4.17 - Balance of Payments - notes
4.17 - Balance of Payments
The definition and components of the balance of payments
The balance of payments is a systematic record that tracks the total value of all economic transactions between a country's residents and the rest of the world over a specific period, typically one year.
Credit and debit items in the balance of payments
- Credit items - These represent transactions that bring foreign currency into the country, recorded with a positive sign (+).
- Debit items - These involve transactions that cause currency to leave the country, recorded with a negative sign (-).
Major components of the balance of payments
The balance of payments consists of three primary sections:
- Current account
- Capital account
- Financial account
The current account and its sub-components
The current account measures a country's net earnings from trade, income, and transfers with the rest of the world.
Balance of trade in goods
This part tracks the value of physical, tangible items that are exported or imported.
Key features:
- Exports of goods count as credits (+).
- Imports of goods count as debits (-).
- Examples include raw materials, intermediate products, and final products.
- A positive balance indicates a surplus in trade in goods.
- A negative balance indicates a deficit in trade in goods.
Balance of trade in services
This covers intangible services that are exported or imported.
Examples of trade in services:
- Insurance, shipping, tourism, education, and financial services.
- When tourists from Sweden holiday in Portugal, it counts as an export for Portugal and an import for Sweden.
- A firm in Denmark providing architectural designs for a project in Kenya records this as an export for Denmark and an import for Kenya.
Net income from abroad (primary income)
This records the difference between income earned from foreign sources and income paid out to foreign entities.
Components of net income from abroad:
- Profits, interest payments, and dividends from overseas investments.
- Wages paid to temporary workers from abroad.
- For example, if a university in Singapore pays a professor from Canada for delivering a seminar, this is recorded as a debit for Singapore.
This component helps distinguish between gross domestic product (GDP) and gross national income (GNI).
Net current transfers
These are one-way transfers without any exchange of goods or services.
Examples of current transfers:
- Remittances sent by migrant workers.
- International pension payments and donations.
- Government-related transfers, such as foreign aid or emergency assistance after natural disasters.
Calculating the current account balance
The overall current account balance is the total of the balances from trade in goods, trade in services, net income, and net transfers.
The capital account and its elements
The capital account deals with transfers of capital and non-produced assets.
Key components of the capital account
- Net capital transfers - These include debt forgiveness or the transfer of assets when migrants move countries.
- Net purchases or sales of non-financial, non-produced assets - This covers items like rights to exploit natural resources, as well as intellectual property such as patents, copyrights, and trademarks.
The financial account, including investments and reserve assets
The financial account tracks changes in ownership of financial assets and liabilities between a country and the rest of the world.
Direct investment
Foreign direct investment (FDI) involves long-term commitments where an entity in one country establishes or expands operations in another, with the aim of maintaining significant influence.
Types of direct investment:
- It often implies acquiring at least 10% of a company's shares.
- Greenfield investment - Involves creating new facilities from the ground up.
- Brownfield investment - Refers to purchasing or investing in existing businesses.
Portfolio and other investments
These are shorter-term or less controlling financial transactions.
Examples of portfolio and other investments:
- Buying or selling stocks, bonds, or making changes to loans and bank deposits.
- If an investor in Norway buys shares in a mining firm in Brazil, the initial transaction is recorded here.
- Any later dividends from that investment would appear in the current account as income.
Official international reserve assets
Central banks maintain these assets to manage balance of payments imbalances or to influence exchange rates.
Components of reserve assets:
- Holdings of foreign currencies, particularly the eight recognised by the IMF as reserve currencies.
- Short-term government bonds that can be quickly converted to cash, along with gold and other assets.
- A decrease in reserves is recorded as a credit (+), while an increase is a debit (-).