The balance of payments

The balance of payments has two separate meanings in economics:

Firstly, to have a balance of payments with the rest of the world, which is seen as an important macroeconomic objective.

Secondly, the balance of payments is a record of the payments into and out of an economy.

Flows of payments occur when a country makes and receives payments relating to international transactions. Payments relate to goods, services, investments, people working abroad, and official financial flows.

A country's balance of payments account

A country's official balance of payments account in broken down into two basic sections, the Current Account and the Financial Account, including a country's 'investment position'.

The current account, which includes:

Trade

Trade flows include payments for goods and services - imports and exports. Trade in goods is referred to as 'visible' trade and trade in services is 'invisible' trade.

Examples of visible trade:

  1. Commodities
  2. Fuels
  3. Semi-finished consumer and capital goods
  4. Finished goods

Examples of invisible trade:

  1. Financial services, including banking, insurance and shipping
  2. Consultancy and design
  3. Advertising services
  4. Tourism

The trade account is often seen as the most important account for a country in terms of trying to achieve a trade balance.

Primary income

The primary income balance records income a country receives and pays on financial and other assets, together with compensation of employees.

Much of this relates to a country's previous investment abroad. For example, if a company purchases another company located abroad, the trading profits are included in primary income.

Secondary income

The secondary income account includes records of transfers;

General government transfers, which includes taxes and other contributions received from non-resident workers and businesses, bilateral international aid; social security payments abroad; and miscellaneous transfers.

Non-government transfers include taxes on income and wealth paid by a country's workers to foreign governments; insurance premiums and claims; and workers’ remittances, and private transfers, including gifts.

Capital and financial account

The capital account of the balance of payments records a country's transactions in fixed capital assets, such as the transfer of ownership of a factory in an overseas territory.

The financial account records flows of payments for financial assets, such as the disposal or acquisition of shares in businesses located abroad.

The financial account is laid out in several categories, including direct investment, portfolio investment, financial derivatives and reserve assets.

Official financing

The financial account also records official financing flows, which arise when a central bank buys or sells foreign currencies, or buys or sells other assets, including gold. It may be necessary to borrow from time to time, or to lend to other countries, and these transactions will be entered in this account.

The reason for this is that the overall balance of payments must balance. Hence, a deficit on a country's current account must be balanced by an equal surplus on its capital and financial account. A surplus on the capital account may not be sufficient to create an overall balance, hence the need for a country to engage in official financing through its central bank.

A country's balance of payments must always balance, with the account equalling zero.

International investment position

The international investment position (IIP) looks at a country's balance sheet with the rest of the world, and measures the difference between the country's net stock of assets and liabilities.

Errors and Omissions

Although the balance of payment should, in theory balance, in practice there are various imperfections in how the data is collected and compiled. These errors and omissions are estimated and a 'net' figure is produced, which is included in the accounts in order to make the overall balance equal zero.

The importance of the Current Account

While the overall balance of payments must always equal zero, this does not mean that a country cannot run into trade difficulties. It is still the case for most advanced economies that the Current Account is regarded as an indicator of economic performance in the global economy. In other words, is the country 'paying its way' in the global economy?

Current account deficits and surpluses

A current account deficit arises when Net trade + Net Primary Income + Net Secondary Income is less than zero.

A current account surplus arises when Net trade + Net Primary Income + Net Secondary Income is greater than zero.

Is a current account deficit a cause for concern?

This depends on several factors.

A current account deficit may be a concern if:

  1. It is a structural deficit rather than a temporary deficit. Temporary deficits are common, and are usually the result of the ebb and flow of the business cycle.
  2. What share of national income (GDP) does the deficit make up? Just a few percent is very different from 10 or 20 percent.
  3. Are there compensating surpluses on the capital account - that does not require official financing?
  4. Is the country able to borrow at a relatively cheap rate if it needs to? In other words, does it have a good credit rating?
  5. Will corrective action by the government or central bank cause difficulties for the economy? For example, one policy used in the past was to restrict the supply of money so that consumer spending fell, and imports would then fall as a by-product of this. However, falling consumer spending can trigger a recession, leading to increased unemployment, falling profits and bankruptcies.

Is a current account surplus a cause for concern?

On the surface, a surplus does not sound such a 'bad' things. And it generally is not considered a significant economic problem. However, there are some issues associated with a surplus.

A current account surplus may be an issue because:

  1. There is an opportunity cost in that an economy could be importing more relative to its exports. Standards of living are, at least in the short run, derived from consumption, and imports contribute to households' standards of living. Moving nearer to a current account balance would improve living standards in the short run.
  2. A country's exchange rate could be driven higher (appreciate), which could make it difficult for certain exporters. Of course, a higher exchange would, to some extent, 'self-correct' a surplus, but the impact would be uneven. Exporters relying on price competitiveness to win overseas customers would be at a disadvantage compared with exporters relying on niche markets, or selling heavily branded goods, where price is less significant than non-price factors.
  3. Other countries with deficits may consider putting up barriers to trade in retaliation for another country building up a surplus.
  4. There may be some corrective action by the government or central bank which might cause difficulties for the economy. For example, pumping in extra demand to encourage more imports could create inflationary pressure.

Conflicts between the current account, and other objectives

Assuming a significant and sustained current account deficit, corrective action may be necessary. This might include:

  1. Raising interest rates to encourage inflows of 'hot money', which could offset a current account deficit. Hot money is short term speculative flows of money which is attracted into an economy to exploit higher short-term interest rates.
  2. However, this can lead to a fall in domestic investment, and trigger a downturn in national income. This, in turn could increase inflation, and worsen public finances as a result of falling tax revenues and increased welfare payments.
  3. Raising direct taxes in order to reduce disposable income and reduce imports might have a similar effect to higher interest rates, with a fall in economic activity and rising unemployment.
  4. Engineering a depreciation in the exchange rate would make exports cheaper - however, it would also make imports more expensive, which could have a significant effect on cost-push inflation.
  5. Finally, direct controls on imports by erecting barriers to trade may restrict imports in the short run, but such barriers may reduce welfare for consumers, and may lead to retaliation.

Some policies to restructure the economy in the long run might not have serious conflicts. For example, supply-side policies designed to improve education and skills, to create a more productive and flexible labour market, and investment in infrastructure may well help to correct trade difficulties while being helpful in the achievement of other objectives.

However, supply-side policies take a long time to plan and to implement, with few short-term gains.