Balance of payments accounts
Balance of payments accounts track the flow of currency transactions that involve the currency of a given country. They are denominated in the home currency. They’re organized both by type of transaction and as currency inflows or outflows, much in the way that a company balance sheet is. But they are really much more like an income statement, since they record the flow of transactions over a period of time, usually a year.
I’m going to approach this topic in several posts. This one will sketch out the major “balances” that comprise the accounts. Subsequent posts will deal with how to interpret what the various balances tell us about the economic health of a country.
How the BoP is organized
The balance of payments has three big divisions:
–inflows vs outflows of currency
–short-term movements vs. long-term movements of currency
–commercial movements vs. government action.
currency inflows minus outflows
These categories generate the main accounts of economic/investment interest, all of which are calculated by adding up inflows of money (that is, flows that require foreigners to buy the local currency) and then subtracting outflows (locals buying foreign currency). They are:
the trade account–this consists in purchases of the local currency that foreigners make in order to pay for local goods or services exported abroad minus purchases of foreign currency by locals to pay for goods or services imported into the country. A country has a trade surplus if the value of its exports exceeds the value of its imports. It has a trade deficit in the opposite case, if the value of its imports exceeds the value of its exports.
the current account—this includes the items in the trade account, but expands it by adding the results (predominantly) of investment income, as well as foreign aid, if any, and salary payments to foreigners in the home country and locals working abroad.
The total calculation is: (exports + income (interest and dividends) received from foreign investments + salaries of foreigners + foreign aid received) minus (imports + income paid to foreigners investing in the home country–including payments on government debt + salaries of locals working abroad + foreign aid granted).
the capital account
The capital account consists of three items:
–short-term trading flows of money
–portfolio investment, that is, purchase of liquid investments like stocks and bonds, and
–foreign direct investment, that is, purchases of long-term illiquid assets, like corporations or commercial real estate of manufacturing plant and equipment.
Sometimes trading and portfolio flows are combined into one account showing short-term capital flows.
The capital account balance is calculated as: (foreign purchase of home country short-term notes + stocks and bonds + direct investment in the home country) minus (home country purchase of foreign short-term notes + stocks and bonds + direct investment abroad)
the basic balance Computationally, this is the sum of the current account balance + the capital account balance. Conceptually, it is the sum of all commercial inflows and outflows of funds for a given country.
After the basic balance, is there any kind of transaction left to deal with? Yes, government intervention in the currency markets.
Why/when would this be needed? At the basic balance level, the inflows and outflows are supposed to balance, that is, to equal one another and net out to zero. It isn’t necessary that the sub-accounts–trade, current and capital–balance. A deficit in one area can offset a surplus in another.
For example, if country X is regarded as a very attractive place for foreign direct investment, the country may experience large capital inflows, creating a capital account surplus. This inflow may both stimulate economic activity and exert upward pressure on the currency, raising consumer incomes which are then spent on purchases of foreign goods. All other things being equal, this activity can create a current account deficit offsetting the capital account surplus. The reality may be more complex than this, but that’s the general idea.
If at the basic balance level, payments are not in balance, there will be a natural tendency for economic events to occur that move the accounts back into balance. More about this process in later posts, but if there is much more foreign demand for the home country currency than there is local demand for foreign currency at a given exchange rate, the price of the local currency will tend to rise. The rising price will not only have effects on the level of inflowing investment capital, it will also reduce the world competitiveness of local industry. This can have significant political fallout in the home country.
Rather than accept the verdict of the markets, a government may choose to intervene in the currency markets in an effort to stop or at least slow the adjustment that the basic balance indicates the currency markets are demanding.