Booklet 3 - The Balance of Payments

What do you Discuss when asked about the Concept of the Balance of Payments:

Balance of Payments Definition

Formula for the Balance of Payment

Explain a Credit Transaction

Explain a Debit Transaction

Define the Balance of Payments:

A record of all economic transactions between the residents of Australia & the residents of the rest of the world, it is comprised of two accounts - the current account & the capital & financial account.

Balance of Payments Formula:

BOP + Current Account + Capital & Financial Account = 0

Define Credit:

A credit is any transaction that leads to a flow of money into a country from overseas. It records inflows of foreign currency, such as export of goods and services, income received from foreign assets, or capital inflows from foreign investment.

Define Debit:

A debit is any transaction that leads to a flow of money out of a country to overseas. It records outflows of currency, such as imports of goods and services, income paid to foreign investors, or capital outflows from investment abroad.

What do you discuss when asked about the Concept of the Double Entry System:

Definition of the Double Entry System

Example

Define the Double Entry System:

Means every transaction is represented by two entries for equal & opposite value reflecting the inflow & outflow element of each exchange.

Example of the Double Entry System:

An Australian resident purchasing a TV from Japan for AUD$1000 - this is an import of a good & will be recorded in the Current Account as a debit of $1000. In exchange for the TV there is an export of Australian currency to Japan - this is recorded as a $1000 credit in the Financial Account. In this example the sum of the credit entries (+1000) are offset by the sum of the debit entries (-1000) balancing the balance of payments.

What do you discuss when asked about the Current Account:

Define the Current Account

Define a Current Account Deficit

Define a Current Account Surplus

Outline the Structure of the Current Account

• Net Goods

• Net Services

• Trade Balance/Balance of Goods & Services

• Net Primary Income

• Net Secondary Income

• Income Balance/Net Income

Definition of the Current Account:

The Current Account records all transactions involving the exchange of net goods, net services & net income between Australian residents & foreign residents.

Define a Current Account Deficit:

When the debits for net goods, net services & net income exceeds the credits for net goods, net services & net income. 

Define Current Account Surplus:

When the credits for net goods, net services & net income exceeds the debits for net goods, net services & net income.

Structure of the Current Account:

Net Goods:

Net goods are the largest component of the current account in the Balance of Payments. They record the difference between the export (credit) and import (debit) of physical goods such as raw materials, manufactures, minerals and fuels, food, and rural products. For Australia, exports are heavily concentrated in commodities (mining and agriculture), while imports mainly consist of capital and intermediate goods for industry, alongside consumer goods.

Net Services:

Net services form around one quarter of the current account & record the difference between service exports (credits) & service imports (debits). They include items such as transport (freight/shipping), travel (students & tourists), tourism-related services, & business services (ICT & finance). Australia typically records a net services deficit (debits > credits), though the long-term trend has been narrowing upwards. Service exports are dominated by education & tourism, while imports are concentrated in business services & outbound tourism.

Trade Balance/Balance of Goods & Services:

The trade balance (or balance on goods & services) is the sum of net goods & net services in the current account. A trade surplus occurs when export credits exceed import debits, while a trade deficit occurs when debits exceed credits. For Australia, the trade balance is a key driver of the overall current account position, often offsetting deficits in net primary income. For example, in December 2024 Australia recorded a $747 million trade surplus, reflecting strong commodity exports.

Net Primary Income:

Net primary income is the largest of the two income accounts in the current account and mainly reflects investment flows. It records income earned by Australian residents from foreign sources (credits) and income paid to foreign residents by Australians (debits). Components include:

1. Compensation of Employees: Wages and salaries earned by Australians working overseas or paid to foreign workers in Australia.

2. Investment Income: Returns on financial capital, such as dividends on equity and interest payments on foreign debt.

Australia typically records a net primary income deficit, as foreign investment in Australia exceeds Australian investment abroad, creating higher outflows than inflows. This deficit is a major driver of Australia’s structural current account deficit historically, although large trade surpluses in recent years have partly offset it.

Net Secondary Income:

Net secondary income is the smaller of the two income accounts in the current account & has little impact on the overall balance. It records one-way transfers where resources (goods, services, or financial assets) are provided without anything of economic value received in return. This includes foreign aid, gifts, donations, & pensions.

Australia generally records a small secondary income deficit, as outbound transfers (e.g. aid and remittances) exceed inflows.

Income Balance/Net Income:

The income balance (or net income) is the sum of net primary income & net secondary income within the current account. A surplus occurs when income credits exceed debits, while a deficit occurs when debits exceed credits.

