Components of the Balance of Payments (DP IB Economics)

An Introduction to the Balance of Payments

• 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/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 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 sub-sections

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.)

Interdependence Between the Accounts

• 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