6.1 - Balance of Payments Accounts
Definitions of key balance of payments concepts
The balance of payments is an accounting system that tracks a country's international transactions over a specific period, such as a quarter or a year. It consists of two main parts: the current account and the capital and financial account. These accounts help measure the flow of goods, services, and financial capital between countries.
Current account (CA)
The current account records a country's net exports of goods and services, net income earned from abroad, and net unilateral transfers (one-way transfers like foreign aid or remittances).
Capital and financial account (CFA)
The capital and financial account records transfers of financial capital and the purchases and sales of assets between countries, such as investments in foreign stocks or real estate.
Balance of payments (BOP)
The balance of payments is the overall record that combines the current account and the capital and financial account to show all international monetary flows.
Components and balances of the current account
The current account focuses on transactions related to trade, income, and transfers. It provides insight into a country's economic interactions through everyday exchanges rather than long-term investments.
Key components of the current account
- Net exports - The difference between a country's exports (goods and services sold abroad) and imports (goods and services bought from abroad). This is also known as the balance of trade.
- Net income from abroad - Earnings from investments overseas minus payments to foreign investors in the home country, such as profits, interest, or dividends.
- Net unilateral transfers - One-way flows of money, like foreign aid received or sent, remittances from workers abroad, or gifts, without expecting something in return.
Current account balances
The current account does not always balance to zero.
Types of current account balance:
- Surplus - When inflows (from exports, income, and transfers) exceed outflows, indicating the country is earning more from the world than it spends.
- Deficit - When outflows exceed inflows, meaning the country is spending more internationally than it earns.
A nation's balance of trade is part of the current account and can also run a surplus (exports > imports) or deficit (imports > exports). These imbalances affect the overall current account balance.
Formula for current account:
Components and balances of the capital and financial account
The capital and financial account deals with longer-term financial flows, capturing how countries invest in each other or transfer capital assets. This account balances the current account by showing where surplus funds are invested or how deficits are financed.
Key components of the capital and financial account
- Financial capital transfers - Movements of money for investment purposes, such as foreign direct investment (buying a controlling stake in a foreign company) or portfolio investment (buying stocks or bonds abroad).
- Purchases and sales of assets - Transactions involving physical assets like real estate or financial assets like government securities between residents and non-residents.
Capital and financial account balances
Like the current account, the capital and financial account does not always balance to zero.
Types of capital and financial account balance:
- Surplus (financial capital inflow) - When more capital enters the country than leaves, often funding a current account deficit.
- Deficit (financial capital outflow) - When more capital leaves the country than enters, typically investing abroad when there is a current account surplus.
These inflows and outflows help adjust for imbalances in the current account.
Formula for capital and financial account:
How credits, debits, and changes affect the balance of payments
In the balance of payments, transactions are recorded as credits or debits based on the direction of money flow. This system ensures the overall balance of payments equals zero when combining the current account and capital and financial account.
Credits and debits in the balance of payments
- Credit - Any transaction that causes money to flow into the country, such as exporting goods (increases current account) or receiving foreign investment (increases capital and financial account).
- Debit - Any transaction that causes money to flow out of the country, such as importing services (decreases current account) or investing abroad (decreases capital and financial account).
The sum of all credits should equal the sum of all debits across both accounts, leading to a balanced system.
Effects of changes in components
Changes in the components of the current account or capital and financial account directly impact the balance of payments.
Changes in current account components:
- An increase in exports improves the current account balance, creating a surplus that might lead to capital outflows in the capital and financial account as the country invests abroad.
- A rise in imports worsens the current account, potentially requiring capital inflows to finance the deficit.
Changes in capital and financial account components:
- Increased foreign investment inflows create a capital and financial account surplus, which can offset a current account deficit.
- Outflows from domestic investments abroad would create a deficit in this account, balancing a current account surplus.
These interactions maintain the overall balance: if the current account has a surplus, the capital and financial account will have a corresponding deficit, and vice versa.
Formula for balance of payments:
Worked example - Calculating current account, capital and financial account, and balance of payments
A country has the following international transactions in a given year: exports of $500 billion, imports of $600 billion, net income from abroad of $50 billion, net unilateral transfers of -$20 billion, net financial capital inflows of $80 billion, and net asset sales abroad of -$10 billion. Calculate the current account, capital and financial account, and balance of payments.
Step 1: Identify the values
- Net exports = $500 billion - $600 billion = -$100 billion
- Net income from abroad = $50 billion
- Net unilateral transfers = -$20 billion
- Net financial capital transfers = $80 billion
- Net purchases and sales of assets = -$10 billion
Step 2: Calculate the current account
Step 3: Calculate the capital and financial account
Step 4: Calculate the balance of payments