03/08/2021

What is Balance of Payments?

By Mariana Almeida Marques

Balance of Payments may not be a term that you hear about on a regular basis. However, it is an extremely important measure that countries use to review their economic situation and define future strategies. Due to its relevance worldwide, it is worth being aware of what Balance of Payments means and how it is calculated.

What does Balance of Payments mean?

Balance of Payments, BOP or Balance of International Payments, is a financial statement of all the transactions made between one country and the rest of the world. Transactions can be made by individuals, government bodies or companies from one country to all the other countries- any kind of transaction is included.

Balance of Payments is usually done quarterly or yearly. Because BOP keeps track of all international movements, it is extremely useful to monitor the economic situation of a country, predict trends and support economic policies.

Categories of Balance of Payments

A BOP statement is usually divided into two categories: the current account and the capital account. The current account includes all transactions for goods, services, investment income and current transfers. The term “current transfers” refers to all international one-sided transfers, where the payer sends a sum of money to a payee in another country for nothing in return. Current transfers can be, for example, grants, donations or tax payments.

The capital account includes transactions of central bank reserves (funds that central banks pass internationally amongst themselves) and financial instruments. Financial instruments are any asset or that can be traded, or any legal agreement that has monetary value (for example, leases, copyrights and franchises). In some instances, the capital account can be divided into capital account and financial account.

Overall, a current account checks the net income of a country, whilst a capital account checks its asset ownership. The Balance of Payments sums to zero because when there is a current account deficit, there is a capital account surplus and vice-versa. We will explore this topic below.

Balance of payments is an accounting term used to measure the economic situation of each country.

What is a trade balance?

A trade balance, or current account balance, is the difference between a country’s exports and imports, for a certain time period. The formula is: Trade Balance = Value of Exports – Value of Imports. A positive balance translates into a current account surplus, whilst a negative balance translates into a current account deficit. The value of the trade balance doesn’t necessarily indicate how well a country is doing economically.

For example, the US has a current account deficit, so it imports more than exports and it borrows money from other countries, which can help it develop faster. Therefore, a current account deficit can actually be a positive thing for emerging market countries. However, long-term, it can turn into a negative factor if the deficit is not corrected over time or the country doesn’t repay its debt.

Some of the countries with a positive trade balance are Germany, Japan and China. They have strong manufacturing industries and export a lot of goods to the rest of the world.

 

Current account deficit vs current account surplus

By its own nature, there are countries with current account deficit and current account surplus. Countries with a current account balance (CAB) deficit have the following characteristics:

  • More imports than exports
  • Borrowing from other countries to pay for imports
  • This contributes to economic growth but long-term, it can turn into continuous debt

Contrarily, current account surplus means that the country:

  • Exports more than it imports
  • Gains enough capital to pay for imports, and doesn’t need to borrow
  • This contributes to financial growth, however, it can also make the country too economically dependent on exports

Capital account deficit vs capital account surplus

Taking the example of the US, a country that has a current account deficit, we can now look into its capital account. A country with CAB deficit usually has a capital account surplus, which means it has more money coming in than going out in the shape of investments and other assets. The US currently has a lot of foreign investment, which drives up the price of the dollar and contributes for its capital account surplus.

As mentioned before, a capital account surplus balances out a current account deficit. The Balance of Payments statement should be zero, because every time a country exports goods (credit in the current account), it receives capital (debit in the capital account).

Balance of Payments helps nations to define global economic policies.

Factors affecting the Balance of Payments

There are many factors that can affect the Balance of Payments of each country. Below are some of the common factors that impact current accounts:

  • Consumer spending

When there is a higher consumer spending rate, a country needs to import more goods and services to match the demand. Having more importations than exportations leads to a deficit in the current account. In the UK, for example, the recession of 2009 prompted consumers to spend less, which improved the deficit of the UK’s current account (less imports and more exports). In periods of economic growth, when people make more purchases, the opposite happens.

  • Saving rates

Countries where residents save more usually have higher exportation rates and higher current account balances. On the other hand, countries where residents spend more usually have higher importation rates (they need to import more goods to meet demand). This will lead to a higher deficit in their current account balance.

  • Exchange rate

If an exchange rate suffers depreciation (currency value decreases), export prices will be more competitive and import prices will be more expensive. This may lead to an increase in exports and a decrease in imports, which will improve the current account. A depreciation in the exchange rate can also contribute to higher inflation rates. If inflation grows, then the prices of all imports increase.

  • Competitiveness

Current accounts are also affected by the general competitiveness of each country’s export industries. Germany, for example, is known to have high productivity rates and a strong export industry, so its current account balance is positive. The UK, on the other hand, has decreased in competitiveness, which means less exports and a lower current account balance. Competitiveness is a fairly subjective measure impacted by multiple factors, including national wages, productivity and investments in technology.

 

 

Different types of currency across the globe.

Economic policies & BOP

A Balance of Payments has great impact in the economic policies of each country, essentially because it tells countries what their economic situation is. It is then up to each country to decide how to approach its Balance of Payments. Below are some strategies that may be used to tackle a current account deficit, along with its speculated positive and negative consequences for the economy:

  • Devaluation of exchange rate

Reducing the value of a currency against other currencies. This can be done through, for example, cutting interest rates, cutting tax or selling the currency to other countries. Devaluation of the exchange rate can help reduce the current account deficit because the price of imports will increase, so people will spend less and there will be less demand for goods. It also makes exports cheaper, since the currency is worth less. This means that there is a reduction in imports and an increase in exports.

If interest rates decrease, more investors may move their money from a UK savings account to a savings account with higher interest rates in another country. This process of quickly moving money to countries with higher interest rates is called “hot money flows”. This will contribute to a decrease in currency value.

  • Reducing demand and spending

This can be done through either increasing taxes or increasing interest rates. With higher interest rates on mortgages or any kind of debt, people have less money to spend, which will lead to a decrease in demand and decrease in imports. With higher taxes, prices will also be higher, so people will buy less. This may come, however, seriously affect personal incomes, general standards of living and unemployment rates.

  • Side trade policies

Countries can adapt certain internal and trade policies to balance their current account. For example, privatising more industries could lead to increases in efficiency and productivity, because the private sector is naturally focused on making profit. An increase in productivity raises the competitiveness of a country’s goods and services, which may lead to more exports.

Lowering wages can also reduce production costs, therefore make a country’s exports cheaper and more appealing. However, low wages also mean that individuals have much less spending power, which can stagnate the economy. Setting policies such as higher tariffs on imports may help reduce imports, but it can generate fraction with other countries and cause them to adopt the same policies.

 

About Imburse

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Author

Mariana Marques

Mariana is a content writer at Imburse, specialising in Finance and Technology topics.

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