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.

• Current account balance = Balance of trade in goods + Balance of trade in services + Net income flows + Net transfers

Four Components of Current Account

Balance of Trade in Goods

• Revenue received from exports of tangible goods minus expenditure on imports of tangible goods over a given period of time.
  • Imports = money leaving the country (debit)
  • Exports = money entering the country (credit).
    • When exports > imports there is a surplus in the balance of trade of goods.
    • When imports > exports there is a deficit in the balance of trade of goods.

Balance of Trade in Services

• Revenue received from exports of services minus the expenditure on the imports of services over a given period of time.
• Includes:
  • Banking
  • Insurance
  • Tourism

Income

• Net monetary movement of profit, interest and dividends moving into and out of the country over a given period of time.
• Includes:
  • Foreign branches of domestic firms that earn profits.
  • Profits and interest from investment in foreign banks or financial institutions.
  • Dividends from investments into foreign companies.

Current Transfers

• Net unilateral transfers from abroad.
• Consists of payments made between countries where no goods or services are exchanged.
• Includes:
  • Foreign aid and grants
  • Remittances
  • Private gifts

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

• Net monetary movements gained or lost through actions such as transfers of goods and financial assets by migrants, debt forgiveness, etc.
• Includes:
  • 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

• Net international sales and purchases of non-produced assets.
• Includes:
  • 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 long-term assets with the aim of gaining a lasting interest in a company or economy.
• Includes:
  • Purchasing of stocks or shares
  • Buying of property
  • Purchase of a business
• This component also includes 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

• This is a measure of stock and bond purchases.
  • They are not direct investment since they do not lead to a lasting interest in a company.
• Includes:
  • Buying and selling of stocks with short-term profits in mind
  • Buying and selling of treasury bills and government bonds
• The buyer expects to be paid back after some time at a profit.
• 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.

Interdependence Between Accounts

• By observing the formula:
  • BOP = Current account + (Capital account + Financial account) = 0
  • We can see that the current account must equal the sum of the capital and financial account so that they cancel out to zero.
• For every recorded entry in the BOP, there thus needs to be an equal and opposite entry.
• Credits and debits must always offset one another.
  • This leads to the balance of payments always being equal to zero.
  • Thus if there is a current account surplus then the sum of the capital and financial account must be a deficit.