5.4 Balance of payments

The balance of payments is a crucial economic indicator that tracks a country's international transactions. It consists of three main components: the current account, capital account, and financial account. Each component captures different types of transactions, providing insight into a country's economic interactions globally.

Understanding the balance of payments is essential for assessing a nation's economic health and its position in the global economy. Imbalances can have significant consequences, affecting exchange rates, foreign reserves, and overall economic performance. Policymakers use this information to make decisions on trade, monetary policy, and international economic relations.

Components of balance of payments

• The balance of payments is a comprehensive record of a country's international economic transactions over a specific period, typically a quarter or a year
• It consists of three main components: the current account, the capital account, and the financial account
• Each component captures different types of transactions, providing a detailed picture of a country's economic interactions with the rest of the world

Current account

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• Records transactions related to the trade of goods and services, primary income (investment income and compensation of employees), and secondary income (transfers) between a country and the rest of the world
• Includes exports and imports of merchandise, services (tourism, transportation, financial services), income earned by foreign investors, and remittances
• A current account surplus indicates a country is a net lender to the rest of the world, while a deficit suggests it is a net borrower

Capital account

• Captures transactions involving the transfer of ownership of fixed assets, as well as the transfer of funds linked to the sale or acquisition of fixed assets
• Includes capital transfers (debt forgiveness, migration transfers) and the acquisition or disposal of nonproduced, nonfinancial assets (natural resources, contracts, leases)
• Typically the smallest component of the balance of payments for most countries

Financial account

• Records transactions involving financial assets and liabilities between a country and the rest of the world
• Includes direct investment (investment in foreign companies), portfolio investment (investment in foreign stocks and bonds), other investment (loans, currency and deposits), and reserve assets (foreign exchange reserves)
• A financial account surplus indicates a net inflow of capital, while a deficit suggests a net outflow of capital

Measuring balance of payments

• The balance of payments is a statistical statement that summarizes a country's economic transactions with the rest of the world over a specific period
• It is compiled using a double-entry bookkeeping system, where each transaction is recorded as a credit and a debit, ensuring the overall balance of payments always balances

Credits vs debits

• Credits represent transactions that result in a receipt of funds from foreign entities, such as exports of goods and services, income receipts, and capital inflows
• Debits represent transactions that result in a payment of funds to foreign entities, such as imports of goods and services, income payments, and capital outflows
• The net balance of credits and debits for each component determines whether there is a surplus (more credits than debits) or a deficit (more debits than credits)

Double-entry bookkeeping system

• Each transaction in the balance of payments is recorded twice, once as a credit and once as a debit, following the principles of double-entry bookkeeping
• This ensures that the overall balance of payments always balances, as the total credits must equal the total debits
• For example, when a country exports goods, it receives a credit in the current account (for the export revenue) and a debit in the financial account (for the corresponding payment received)

Errors and omissions

• Due to the complexity of international transactions and data collection, the balance of payments may not always balance perfectly
• Any discrepancies between total credits and total debits are recorded in the "errors and omissions" category
• A persistent or large errors and omissions figure may indicate issues with data quality or the presence of unrecorded or illicit transactions

Current account in depth

• The current account is a key component of the balance of payments, recording a country's transactions in goods and services, primary income, and secondary income
• It provides valuable insights into a country's trade relationships, competitiveness, and the sustainability of its external position

Goods and services

• Captures transactions related to the trade of tangible goods (merchandise) and intangible services between a country and the rest of the world
• Goods include manufactured products, raw materials, and other physical items, while services encompass tourism, transportation, financial services, and other intangible offerings
• The difference between exports and imports of goods and services is known as the trade balance, a key indicator of a country's trade performance

Primary income

• Records income earned by residents from foreign sources and income paid to foreign residents from domestic sources
• Includes compensation of employees (wages and salaries earned by border, seasonal, and other short-term workers) and investment income (dividends, interest, and profits earned on foreign investments)
• A positive primary income balance indicates a country is earning more income from abroad than it is paying out, while a negative balance suggests the opposite

Secondary income

• Captures current transfers between a country and the rest of the world, such as remittances, foreign aid, and other unilateral transfers
• Remittances are funds sent by migrant workers to their home countries, which can be a significant source of foreign exchange and support for domestic consumption in some developing economies
• Foreign aid includes grants and other forms of assistance provided by governments, international organizations, and NGOs for humanitarian, development, or other purposes

