Balance of payments
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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]
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[edit] Balance of Payments Identity
The Balance of Payments is the sum of the Current Account and the Capital Account and the Financial Account. The Balance of Payments Identity states that:
- Current Account + Capital Account + Financial Account + Net Errors and Omissions = Change in Official Reserve Account
A country will have a negative balance of payments (a net decrease in official reserves, net errors and omissions, or some combination) if the net of the current account, the capital account and the financial account is a deficit. Similarly, there will be a positive balance of payments (a net increase in official reserves, net errors and omissions, or some combination) if the net of the current, the financial 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 is supplied capital from abroad (a capital account surplus).[1]
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".
[edit] Components
The Balance of Payments for a country is the sum of the current account, the financial account and the capital account, and the change in official reserves.
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.)
- Trade Balance
[edit] Capital Account
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 and so on. Summing up: the Capital Account accounts for the transfer of capital goods. (source: see book reference list)
[edit] Financial Account
The financial account (or Official reserve account) is the net change in foreign ownership of domestic financial assets. 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 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
[edit] Current Account
This section covers the flow of goods, services and income in and out of a given country and also financial aid from governments abroad:
- Trade in goods is also known as trade in visibles or tangibles,
- Trade in services is also known as trade in invisibles or intangibles.
- Income refers not only to the money given back from investments made abroad (attention!: investments are recorded in the financial account but income from investments is recorded in the current account) but also to the money sent by individuals working abroad that send money to their families back home (this is usual only in diasporas and developing countries). (source: see book reference list)
[edit] Net Errors and Omissions
This is the last component of the BOP and only 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. It is often referred as "the balancing item". (source: see book reference list)
[edit] 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.[3] 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.
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 or bonds, to support its value relative to whatever asset, usually a foreign currency, that they are selling in exchange.[4] 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.[1]
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.[6] Note that the reported deficit of official reserves representing an outflow of yen on this publication is not in accordance with the IMF standards.
[edit] 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.[7] 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 criterion.[2]
[edit] 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 in recent years, 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.
[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
- ^ a b http://www.econlib.org/library/Enc/BalanceofPayments.html Herbert Stein, "The Balance of Payments" in The Concise Encyclopedia of Economics.
- ^ a b c Bank of Canada - Intervention in the Exchange Market - Fact Sheet - The Bank in Brief.
- ^ http://stats.oecd.org/glossary/detail.asp?ID=2319 OECD Glossary of Statistical Terms
- ^ http://www.imf.org/external/np/sta/bop/BOPman.pdf Balance of Payments Manual - International Monetary Fund
- ^ http://www-personal.umich.edu/~alandear/glossary/e.html#ExchangeMarketIntervention International Economics Glossary
- ^ [http://www.mof.go.jp/bpoffice/bpdata/es1bop.htm reported Bank of Japan - Balance of Payments
- ^ http://www-personal.umich.edu/~alandear/glossary/b.html Glossery of International Economics
- Economics 8th Edition by David Begg, Stanley Fischer and Rudiger Dornbusch, McGraw-Hill
- Economics Third Edition by Alain Anderton, Causeway Press
- AS and A Level Economics, Cambridge University Press
[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:
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 | |
| Schools of thought | |
| Related issues | |
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