Australia almost always records a net income deficit, as foreign investment in Australia generates higher outflows (interest, dividends, aid, pensions) than inflows from Australian investment abroad. For example, in December 2024, Australia recorded a –$2,040 million income deficit.

What do you Discuss when asked about the Capital & Financial Account:

Definition of the Capital Account

Structure of the Capital Account

• Capital Transfers

• Acquisition of Non-Produced Non-Financial Assets

Definition of the Financial Accounts

Structure of the Financial Account

• Direct Investment

• Portfolio Investment

• Other Investment

• Financial Derivatives

• Reserve Assets

Capital & Financial Account:

Capital Account Definition: Records financial transactions that do not affect income or production.

Capital Transfers: Capital transfers includes migrant migrant funds & types of aid related to capital formation, it is the most dominant component of the capital account.

Acquisition of Non-Produced Non-Financial Assets: Non-Produced Non-Financial assets refers to intangible assets, for example copyrights, patents & franchises.

Financial Account Definition: Comprises transactions associated with changes of ownership of Australia’s foreign financial assets & liabilities.

Direct Investment:

Direct investment is a key component of the financial account in the Balance of Payments. It occurs when an investor acquires 10% or more of a company’s shares or assets, or when a firm establishes a subsidiary abroad, with the aim of securing a lasting interest & managerial influence.

A credit arises when overseas residents invest in Australian firms or assets, bringing capital inflows, while a debit occurs when Australian residents invest abroad, creating outflows. Direct investment is generally associated with long-term, stable capital flows and contributes to Australia’s integration into the global economy.

Portfolio Investment:

Portfolio investment is a major component of the financial account & refers to foreign investment in securities, bonds, & other financial assets where the investor owns less than 10% of a company or asset. Unlike direct investment, portfolio flows are typically short-term & speculative, as investors have no influence over management or decision-making.

A credit occurs when overseas residents purchase Australian financial assets, while a debit arises when Australian residents invest in foreign assets. Portfolio investment is highly responsive to changes in interest rates, exchange rates, & global financial conditions.

Other Investments:

A residual category within the financial account, capturing transactions that do not fit into direct or portfolio investment. It includes:

• Currency – inflows (credit) and outflows (debit) associated with trade and investment transactions.

• Deposits – cross-border bank deposits or withdrawals.

• Trade credits – when importers purchase goods and defer payment until delivery.

These transactions facilitate short-term liquidity & trade financing. Credits increase Australia’s financial inflows, while debits represent capital leaving the country.

Financial Derivatives:

Financial derivatives are a component of the financial account that record transactions in contracts whose value is derived from an underlying financial asset or index, such as futures or options contracts. They are typically used to hedge risks or for speculative purposes.

A credit occurs when overseas residents enter into derivative contracts with Australian residents, while a debit occurs when Australians engage in contracts with foreign counterparts.

Reserve Assets:

Reserve assets are financial assets controlled by the Reserve Bank of Australia (RBA) & form part of the financial account. They include monetary gold, foreign exchange reserves, & government bonds, and are used to manage the country’s exchange rate, provide liquidity, & support balance of payments stability.

Credits occur when the RBA acquires reserve assets from overseas, increasing Australia’s foreign assets, while debits occur when reserves are drawn down or sold abroad.

What do you Discuss when asked about Reasons for Australia’s Current Account Balance - Trade Balance:

Definition of the Trade Balance

Formula for the Trade Balance

Factors Affecting the Trade Balance:

• Commodity Prices

• Global Demand of Exports/Global Economic Conditions

• Exchange Rates

• Domestic Economic Conditions

• Free Trade Agreements

• Technological Change

• Transportation & Infrastructure

Definition of the Trade Balance:

The difference between the value of a country’s exports & imports of goods & services

Trade Balance Formulas:

Net Goods + Net Services

or

Total Exports - Total Imports

Factors Affecting the Trade Balance:

1. Commodity Prices:
   Commodity prices are a key determinant of Australia’s trade balance due to the country’s heavy reliance on exports of minerals (iron ore, coal), agricultural products, & energy resources. When global commodity prices rise, the value of exports (credits in net goods) increases, boosting the trade balance. Conversely, falling commodity prices reduce export earnings, weakening the trade balance.

   For example, an increase in iron ore prices directly raises Australia’s export receipts, strengthening the trade balance, while a decline in global agricultural prices would have the opposite effect.

2. Global Demand of Exports/Global Economic Conditions:
   Global demand for exports is a major factor influencing Australia’s trade balance, as it determines the value of export credits in net goods & services. Economic conditions in key trading partners, such as China & other Indo-Pacific countries, directly affect demand for Australian commodities, agricultural products, & services.