Capital account in depth

• The capital account is a component of the balance of payments that records transactions involving the transfer of ownership of fixed assets and the transfer of funds related to the sale or acquisition of fixed assets
• While typically the smallest component of the balance of payments, it captures important transactions that can have long-term implications for a country's productive capacity and wealth

Capital transfers

• Includes one-way transfers of ownership of fixed assets, such as debt forgiveness, investment grants, and migration transfers (assets accompanying migrants as they enter or leave a country)
• Debt forgiveness occurs when a creditor agrees to cancel or reduce the debt owed by a debtor, often in the context of bilateral or multilateral debt relief initiatives
• Investment grants are capital transfers in cash or in kind made by governments or international organizations to finance the acquisition of fixed assets, such as infrastructure projects

Nonproduced nonfinancial assets

• Captures transactions involving the acquisition or disposal of nonproduced, nonfinancial assets, such as natural resources, contracts, leases, and licenses
• Natural resources include land, mineral rights, and other naturally occurring assets that are not the result of production processes
• Contracts, leases, and licenses involve the transfer of the right to use or exploit nonproduced, nonfinancial assets for a specified period, such as the right to extract natural resources or use radio spectra

Financial account in depth

• The financial account records transactions involving financial assets and liabilities between a country and the rest of the world
• It is divided into four main categories: direct investment, portfolio investment, other investment, and reserve assets

Direct investment

• Refers to cross-border investments in which the investor acquires a lasting interest (usually 10% or more of voting power) in an enterprise in another country
• Includes equity capital (ownership stakes), reinvested earnings (profits not distributed as dividends), and intercompany debt transactions
• Direct investment can take the form of greenfield investments (establishing new operations) or mergers and acquisitions (purchasing existing companies)

Portfolio investment

• Captures cross-border transactions involving equity and debt securities, excluding those classified as direct investment or reserve assets
• Equity securities include shares, stocks, and other forms of ownership in companies, while debt securities include bonds, notes, and money market instruments
• Portfolio investment is often driven by differences in interest rates, exchange rates, and perceived risk and return across countries

Other investment

• Covers transactions in financial assets and liabilities not included in direct investment, portfolio investment, or reserve assets
• Includes currency and deposits, loans, trade credits, and other accounts receivable and payable
• Currency and deposits refer to physical currency and bank deposits held by residents in foreign banks or by non-residents in domestic banks
• Loans capture cross-border lending and borrowing, including bank loans, official loans (government-to-government), and other types of credit

Reserve assets

• Consists of external assets readily available to and controlled by monetary authorities for meeting balance of payments financing needs, intervening in exchange markets, and other related purposes
• Includes monetary gold, special drawing rights (SDRs) allocated by the IMF, reserve position in the IMF, foreign exchange assets (currency, deposits, and securities), and other claims
• Changes in reserve assets reflect the actions of central banks and monetary authorities to manage their foreign exchange reserves and maintain financial stability

Imbalances in balance of payments

• Imbalances in the balance of payments occur when there are persistent surpluses or deficits in the current account, capital account, or financial account
• These imbalances can have significant implications for a country's exchange rates, foreign reserves, and overall economic performance

Current account deficit vs surplus

• A current account deficit occurs when a country's imports of goods and services, primary income payments, and secondary income payments exceed its exports and income receipts
• A current account surplus occurs when exports and income receipts exceed imports and income payments
• Persistent current account deficits may indicate a country is consuming more than it produces, which can lead to increased foreign indebtedness and vulnerability to external shocks

Capital and financial account deficit vs surplus

• A capital and financial account deficit (or net outflow) occurs when a country's outward investment and lending exceed its inward investment and borrowing
• A capital and financial account surplus (or net inflow) occurs when inward investment and borrowing exceed outward investment and lending
• Imbalances in the capital and financial account can reflect differences in investment opportunities, interest rates, and perceived risk across countries

Causes of imbalances

• Imbalances in the balance of payments can stem from various factors, including:
  • Differences in economic growth and productivity across countries
  • Changes in exchange rates and relative prices
  • Shifts in global demand and supply for goods, services, and financial assets
  • Economic policies (fiscal, monetary, and trade) pursued by governments
  • Demographic factors, such as population aging and labor force participation rates

Consequences of imbalances

• Persistent imbalances in the balance of payments can have significant consequences for a country's exchange rates, foreign reserves, and overall economic performance
• These consequences can vary depending on the nature and magnitude of the imbalances, as well as the policy responses adopted by governments and central banks

