balance of payments

 

balance between all payments out of a country within a given period and all payments into the country, an outgrowth of the mercantilist theory of balance of trade. Balance of payments includes all payments between a country and its trading partners and is made up of the balance of trade, private foreign loans and their interest, loans and grants by governments or international organizations, and movements of gold (capital account). A chronically unfavorable balance of payments, when debits exceed credits, may affect the stability of the nation's currency, particularly where exchange rates are no longer fixed. After World War II the International Monetary Fund was established to handle problems relating to the balance of payments and foreign exchange.

Since the late 1950s the United States has generally experienced an unfavorable balance of payments because of large-scale foreign aid, sizable U.S. investment in Europe, and major U.S. military investments abroad. In the early 1970s the United States, in an effort to create a more favorable balance of payments, announced (1971, 1973) a devaluation of the U.S. dollar. However, the increase in the cost of petroleum from the Arab states (1973–74) had a negative effect on the balance of payments in the United States and most countries in Western Europe. In addition, tight money policies and high deficits adversely affected the savings rate in the United States in the 1980s and caused the balance of payments to decline even further. As a result, the United States looked to foreign borrowing to fill the gap, but the interest payments only increased the shortfall in the balance of payments. In the late 1990s and 2000s the U.S. balance of payments reached record negative levels.

Bibliography

See N. Fatemi, Problems of Balance of Payment and Trade (1975); T. De Saint Phalle, Trade, Inflation, and the Dollar (1981); D. Bigman, ed., Floating Exchange Rates and the State of World Trade Payments (1984).

The balance of payments, (or BOP) measures the payments that flow between any individual country and all other countries. It is used to summarize all international economic transactions for that country during a specific time period, usually a year. The BOP is determined by the country's exports and imports of goods, services, and financial capital, as well as financial transfers. It reflects all payments and liabilities to foreigners (debits) and all payments and obligations received from foreigners (credits). Balance of payments is one of the major indicators of a country's status in international trade, with net capital outflow.

Balance of Payments Identity

The Balance of Payments is the sum of the Current Account and the Capital Account (also referred to as the Financial Account). The Balance of Payments Identity states that:

Current Account + Capital Account = Change in Official Reserve Account

A country will have a negative balance of payments (a net decrease in official reserves) if the net of the current account and the capital account is a deficit. Similarly, there will be a positive balance of payments (a net increase in official reserves) if the net of the current and the capital account results in a surplus. The basic principle behind the identity is that a country can only consume more than it produces (a current account deficit) if it borrows from abroad (a capital account surplus, where 'borrowing' includes all forms of investment from abroad).

When the change in official reserves in a given year is small relative to the Current Account and the Capital Account, it may be approximated as zero. For example, if a government runs a current account deficit and has no change in official reserves, then the current account deficit must (by definition) be balanced by a capital account surplus.

Components

The Balance of Payments for a country is the sum of the current account, the financial account (formerly capital account), and the change in official reserves.

[Note: The name of the "capital account" was changed in the US in 1999. It is now referred to as the financial account. ^[1]]

The current account is the sum of net sales from trade in goods and services, net factor income (such as interest payments from abroad), and net unilateral transfers from abroad. Positive net sales to abroad corresponds to a current account surplus; negative net sales to abroad corresponds to a current account deficit. Because exports generate positive net sales, and because the trade balance is typically the largest component of the current account, a current account surplus is usually associated with positive net exports.

The Income Account or Net Factor Income, a sub-account of the Current Account, is usually presented under the headings "Income Payments", as outflows, and "Income Receipts", as inflows. If the Income Account is negative, the country is paying more than it is taking in interest, dividends, etc. For example, the United States' net income has been declining exponentially since it allowed the Dollar's price relative to other currencies to be determined by the market to a point where income payments and receipts are roughly equal. The difference between Canada's Income Payments and Receipts have been declining exponentially as well since its central bank in 1998 began its strict policy not to intervene in the Canadian Dollar's foreign exchange.^[2] The various subcategories in the Income Account are linked to specific respective subcategories in the Financial account. From here, economists and central banks determine implied rates of return on the different types of capital exchanged in the Financial Account. The United States, for example, gleans a substantially larger rate of return from foreign capital than foreigners from domestic capital.

When analyzing the current account theoretically, it is often written as a function X of the real exchange rate, p, domestic GDP, Y, and foreign GDP, Y*. Thus the current account can be written as X(p, Y, Y*). According to theory, the current account X should increase if (1) the domestic currency depreciates (p increases), (2) domestic GDP decreases, or (3) foreign GDP increases. A domestic currency depreciation makes domestic goods relatively cheaper, boosting exports relative to imports. A decrease in domestic GDP reduces domestic demand for foreign goods, lowering imports without affecting exports. An increase in foreign GDP increases foreign demand for domestic goods, increasing exports without affecting imports.

Current account =

• Trade Balance
  • Net Exports (Exports - Imports) of Merchandise (tangible goods)
  • Net Exports (Exports - Imports) Services (such as legal and consulting services)
• + Net Factor Income From Abroad (such as interest and dividends)
• + Net Unilateral Transfers From Abroad (such as foreign aid, grants, gifts, etc.)

Financial Account

The financial account is the net change in foreign ownership of domestic assets. If foreign ownership of domestic 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 assets has increased more quickly than foreign ownership of domestic assets, then the domestic country has a financial account deficit

The accounting entries in the financial account record the purchase and sale of domestic and foreign 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).

