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Fridays Academy: The Balance of Payments

Ignacio Hernandez's picture

From the lecture notes prepared by Raj Nallari and Breda Griffith, this Friday we review the Balance of Payments.

 

In previous Fridays we examined how we assess and measure a country’s economic position as measured by GDP. The Balance of Payments (BOP) allows us to assess and measure a country’s external position. The BOP refers to economic transactions and financial flows between a country and the rest of the world for a given time period, keeping account of payments to and receipts from nonresidents.

 

Based on the double-entry accounting system whereby each recorded transaction is represented by two entries with equal values but opposite signs – a credit (+) and a debit (-) –the sum of all credits should be equal to the sum of all debits. Therefore the balance of payments should always be in balance.

Examples of items recorded as credits and debits:

  • Exports of goods and services              Credit (+)
  • Imports of goods and services              Debit (-)
  • Increase in financial liabilities               Credit (+)
  • Decrease in liabilities                            Debit (-)
  • Increase in financial assets                  Debit (-)
  • Decrease in assets                               Credit (+)

In reality of course, accounts tend not to balance and thus all balance of payments accounts include an item ‘net errors and omissions’. The item is recorded as a net item because of the possibility that credit errors will offset debit errors, e.g. an underestimation of exports may be offset by an overestimation of imports. Thus the size/value of net errors and omissions cannot be taken as an indicator of the relative accuracy of the balance of payments.

 

Main components
There are three main components to the balance of payments accounts – the current account, the capital account and net errors and omissions discussed above.

 

The Current Account

The current account is subdivided into four smaller accounts, the merchandise trade account, the services account, the investment income account, and the transfer payments account. 

  • The merchandise trade account includes imports and exports of tangible goods such as cars, computers, clothes, televisions, etc.  If a country’s imports more than it exports in this category, then it is said to have a trade deficit.
  • The services account includes flows of payment in exchange for services countries provide to each other:  transportation, insurance, banking, tourism, etc.
  • The investment income account reflects domestic resident investment earnings from foreign stocks, bonds, real estate, etc., minus foreigners’ investment earnings from domestic stocks, bonds, real estate, etc.
  • The fourth sub-account of the current account is the transfer payments account.  This account includes gifts or payments from private citizens and government of a country to people living abroad or vice versa.

Capital Account

The capital account includes a variety of sub-accounts all dealing with purchases and sales of financial assets or real estate (stocks, bonds, land, buildings, businesses, etc.). 

The balance on the capital account is the sum of the changes in the above-mentioned capital sub-accounts.  This amount, added to central bank build-up or drawdown of reserves during the given period, should equal the balance on the current account.  However, if it does not, there is a statistical discrepancy, which given the size of the money flows and the difficulty in measuring the literally millions of international trade transactions, is sometimes a substantial number.

 

Analyzing the External Position

Under the double-entry accounting system, the sum of credits equals the sum of debits so that the overall balance is zero. However, it is possible to have imbalances in the external account. We speak of surpluses and deficits in the trade and current account. A surplus arises in the trade account if we export more than we import; a deficit arises if the converse holds. The trade balance is often a timely indicator of trends in the current account (as trade data are often easier to collect and more readily available than trade in services).  The current account balance is the difference between credits and debits of goods, services, income and transfers. It is one of the most useful indicators of an external imbalance. Persistent large current account deficits call for policy adjustments since a country cannot continue to finance deficits indefinitely by borrowing abroad or running down international reserves.

 

The overall balance equals the current account balance plus all capital and financial transactions that are not considered to be financing items. The overall balance is an important indicator of the external payments position. Deficits are usually financed by a decline in net foreign assets or reserves, which illustrates the extent to which the Central Bank has been financing payments imbalances.

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