Balance of payments

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In economics, 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.^{[citation needed]}

The balance, like other accounting statements, is prepared in a single currency, usually the domestic. Foreign assets and flows are valued at the exchange rate of the time of transaction.

Contents 1 IMF definition 2 Components 2.1 Current account 2.1.1 Income Account 2.1.2 Unilateral Transfers 2.2 Capital account (IMF/economics) 2.3 Financial account (IMF) / Capital account (economics) 2.3.1 Official reserves 2.4 Net errors and omissions 3 Balance of payments identity 4 History 5 See also 6 References 7 External links 7.1 Data 7.2 Analysis

[edit] IMF definition

The IMF definition: "The balance of payments is a statistical statement that summarizes transactions between residents and nonresidents during a period."^[1] The balance of payments comprises the current account, the capital account, and the financial account. "Together, these accounts balance in the sense the sum of the entries is conceptually zero."^[1]

• 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.^[2]

[edit] Components

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

[edit] Current account

Main article: 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 unilateral transfers from abroad (such as foreign aid, grants, gifts, etc).

[edit] Income Account

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

Strangely, the net of the income account of the United States has been negligible as a percentage of total debits or credits for decades, an extremely outlying instance.

[edit] 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.^[3]

[edit] Capital account (IMF/economics)

According to the IMF's definition, the capital account "records the international flows of transfer payments relating to capital items". It therefore records a country's inflows and outflows of payments and transfer of ownership of fixed assets (capital goods). Examples of such goods could be factories or heavy machinery transferred to or from abroad and so on. Summing up: the capital account accounts for the transfer of capital goods. (source: see book reference list)

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

[edit] Financial account (IMF) / Capital account (economics)

Main article: Capital account

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.

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.^[4]

The United States receives roughly twice the rate of return on all foreign investment than domestic investment by foreigners.

[edit] Official reserves

The official reserve account records the change in stock of 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 practically extinct, changes in reserve assets at private monetary authorities are included, as well. Reserves include official gold reserves, foreign exchange reserves, IMF Special Drawing Rights (SDRs), or nearly any foreign property held by the monetary authority all denominated in domestic currency. Changes in the official reserve account equal the differences between the capital account and current account (and errors & omissions) by accounting identity and are mostly composed of foreign exchange interventions and deposits into international organizations such as the IMF; the magnitude of these changes will depend upon monetary policy and government mandate.

According to the standards published by the IMF in the IMF Balance of Payments Manual, net decreases of official reserves indicate that a country is buying its domestic assets, usually currency then bonds, to support its value relative to whatever asset, usually a foreign currency, that they are selling in exchange.^[5] 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.^[6][7] 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.^[8]

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.^[9] Note that the reported deficit of official reserves representing an outflow of yen on this publication is not in accordance with the IMF standards.

Changes in reserves are no longer booked as a major account. It is distinguished principally for economic purposes.

[edit] 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.^[10]

Omissions are rarely used usually by governments to conceal transactions.

They are often referred to as "balancing items".

[edit] 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:

where:

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

Rearranging, we have:

,

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).^[8] From Alfred Marshall's Money, Credit, and Commerce, "In short, when a country lends abroad ₤1,000,000 in any form, she gives foreigners the power of taking from her ₤1,000,000 of goods".

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

This is a condition where there are no changes in Official Reserves.^[11] When there is no change in Official Reserves, the balance of payments may also be stated as follows:

or:

Canada's Balance of Payments currently satisfies this criterion. It is the only large monetary authority with no Changes in Reserves.^[7]

[edit] 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 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 in recent years, reaching record high levels in 2006 both in absolute terms ($758 billion) and as a fraction of GDP (6%). Milton Friedman (Balance of Trade) has tried to explain that cheaper, riskier, foreign capital is exchanged for "riskless", expensive, US capital and that the difference is made up with extra goods and services.^{[citation needed]} 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 so only applies to Canada and, to a lesser extent, the United States.

[edit] 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
• IMF Balance of Payments Manual

[edit] References

[edit] External links

[edit] 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

[edit] Analysis

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

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