   For example, during periods of high economic growth in China, demand for Australian iron ore, coal, & LNG increases, raising export receipts & strengthening the trade balance. Conversely, a slowdown in major trading partners reduces demand, lowering export earnings & weakening the trade balance.

3. Exchange Rates:
   Exchange rates directly affect the competitiveness of Australian goods & services in global markets. A strong Australian dollar (AUD) makes exports more expensive for overseas buyers (reducing credits) & imports cheaper for Australians (increasing debits), leading to a lower trade balance & weaker current account. Conversely, a weaker AUD makes exports cheaper & imports more expensive, boosting the trade balance.

   For example, a depreciation of the AUD increases demand for Australian exports such as tourism & education services, while reducing demand for imports like passenger motor vehicles, resulting in higher credits & lower debits in the current account & an improved trade balance.

4. Domestic Economic Conditions:
   Domestic economic conditions influence both exports & imports, thereby affecting the trade balance. Strong economic growth increases production & national income, boosting exports through higher output while also raising household disposable income, which increases demand for imports.

   For example, during periods of robust GDP growth in Australia, imports such as passenger motor vehicles & outbound tourism are likely to rise, increasing debits & potentially reducing the trade balance. Simultaneously, higher production capacity can support greater export volumes, increasing credits & strengthening the trade balance.

5. Free Trade Agreements: 
   Free Trade Agreements (FTAs) influence the trade balance by altering the costs of imports & exports. Reductions in tariffs & trade barriers can increase Australian exports (credits) by improving market access, while also potentially increasing imports (debits) if domestic consumers access cheaper foreign goods. The overall effect on the trade balance depends on the relative magnitude of these changes.

   For example, the China-Australia Free Trade Agreement (ChAFTA, 2015) eliminated tariffs on Australian commodities exported to China, boosting exports & increasing credits in Net Goods, thereby positively contributing to the trade balance

6. Technological Change: 
   Technological change can significantly influence trade patterns by altering the types & efficiency of goods & services produced for export & import. Advancements can increase production efficiency, reduce costs, & enable the development of high-value commodities, thereby increasing export competitiveness.

   For example, technological improvements in the mining sector facilitated Australia’s shift from traditional agricultural exports, such as wool, to high-value resources like LNG & gold, increasing export credits in Net Goods & strengthening the trade balance.

7. Transportation & Infrastructure:
   Transportation & infrastructure impact the trade balance by influencing the cost, speed, & efficiency of moving goods & services internationally. Improved logistics reduce export costs, enhance competitiveness, & can increase export receipts (credits), while also facilitating imports if required.

   For example, enhancements in Australia’s ports, rail networks, & freight systems improve the international competitiveness of Australian exports, boosting credits in Net Goods & Net Services & strengthening the trade balance.

What do you Discuss when asked about Reasons for Australia’s Current Account Balance - Income Balance:

Definition of the Income Balance:

Income Balance Formula

Factors Affecting the Income Balance:

• Interest & Dividend Payments

• Foreign Aid & Remittance

• Exchange Rates

• Global Economic Conditions

Definition of the Income Balance:

The Australian Income balance reflects the net income earned by Australian residents/firms from foreign investments minus the income paid to foreign investors by Australian residents/firms.

Income balance Formula:

Net Primary Income + Net Secondary Income

or

Total Income Inflow - Total Income Outflow

Factors Affecting the Income Balance:

1. Interest & Dividend Payments
   Interest & dividend payments are a key determinant of Australia’s income balance, as they represent returns on foreign investment liabilities. Australia typically runs a net foreign investment liability position, meaning total foreign investment inflows exceed outflows. Payments to foreign investors (dividends on equity and interest on debt) are recorded as debits in net primary income, reducing the income balance.

   For example, if Australia increases foreign investments through FDI, portfolio, or other investments, dividend & interest outflows rise, generating higher debits in the primary income account & decreasing the income balance.

2. Foreign Aid Remittances:
   Foreign aid & remittances influence Australia’s income balance through one-way transfers recorded in the current account. Foreign aid represents a debit in net secondary income, reducing the income balance, while remittances or wages earned by Australians working abroad are credits in net primary income, increasing the income balance.

   For example, an increase in Australian foreign aid to Ukraine would raise debits in secondary income, lowering the income balance. Conversely, higher wages or salaries earned by Australians working internationally would increase credits in primary income, improving the income balance.

