Balance of Payments explained

Neven Valevwww.TheGlobalEconomy.com

The Balance of Payments summarizes the international transactions of a country.

These transactions can be broadly categorized into two types – international trade and payments (current account) and international investment (financial account).

The Current Account includes:Imports and exports of goods.

Imports and exports of services – financial, legal, medical, travel, etc.

Income on financial assets. For example: if a U.S. mutual fund invests in a Mexican company, the dividends from that investment will be recorded in the current account. Also, if the Chinese government buys U.S. government bonds, then the interest on these bonds will be recorded in the current account.

Transfers between countries. This includes, for example, foreign aid, remittances, and international gifts.

The Financial Account includes:

Foreign direct investment: the purchase or creation of facilities for the production of goods or services (e.g. a Toyota plant in the U.S.).

Portfolio investment: the purchases of equity (less than 10% of the value of a firm) and bonds.

Other financial transactions such as cross-border bank deposits.

Deficit and surplusThe current account could be in surplus if, for example, exports are greater than imports. It could be in deficit if imports are greater than exports or if, say, the domestic country makes large transfer payments to foreign countries.

The financial account is in surplus if the foreign investment into the country is greater than the country's investment in other countries. In contrast, the financial account is in deficit if domestic citizens invest more internationally than the amount foreigners invest in the local economy.

The current accounts of the U.S. and China

Bookkeeping rulesA simple rule of thumb is that transactions that require the sale of the local currency for a foreign currency enter with a minus sign.

For example, if a U.S. family goes on a holiday to Mexico, they have to sell dollars and buy peso to make payments in Mexico. This transaction will go with a minus sign in the U.S. Balance of Payments (more specifically in the current account) and with a plus sign in the Mexican Balance of Payments.

The reverse is true for transactions that require the purchase of the domestic currency: these are recorded with a plus sign. For example, a German company that wants to import machinery from the U.S. has to buy dollars to make the payment. That will be recorded with a plus sign in the U.S. Balance of Payments and with a minus sign in the German Balance of Payments.

Double entry for transactionsEach international transaction creates two entries in the balance of payments with the same absolute magnitude and an opposing sign.

For example, a Japanese consumer buys an American car for $10,000. This is recorded as + $10,000 in the U.S. Current Account. To purchase the car, the Japanese consumer buys $10,000 from, say, Citibank.

Now Citibank has $10,000 worth of yen. It uses the yen to buy Japanese government bonds. That purchase enters with a (-) sign in the U.S. Financial Account.

Always in balanceSo, we have two transactions of equal absolute magnitude but with opposite signs. Since this is true for each international transaction, when we add up all the “+” entries and all the “-“ entries, we’ll arrive at the same absolute number. Therefore,

Balance of Payments = Current account balance + Financial account balance = 0

In other words, while the current account and the financial account can be in surplus or deficit, the overall Balance of Payments is always in “balance.”

More informationCurrent account balances by country

Foreign direct investment by country

Compare countries over time

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