Balance of payments

The Balance of Payments (BOP) is a measure of all the financial payments flowing between one country and all other countries during a specific period, usually a quarter or a year. It is also the name of the official record of these payments. A positive, or favorable, balance of payments is one in which more payments have come in to a country than have gone out. A negative or unfavorable balance means more payments are exiting than arriving.

The BOP is a major indicator of a country's status in international trade.

Components and Procedures

Within any country, the BOP record comprises three "accounts": the current account, which includes primarily trade in goods and services (often referred to as the balance of trade), along with earnings on investments; the capital account, including transfers of non-financial capital such as debt forgiveness, gifts and inheritance transfers; and the financial account, essentially trade in such assets as currencies, stocks, bonds, real estate, and gold, among others.

Each of these components is further divided into subcomponents. Thus, for example, the current account comprises trade in merchandise, trade in services (such as tourism and law), income receipts such as dividends, and unilateral transfers of money, including direct foreign aid. Likewise, the capital account includes such "transfers" as debt forgiveness, money that migrant workers take home with them when they leave the country, and sales and purchases of natural resources. And the financial account consists both of assets owned abroad, and of foreign-owned assets within the country.

When payments leave a country—for example, to finance a purchase, or to invest in a foreign corporation—the transaction is recorded as a debit by that country, and as a credit by the receiving country. Thus, internationally, the system should always be in "balance."

Domestically as well, the BOP should always balance. As with all other business accounting systems, the record of a country's financial transactions is prepared "in accordance with double-entry bookkeeping." That is, each transaction is recorded as both a debit and a credit. When a country or its citizen buys a foreign good—furniture, say—that is recorded as an increase in the asset of furniture (indicated, according to convention, by a debit-entry in the record). At the same time, that entry is countered, or balanced, by a decrease in the asset of money (indicated by a credit-entry).

Further, the Current Account should always balance the Capital and Financial Accounts. In practice, however, this is not always the case, given "statistical discrepancies, accounting conventions, and exchange rate movements that change the recorded value of transactions."

IMF definition

The IMF definition: "Balance of Payments is a statistical statement that summarizes transactions between residents and nonresidents during a period." The balance of payments comprises the current account, the capital account, and the financial account. "Together, these accounts balance in the sense that the sum of the entries is conceptually zero."

• The current account consists of the goods and services account, the primary income account and the secondary income account.
• The financial account records transactions that involve financial assets and liabilities and that take place between residents and nonresidents.
• The capital account in the international accounts shows (1) capital transfers receivable and payable; and (2) the acquisition and disposal of nonproduced nonfinancial assets.

In economic literature, "capital account" is often used to refer to what is now called the financial account and remaining capital account in the IMF manual and in the System of National Accounts. The use of the term capital account in the IMF manual is designed to be consistent with the System of National Accounts, which distinguishes between capital transactions and financial transactions.

Components

File:Current Account Balance 2006.png

2006 account balance

The Balance of Payments for a country is the sum of the current account, the capital account, the financial account.

Current account

The current account is the net change in current assets from trade in goods and services (balance of trade), net factor income (such as dividends and interest payments from abroad), and net current transfers from abroad (such as foreign aid, grants, gifts, etc).

${\begin{aligned}{\mbox{Current account}}=&{\mbox{Balance of trade}}\\&+{\mbox{Net factor income from abroad}}\\&+{\mbox{Net unilateral transfers from abroad}}\\\end{aligned}}$

Income Account

The income account accounts mostly for investment income from dividends and interest on credit and payments on foreign taxes.

Unilateral Transfers

Unilateral transfers are usually conducted between private parties. For example, Mexico has a large surplus of remittances from the United States sent by emigrant workers to loved ones back home.

India has the world's largest surplus of remittances.

Capital account (IMF/economics)

Capital accounts are reversible and are different from current accounts because they are investments over longer periods of time. Capital accounts involve the exchange of migrant assets, foreign aid capital and homeowner's property.

