial assets.
Capital transfers: one-off transfers of ownership of assets or of funds tied to investment, such as debt forgiveness or an investment grant.
- The capital account is normally the smallest account in the balance of payments.
- It records capital transfers, such as debt forgiveness and the transfer of ownership of fixed assets.
- It also records sales and purchases of non-produced, non-financial assets, such as patents, copyrights and trademarks.
Foreign direct investment: cross-border investment giving a lasting interest and significant control in a foreign enterprise.
Portfolio investment: purchase of foreign financial assets such as shares and bonds without acquiring control.
Reserve assets: foreign currency and gold held by the central bank to settle international payments and influence the exchange rate.
The financial account
- The financial account records cross-border flows of investment and changes in the ownership of financial assets.
- Direct investment buys lasting control of a firm or productive asset abroad, for example building a factory overseas.
- Portfolio investment buys shares and bonds abroad without gaining control.
- It also covers other investment, such as loans and bank deposits, and changes in the official reserve assets held by the central bank.
Why the accounts balance
- A current account deficit means residents spend more abroad than they earn, so the gap must be financed from overseas.
- That finance arrives as a net inflow on the capital and financial accounts, for example foreigners buying domestic bonds.
- The three accounts plus a balancing item for errors and omissions therefore sum to zero.
- It follows that a lasting deficit implies steadily selling domestic assets or borrowing from abroad.
- Many economies run persistent current account deficits financed by financial inflows.
- Foreign investors buy domestic assets such as shares, bonds and property, which supplies that finance.
- Whether this is sustainable depends on why funds flow in: stable long-term investment is safer than volatile hot money that can reverse.
Calculating the balances
- The balance of trade in goods is exports less imports of goods.
- Adding the balance of trade in services gives the balance of trade in goods and services.
- Adding primary income and secondary income gives the current account balance.
- A negative total is a deficit and a positive total is a surplus.
- Suppose trade in goods is −$100bn, trade in services is +$60bn, primary income is +$10bn and secondary income is −$15bn.
current account = (−100) + 60 + 10 + (−15) = −$45bn
- The economy runs a current account deficit of $45bn, matched by a net inflow of $45bn on the capital and financial accounts.
- Write out each current account component with its sign before you add.
- Work from trade in goods, to goods and services, to the current account, one step at a time.
- Remember the whole balance of payments sums to zero, so name the account that finances any deficit.
- Do not treat the whole balance of payments as if it were only the current account.
- A current account deficit is financed by a surplus on the capital and financial accounts; it is never simply left unfinanced.
- What does the balance of payments record, and over what period?
- Name and define the four components of the current account.
- What does the capital account record?
- How do direct and portfolio investment differ on the financial account?
- Why do the three accounts plus errors and omissions sum to zero?
