The Balance of Payments (AQA A Level Economics)

The Balance of Payments (BoP)

• The Balance of Payments (BoP) for a country is a record of all the financial transactions that occur between it and the rest of the world
  

• The BoP has two main sections:

  • The current account: all transactions related to goods and services, along with payments related to the transfer of income

  • The financial and capital account: all transactions related to savings, investment and currency stabilisation
    
    

• Money flowing into an account is recorded in the relevant account as a credit (+) and money flowing out as a debit (-)

  • If more money flows into an account than out of it, there is a surplus in the account

  • If more money flows out of an account than into it, there is a deficit in the account
    

The Current Account

• The Current account comprises trade in goods, trade in services, primary income and secondary income

• The Current Account is often considered to be the most important account in the BoP

• This account records the net income that an economy gains from international transactions
   

An Example of the UK Current Account Balance for 2017

• Goods are also referred to as visible exports/imports

• Services are also referred to as invisible exports/imports

• Net income consists of income transfers by citizens and corporations

  • Credits are received from UK citizens who are abroad and send remittances home

  • Debits are sent by foreigners working in the UK back to their countries

• Current transfers are typically payments at government level between countries, e.g. contributions to the World Bank

The Capital Account

• The Capital Account records small capital flows between countries and is relatively inconsequential

•  The capital account is made up of two sections:

1. Capital transfers

• Smaller flows of money between countries

• E.g. Debt forgiveness payments by the government toward developing countries

• E.g. Capital transfers by migrants as they emigrate and immigrate
  

2. Transactions in non-produced, non-financial assets

• Small payments are usually associated with royalties or copyright, e.g. royalty payments by record labels to foreign artists

The Financial Account

• The Financial Account records the flow of all transactions associated with changes of ownership of the country’s foreign financial assets and liabilities

• It includes the following subsections:

1. Foreign Direct Investment (FDI)

• Flows of money to purchase a controlling interest (10% or more) in a foreign firm. Money flowing in is recorded as a credit (+) and money flowing out is a debit (-) 

2. Portfolio Investment

• Flows of money to purchase foreign company shares and debt securities (government and corporate bonds). Money flowing in is recorded as a credit (+) and money flowing out is a debit (-) 

3. Official Borrowing

• Government borrowing from other countries or institutions outside of their own economy e.g. loans from the International Monetary Fund (IMF) or foreign banks

• When the money is received,  it is recorded as a credit (+) and when the money (or interest payments) are repaid, it is recorded as a debit (-) 

4. Reserve Assets

• These are assets controlled by the Central Bank and available for use in achieving the goals of monetary policy

• They include gold, foreign currency positions at the International Monetary Fund (IMF) and foreign exchange held by the Central Bank (USD, Euros etc.)

Deficit & Surplus on the Current account

• It is called the BoP as the current account should balance with the capital and financial account and be equal to zero

  • If the current account balance is positive, then the capital/financial account balance is negative (and vice versa)

  • In reality, it never balances perfectly and the difference is called 'net error and omissions'
    
    

• If there is a current account deficit, there must be a surplus in the capital and financial account

  • The excess spending on imports (current account deficit) has to be financed from money flowing into the country from the sale of assets (financial account surplus)
    
    

• If there is a current account surplus, there must be a deficit in the capital and financial account

  • The excess income from exports (current account surplus) is financing the purchase of assets (financial account deficit) in other countries

The Factors that Influence a Country’s Current Account

• Productivity, inflation and exchange rates can influence a country’s current account: 

Productivity

• Supply-side policies, such as tax incentives or education can improve labour productivity

  • There is an increase in output per worker as a result of price and quality competitiveness 

  • Which may result in an increase in export volumes in international markets 
    

Inflation 

• High rates of inflation relative to trading partners, can make exports more expensive for foreign markets and imports cheaper for domestic consumers 

  • This can result in a worsening of current account or a trade deficit
    
    

• Low inflation or deflation relative to trading partners, can make exports cheaper in foreign markets and imports more expensive for domestic consumers 

  • This can result in an improvement in the current account balance (or a trade surplus)
    

Exchange rates

• A stronger exchange rate makes imports cheaper and exports more expensive

  • When a country's currency appreciates, its exports become relatively more expensive for foreign buyers, potentially leading to a decrease in export volumes

  • Imports become relatively cheaper for domestic consumers, which may lead to an increase in import volumes
     

• A weaker exchange rate makes imports more expensive and exports cheaper

  • When a country's currency depreciates, its exports become relatively cheaper for foreign buyers, potentially leading to an increase in export volumes.

  • At the same time, imports become relatively more expensive for domestic consumers, which may result in a decrease in import volumes

The Consequences of Investment Flows Between Countries

• The financial account measures the inflows and outflows of financial assets, including foreign direct investment and portfolio investment  

• Changes in the financial account can impact the exchange rate

  • When there is an inflow of foreign investment into a country, it increases the demand for the country's currency, potentially leading to an appreciation of the exchange rate

  • When there is an outflow of domestic investment to other countries, it increases the supply of the country's currency in the foreign exchange market, potentially leading to a depreciation of the exchange rate
     

• The exchange rate influences the attractiveness of a country for foreign investment

  • A stronger exchange rate makes foreign investments more expensive in terms of the investor's home currency, potentially reducing the appeal of investing in that country.

  • A weaker exchange rate can make a country's assets more affordable for foreign investors, potentially increasing the attractiveness of investing in that country