Balance of Payments

Balance of Payments (BOP) Definition

• A record of the value of all transactions of a country with the rest of the world over a period of time.
• BOP keeps track of a country's money inflow and outflow.

• Debit: Money flowing out
• Credit: Money flowing in

• Without simplification, it is very difficult to compare the balance of payments of one country with another.

Main Components of BOP

• BOP = Current account + (Capital account + Financial account) = 0
• Thus the main components of BOP are Current, capital and financial account.
• Current account is the most significant out of these accounts.

Current Account

• The most discussed component of the BOP.
• The current account (CA) is the record of money coming in and out of a country for goods, services, income flows, and current transfers.

Four Components of Current Account

Balance of Trade in Goods

• Imports = money leaving the country (debit); Exports = money entering the country (credit).

Balance of Trade in Services

• Same as goods however, it's about banking, insurance, tourism.

Income

• Income citizens receive from financial investment's abroad such as rent, dividends, profits, etc.

Current Transfers

• Transfers between countries not dealing with investments or payment such as foreign aid, remittances (sending money home to family), etc.

Current Account Balance

• Current account balance =  balance of trade in goods + balance of trade in services + net income flows + new transfers

Surplus and Deficit

• The main focus when discussing BOP is surplus and deficit related to the CA.

Current Account Deficit

• Exists when the sum of net exports of goods and services plus net income plus net current transfers is negative.
  • Net exports of goods and services + net income + net current transfers < 0
• Or simply, when debits or outflows are greater than credits or inflows.

Current Account Surplus

• Exists when the sum of the net exports of goods and services plus net income plus net current transfers are positive.
  • Net exports of goods and services + net income + net current transfers > 0
• Or simply, when credits or inflows are greater than debits or outflows.

Capital Account

• Capital account is relatively small and generally not of much focus.
• It is a subaccount of the balance of payments that includes credit and debit entries for non-produced, non-financial assets as well as capital transfers between residents and non-residents.

Two Components of Capital Account

Capital Transfers

• Include financial or non-financial assets for items including:
  • The transfers of goods and financial assets of migrants entering or leaving the country
  • Debt forgiveness
  • Transfer relating to the sale of fixed assets (tangible assets that firms own and use in production that have a useful life of at least one year )
  • Gift taxes
  • Inheritance taxes.

Transaction in non-production, non-financial assets

• Non-produced assets such as:
  • Land
  • Rights to natural resources and intangible assets like patents
  • Copyrights
  • Brand names or franchises

Financial Account

• Measures the net change in foreign ownership of domestic financial assets.

Four Components of Financial Account

(Foreign) Direct Investment

• The purchase of a firm, or part of a firm, by a firm from another country; long term assets it's a lasting interest.
• FDI: investment by multinational corporations in another country that is a big component of that country's stocks.
  • Must be >10% of the ownership

Portfolio Investment

• The purchase or sale of financial capital such as stocks, bonds, or currency trading (not lasting, not long term) plus savings accounts.
• Investment by multinational corporations <10% ownership.

Reserve Assets

• Foreign currencies are held by the central banks in reserve.
• These reserve currencies can be used to adjust exchange rate.
• The net changes of the Reserve Assets balances the (other) accounts.
• Official Borrowing possibly needed when there is an overall deficit.