Financial account =

• Increase in foreign ownership of domestic assets
• - Increase of domestic ownership of foreign assets

Current Account

This section covers capital transfers and acquisition/disposal of non-produced, nonfinancial assets. For example, foreign aid and migrants' goods as they cross a country's borders..^[3]

Official reserves

The official reserves account records the current stock of reserve assets (and often simply referred to as foreign exchange reserves) available to and controlled by the country's authorities for financing of international payment imbalances, foreign exchange intervention and other uses.^[4] Reserves include official gold reserves, foreign exchange reserves, and IMF Special Drawing Rights (SDRs), all denominated in foreign currency (although the amounts may be expressed in any relevant unit). Changes in the official reserves account for the differences between the capital account and current account, and effectively represent foreign exchange interventions; the magnitude of these changes will depend on monetary policy.

In general, net decreases in official reserves indicate that a country is buying its domestic currency to support its value relative to whatever foreign currency they are selling in exchange for the domestic one. Countries with large net increases in official reserves are effectively attempting to keep the price of their currency low by selling domestic currency and purchasing foreign currency, increasing official reserves.^[5][2] For countries with floating exchange rates, the official reserves will tend to change less, and be used as another tool of monetary policy to influence intervention by directly controlling the domestic money supply (by buying or selling foreign currency); however, this usage has been challenged by economists such as Milton Friedman who in an interview on Icelandic television said that a central bank can control an exchange rate or control inflation but cannot do both:

Interest in official reserve positions as a measure of balance of payments greatly diminished after 1973 as the major countries gave up their commitment to convert their currencies at fixed exchange rates. This reduced the need for reserves and lessened concern about changes in the size of reserves.^[6]

Countries that attempt to control the price of their currency will tend to have large net changes in their official reserves. Some of the most extreme examples include China and Japan. In 2003 and 2004, Japan had an outflow of reserves, yen, by more than equivalently one third of one trillion US Dollars if calculated using exchange rates prevailing at the time.^[7]

Balance of Payments Equilibrium

A Balance of Payments Equilibrium is defined as a condition where the sum of debits and credits from the Current Account and the Financial Account equal to zero; in other words, equilibrium is where

Current Account + Financial Account = 0

This is a condition where there are no changes in Official Reserves.^[8] When there is no change in Official Reserves, the balance of payments may also be stated as follows:

Current Account = - Financial Account or

Current Account Deficit (Surplus) = Financial Account Surplus (Deficit)

Canada's Balance of Payments currently satisfies this criteria.^[2]

History

Historically these flows simply were not carefully measured, and the flow proceeded in many commodities and currencies without restriction, clearing being a matter of judgement by individual banks and the governments that licensed them to operate. Mercantilism was a theory that took special notice of the balance in 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).

As mercantilism gave way to classical economics, these crude 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, which was redeemable nominally in gold. In the 1970s this redemption ceased, leaving the system without a formal base. 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. Since OPEC prices oil in US dollars, the US dollar remains a reserve currency, but is increasingly challenged by the euro, and to a small degree the Japanese yen.

The United States has been running a current account deficit since the early 1980s. The U.S. current account deficit has grown considerably during the Bush era, reaching record high levels in 2006 both in absolute terms ($758 billion) and as a fraction of GDP (6%). This interpretation of the data, however, is disputed by Milton Friedman (Balance of Trade) claiming that cheaper, riskier, foreign capital is exchanged for "riskless", expensive, US capital and that the difference is made up with extra goods and services. Nevertheless, Friedman's interpretation is incomplete with respect to countries that interfere with the market prices of their currencies through the changes in their reserves.

See also

• Current account
• Capital account
• Balance of trade
• Floating currency
• List of countries and territories by current account balance
• Capital surplus
• International investment position
• Foreign exchange reserves
• Sovereign wealth funds
• Money supply
• United States public debt
• Pink Book
• Milton Friedman

References

1. ^ Upcoming Changes in the Classification of Current and Capital Transactions in the U.S. International Accounts from BEA
2. ^ ^{a b c} Bank of Canada - Intervention in the Exchange Market - Fact Sheet - The Bank in Brief.
3. ^ http://www.imf.org/external/np/exr/glossary/showTerm.asp#86 IMF Glossary of Selected Financial Terms
4. ^ http://stats.oecd.org/glossary/detail.asp?ID=2319 OECD Glossary of Statistical Terms
5. ^ http://www-personal.umich.edu/~alandear/glossary/e.html#ExchangeMarketIntervention International Economics Glossary
6. ^ http://www.econlib.org/library/Enc/BalanceofPayments.html Herbert Stein, "The Balance of Payments" in The Concise Encyclopedia of Economics.
7. ^ [http://www.mof.go.jp/bpoffice/bpdata/es1bop.htm reported Bank of Japan - Balance of Payments
8. ^ http://www-personal.umich.edu/~alandear/glossary/b.html Glossery of International Economics

External links

Data

• IMF DSBB
  • United States DSBB (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

International trade
Definitions	Balance of payments · Current account (Balance of trade) · Capital account · Foreign exchange reserves · Sovereign wealth funds · Net Capital Outflow · Comparative advantage · Absolute advantage · Import substitution · International trade
Organizations and policies	World Trade Organization · International Monetary Fund · World Bank Group · International Trade Centre · Trade bloc · Free trade zone · Trade barrier · Import quota · Tariff
Schools of thought	Free trade · Balanced trade · Mercantilism · Protectionism
Related issues	Globalization · Outsourcing · Trade justice · Fair trade

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