Impact on exchange rates

• Imbalances in the balance of payments can affect the demand for and supply of a country's currency in foreign exchange markets
• A persistent current account deficit may lead to a depreciation of the country's currency, as the demand for foreign currency to pay for imports exceeds the supply of foreign currency from exports
• Conversely, a persistent current account surplus may lead to an appreciation of the country's currency, as the supply of foreign currency from exports exceeds the demand for foreign currency to pay for imports

Impact on foreign reserves

• Imbalances in the balance of payments can also affect a country's foreign exchange reserves, which are assets held by central banks to manage exchange rates and ensure financial stability
• A persistent current account deficit may lead to a depletion of foreign reserves, as the central bank sells foreign currency to finance the deficit and support the domestic currency
• A persistent current account surplus may lead to an accumulation of foreign reserves, as the central bank purchases foreign currency to prevent an excessive appreciation of the domestic currency

Impact on domestic economy

• Imbalances in the balance of payments can have spillover effects on a country's domestic economy, influencing variables such as economic growth, employment, and inflation
• A persistent current account deficit may stimulate domestic demand and economic growth in the short run, but it can also lead to increased foreign indebtedness and vulnerability to external shocks
• A persistent current account surplus may reflect weak domestic demand and a reliance on export-led growth, which can make the economy more susceptible to fluctuations in global demand

Policies to address imbalances

• Governments and central banks can adopt various policies to address imbalances in the balance of payments, depending on the specific nature and causes of the imbalances
• These policies can aim to adjust exchange rates, influence trade flows, or alter domestic economic conditions

Exchange rate adjustments

• Exchange rate policies can be used to address imbalances in the balance of payments by influencing the relative prices of a country's exports and imports
• A country with a persistent current account deficit may choose to devalue or depreciate its currency, making its exports more competitive and its imports more expensive, thus helping to reduce the deficit
• A country with a persistent current account surplus may allow its currency to appreciate, making its exports less competitive and its imports cheaper, thus helping to reduce the surplus

Trade policies

• Trade policies, such as tariffs, quotas, and subsidies, can be used to influence the flow of goods and services between countries and address imbalances in the balance of payments
• A country with a persistent current account deficit may impose tariffs or quotas on imports to reduce the inflow of foreign goods and encourage domestic production
• A country with a persistent current account surplus may face pressure from trading partners to reduce its exports or appreciate its currency to help rebalance global trade flows

Fiscal and monetary policies

• Fiscal and monetary policies can be used to influence domestic economic conditions and, indirectly, the balance of payments
• Expansionary fiscal policy (increased government spending or reduced taxes) can stimulate domestic demand and economic growth, which may lead to increased imports and a reduction in the current account surplus
• Contractionary monetary policy (higher interest rates) can reduce domestic demand and inflation, which may lead to reduced imports and an improvement in the current account balance

Global implications of imbalances

• Imbalances in the balance of payments can have significant implications not only for individual countries but also for the global economy as a whole
• Persistent imbalances can create spillover effects, influence global financial stability, and shape the role of international organizations in managing the international monetary system

Spillover effects

• Imbalances in one country's balance of payments can have spillover effects on other countries through trade, financial, and exchange rate channels
• For example, a persistent current account deficit in a large economy may lead to increased global demand for goods and services, benefiting exporting countries but also potentially contributing to global inflationary pressures
• Similarly, a persistent current account surplus in a major economy may lead to increased global savings and lower interest rates, which can influence investment and consumption patterns in other countries

Global financial stability

• Large and persistent imbalances in the balance of payments can pose risks to global financial stability, particularly if they are accompanied by other vulnerabilities such as high levels of debt, weak financial regulation, or political instability
• The global financial crisis of 2008-2009, for example, was partly fueled by large imbalances in the U.S. current account deficit and the corresponding surpluses in other countries, which contributed to the buildup of financial risks and the eventual collapse of the subprime mortgage market
• Addressing global imbalances and promoting more sustainable and balanced growth has become a key priority for policymakers and international organizations in the aftermath of the crisis

Role of international organizations

• International organizations, such as the International Monetary Fund (IMF), the World Bank, and the World Trade Organization (WTO), play important roles in monitoring, analyzing, and addressing imbalances in the global economy
• The IMF, for example, conducts regular surveillance of its member countries' economic policies and provides financial assistance and policy advice to countries facing balance of payments difficulties
• The WTO promotes an open and rules-based global trading system, which can help to reduce trade imbalances and promote more balanced growth
• These organizations also provide forums for international cooperation and policy coordination, which can be crucial in managing the complex and interconnected challenges posed by global imbalances