3. Exchange Rates:
   Exchange rates influence the income balance by affecting the domestic currency value of interest & dividend payments on foreign investments. An appreciation of the AUD reduces the AUD cost of servicing foreign debt, lowering debits in net primary income & increasing the income balance. Conversely, a depreciation of the AUD increases the domestic cost of these payments, raising debits & reducing the income balance.

   For example, if the AUD appreciates, Australian borrowers paying interest to overseas lenders spend fewer AUD, resulting in a smaller primary income debit & an improved income balance.

4. Global Economic Conditions:
   Global & domestic economic conditions affect the income balance through their influence on profits, interest, & dividend flows. Strong economic growth, high business profitability, or rising interest rates in Australia or trading partners can increase primary income debits & credits, depending on investment positions.

   For example, during a domestic economic boom, Australian firms (particularly in the mining sector) generate higher profits, part of which is returned to foreign investors as dividend payments, increasing debits in net primary income & reducing the income balance.

What do you Discuss when asked about the Current Account Balance & the Savings/Investment Gap:

Definition of Savings-Investment Gap

Savings Investment Gap Formula

Current Account Balance Formula

What this implicates

Definition of Saving-Investment Gap:

The difference between the domestic supply of savings & the domestic demand of investment.

Saving/Investment Gap Formula:

Savings (S) - Investment (I)

Current Account Balance Formula:

Savings-Investment gap

What the Savings investment Gap implicates for the Current Account Balance:

The savings-investment gap reflects the difference between a country’s domestic savings and investment and is a key determinant of the current account balance (CAB). When investment exceeds savings (negative gap), Australia relies on foreign capital inflows, generating a current account deficit. Conversely, when savings exceed investment (positive gap), there is excess domestic capital available for investment abroad, resulting in a current account surplus.

For example, prior to 2019, Australia had a negative savings-investment gap due to high domestic investment in mining and resources and limited domestic savings, contributing to persistent current account deficits. During 2020–2023, savings exceeded investment as pandemic-related reduced consumption increased domestic savings, producing a current account surplus. Since 2024, investment has again exceeded savings, partly drawing down pandemic-era savings and supported by foreign inflows, leading to a current account deficit.

What do you discuss when asked about Forms of Foreign Investment to fill the Savings-Investment Gap:

Foreign Equity:

Foreign Debt:

Foreign Equity:

Foreign equity (Inflows) refers to Australian assets (such as companies, shares, or land) owned by foreign investors. These investments help fill Australia’s savings-investment gap by providing additional capital when domestic savings are insufficient to meet investment demand.

An increase in foreign equity inflows generates primary income debits in the form of dividends and rent payments to foreign investors. This reduces the income balance and, consequently, the current account balance, even though it finances domestic investment.

Foreign Debt:

Foreign debt refers to loans provided to Australian residents or firms by foreign investors, helping to finance domestic investment when domestic savings are insufficient. These loans supplement the savings-investment gap, enabling continued economic growth and investment activity.

An increase in foreign debt inflows generates primary income debits in the form of interest payments to foreign lenders, reducing the income balance and thereby decreasing the current account balance. While foreign debt supports domestic investment, it contributes to current account deficits due to the associated interest outflows.

Trends in Australia’s Current Account & Financial Account over the Last 10 Years:

Over the past decade, Australia’s current account balance (CAB) has been shaped by fluctuations in the trade balance & a generally persistent income balance deficit. The trade balance is more volatile, responding to changes in commodity prices, global demand, and domestic economic conditions, while the income balance is usually negative due to Australia’s reliance on foreign investment. Overall, the trade balance and CAB exhibit a strong positive relationship.

2015–2019: Falling Current Account Deficit (CAB improving)

• Trade balance: Surpluses grew as export credits increased due to rising commodity prices (e.g., high iron ore prices following the Brazil dam collapse) and strong global demand, particularly from China.

• Income balance: Improved slightly as low global interest rates reduced interest payments on foreign debt (lower debits), and higher profitability of Australian businesses increased dividends from foreign equity (higher credits).

2020–2023: Current Account Surplus

• Pandemic-related reductions in consumption increased domestic savings, reducing the savings-investment gap. Strong export demand (commodities) combined with constrained imports contributed to a current account surplus.

2024 onward: Return to Current Account Deficit

• Investment exceeded savings, drawing on pandemic-era savings and attracting increased foreign investment inflows (equity and debt).

• The trade balance remains strong but is partially offset by a rising income balance deficit due to increased interest and dividend payments to foreign investors.

The financial account mirrored these trends, with foreign inflows (direct and portfolio investment, debt) supplementing domestic savings, particularly during periods when investment exceeded savings, helping finance economic growth but also contributing to income balance debits.