According to the IMF's definition, the capital account "records the national flows of transfer payments relating to capital items." It therefore records a country's inflows and outflows of debts and transfer of ownership of nonproduced nonfinancial assets such as leases and licenses.

In economics, the term saver's account usually refers to what the IMF calls the financial account and capital account, combined.

Financial account (IMF) / Capital account (economics)

According to the IMF's definition, the financial account is the net change in foreign ownership of investment assets. In economics, the term capital account has historically been used to refer to the IMF's definition of the capital and financial accounts.

${\begin{aligned}{\mbox{Financial account}}&={\mbox{Increase in foreign ownership of domestic assets}}\\&-{\mbox{Increase of domestic ownership of foreign assets}}\\&={\mbox{Foreign direct investment}}\\&+{\mbox{Portfolio investment}}\\&+{\mbox{Other investment}}\\\end{aligned}}$

The accounting entries in the financial account record the purchase and sale of domestic and foreign investment assets. These assets are divided into categories such as foreign direct investment (FDI), portfolio investment (which includes trade in stocks and bonds), and other investment (which includes transactions in currency and bank deposits).

If foreign ownership of domestic financial assets has increased more quickly than domestic ownership of foreign assets in a given year, then the domestic country has a financial account surplus. On the other hand, if domestic ownership of foreign financial assets has increased more quickly than foreign ownership of domestic assets, then the domestic country has a financial account deficit.

The United States persistently has the largest capital (and financial) surplus in the world.

Official international reserves

The official international reserve account records the change in stock of official international reserve assets (also known as foreign exchange reserves) at the country's monetary authority . Frequently, this is the responsibility of a government established central bank. Although usually negligible, official international reserve assets held at private institutions are included as well. Official international reserves include official gold reserves, foreign currencies and foreign currency denominated bonds (called foreign exchange reserves), IMF Special Drawing Rights (SDRs) and other foreign assets. Changes in official international reserves equal the differences between current account (plus capital account) and the non-reserve portion of the financial account.

Decreases in official international reserves indicate the central bank is selling the assets in return for domestic currency denominated assets, usually to maintain the value of the domestic currency. Increases in official international reserves indicate that the central bank is buying the assets in return for domestic currency denominated assets, usually to maintain the value of a foreign currency. Countries that attempt to influence the value of their currencies can have large net changes in their official reserves. In 2003 and 2004, the Bank of Japan increased its official international reserves by more than US$330 billion

Net errors and omissions

This is the last component of the balance of payments and principally exists to correct any possible errors made in accounting for the three other accounts. These errors are common to occur due to the complexity of the calculations and difficulty in obtaining measurements.

Omissions are rarely used usually by governments to conceal transactions.

They are often referred to as "balancing items."

Balance of payments identity

The balance of payments identity states that:

Current Account = Capital Account + Financial Account + Net Errors and Omissions

This is a convention of double entry accounting, where all debit entries must be booked along with corresponding credit entries such that the net of the Current Account will have a corresponding net of the Capital and Financial Accounts:

$X+K_{i}=M+K_{o}\,$

where:

• X = exports
• M = imports
• K_i = capital inflows
• K_o = capital outflows

Rearranging, we have:

$(X-M)=K_{o}-K_{i}\,$,

yielding the BOP identity.

The basic principle behind the identity is that a country can only consume more than it can produce (a current account deficit) if it is supplied capital from abroad (a capital account surplus).

Mercantile thought prefers a so-called balance of payments surplus where the net current account is in surplus or, more specifically, a positive balance of trade.

A balance of payments equilibrium is defined as a condition where the sum of debits and credits from the current account and the capital and financial accounts equal to zero; in other words, equilibrium is where

${\mbox{Current account}}+({\mbox{Capital and financial accounts}})=0\,$

This is a condition where there are no changes in Official Reserves. When there is no change in Official Reserves, the balance of payments may also be stated as follows:

${\mbox{Current account}}=-({\mbox{Capital and financial accounts}})\,$

or:

${\mbox{Current account deficit (or surplus)}}=-{\mbox{Capital and financial account surplus (or deficit}})\,$

Canada's Balance of Payments currently satisfies this criterion. It is the only large monetary authority with no Changes in Reserves.

