8.1 Balance of payments accounts and components

The balance of payments (BOP) is a crucial tool for understanding a country's economic interactions with the world. It records all transactions between residents and non-residents, including goods, services, income, and financial flows.

The BOP consists of three main accounts: current, capital, and financial. These accounts are interconnected, with the current account balance mirroring the combined capital and financial account balances. This relationship provides insights into a nation's economic health and global positioning.

Balance of Payments Accounts and Components

Components of balance of payments

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• Balance of payments (BOP) summarizes all transactions between residents of a country and the rest of the world over a specific period
  • Encompasses transactions involving goods (exports and imports), services (tourism and consulting), income (interest and dividends), transfers (foreign aid and remittances), and changes in ownership of assets (foreign direct investment and portfolio investment)
• Three main components of the BOP:
  • Current account records transactions involving goods, services, income, and current transfers
    • Goods include physical products (automobiles and electronics)
    • Services include intangible products (financial services and telecommunications)
  • Capital account records capital transfers and the acquisition or disposal of non-produced, non-financial assets
    • Capital transfers include debt forgiveness and investment grants
    • Non-produced, non-financial assets include natural resources (land and mineral rights)
  • Financial account records transactions involving financial assets and liabilities between residents and non-residents
    • Financial assets include stocks, bonds, and bank deposits
    • Financial liabilities include loans and trade credits

Relationships between account types

• Sum of current account balance, capital account balance, and financial account balance should theoretically equal zero
  • Statistical discrepancies or errors recorded in separate "net errors and omissions" category to ensure overall BOP balances
• Current account balance equals sum of capital and financial account balances with sign reversed
  • Current account deficit must be financed by surplus in capital and financial accounts (country borrows from abroad)
  • Current account surplus must be offset by deficit in capital and financial accounts (country lends to other countries)
• Financial account balance mirrors sum of current and capital account balances
  • Positive financial account balance indicates net capital inflows (foreign investment exceeds domestic investment abroad)
  • Negative financial account balance indicates net capital outflows (domestic investment abroad exceeds foreign investment)

Transactions in balance of payments

• Current account transactions:
  • Exports of goods and services increase current account balance (country receives foreign currency)
  • Imports of goods and services decrease current account balance (country pays foreign currency)
  • Income receipts (interest and dividends) increase current account balance
  • Income payments decrease current account balance
• Capital account transactions:
  • Capital transfers received (debt forgiveness) increase capital account balance
  • Capital transfers paid decrease capital account balance
• Financial account transactions:
  • Foreign direct investment inflows, portfolio investment inflows, and other investment inflows increase financial account balance
    • Examples: foreign company building factory (FDI), foreign investors buying domestic stocks (portfolio investment), and foreign banks lending to domestic borrowers (other investment)
  • Foreign direct investment outflows, portfolio investment outflows, and other investment outflows decrease financial account balance
    • Examples: domestic company acquiring foreign subsidiary (FDI), domestic investors purchasing foreign bonds (portfolio investment), and domestic banks extending loans to foreign borrowers (other investment)

Economic performance from payments data

• Persistent current account deficit may indicate:
  1. Low competitiveness of domestic industries (inability to compete in global markets)
  2. High domestic consumption or investment relative to saving (country living beyond its means)
  3. Overvalued exchange rate (domestic currency too strong, making exports expensive and imports cheap)
• Persistent current account surplus may indicate:
  1. High competitiveness of domestic industries (ability to compete successfully in global markets)
  2. Low domestic consumption or investment relative to saving (country not spending enough to stimulate economy)
  3. Undervalued exchange rate (domestic currency too weak, making exports cheap and imports expensive)
• Country with large current account deficit vulnerable to sudden stops in capital inflows, potentially leading to balance of payments crisis (inability to finance deficit)
  • Examples: Latin American debt crisis (1980s) and Asian financial crisis (1997-1998)
• Country with large current account surplus may face pressure from trading partners to appreciate its currency or stimulate domestic demand
  • Examples: China's exchange rate policy and Germany's trade surpluses within the European Union