History

Historically these flows simply were not carefully measured due to difficulty in measurement, and the flow proceeded in many commodities and currencies without restriction, clearing being a matter of judgment by individual private banks and the governments that licensed them to operate. Mercantilism was a theory that took special notice of the balance of payments and sought simply to monopolize gold, in part to keep it out of the hands of potential military opponents (a large "war chest" being a prerequisite to start a war, whereupon much trade would be embargoed) but mostly upon the theory that large domestic gold supplies will provide lower interest rates. This theory has not withstood the test of facts.

As mercantilism gave way to classical economics, and private currencies were taxed out of existence, the market systems were later regulated in the 19th century by the gold standard which linked central banks by a convention to redeem "hard currency" in gold. After World War II this system was replaced by the Bretton Woods institutions (the International Monetary Fund and Bank for International Settlements) which pegged currency of participating nations to the US dollar and German mark, which was redeemable nominally in gold. In the 1970s this redemption ceased, leaving the system with respect to the United States without a formal base, yet the peg to the Mark somewhat remained. Strangely, since leaving the gold standard and abandoning interference with Dollar foreign exchange, the surplus in the Income Account has decayed exponentially, and has remained negligible as a percentage of total debits or credits for decades. Some consider the system today to be based on oil, a universally desirable commodity due to the dependence of so much infrastructural capital on oil supply; however, no central bank stocks reserves of crude oil. Since OPEC oil transacts in US dollars, and most major currencies are subject to sudden large changes in price due to unstable central banks, the US dollar remains a reserve currency, but is increasingly challenged by the euro, and to a small degree the pound.

The United States has been running a current account deficit since the early 1980s. The U.S. current account deficit has grown considerably in recent years, reaching record high levels in 2006 both in absolute terms ($758 billion) and as a fraction of GDP (6%).

See also

• Current account
• Capital account
• Balance of trade
• Floating currency
• Capital surplus
• International investment position
• Foreign exchange reserves
• Sovereign wealth fund
• Money supply
• United States public debt
• FRED (Federal Reserve Economic Data)
• Pink Book
• Milton Friedman
• IMF Balance of Payments Manual
• List of countries by current account balance

References

ISBN links support NWE through referral fees

• Economics 8th Edition by David Begg, Stanley Fischer and Rudiger Dornbusch, McGraw-Hill
• Economics Third Edition by Alain Anderton, Causeway Press
• AS and A Level Economics, Cambridge University Press

External links

Data

• IMF
  • [2] (See "External Sector")
• BEA U.S. International Transactions Accounts Data
• BEA U.S. International Transactions Accounts Data Help
• Balance of Payments in Hong Kong

You can also download historical balance of payments information from 1960 under the "All Tables" link of the following page:

• BEA Balance of Payments Section

Analysis

• Where Do U.S. Dollars Go When the United States Runs a Trade Deficit? from Dollars & Sense magazine

Credits

New World Encyclopedia writers and editors rewrote and completed the Wikipedia article in accordance with New World Encyclopedia standards. This article abides by terms of the Creative Commons CC-by-sa 3.0 License (CC-by-sa), which may be used and disseminated with proper attribution. Credit is due under the terms of this license that can reference both the New World Encyclopedia contributors and the selfless volunteer contributors of the Wikimedia Foundation. To cite this article click here for a list of acceptable citing formats.The history of earlier contributions by wikipedians is accessible to researchers here:

• Balance of payments  ^history

The history of this article since it was imported to New World Encyclopedia:

• History of "Balance of payments"

Note: Some restrictions may apply to use of individual images which are separately licensed.