Balance of Payments

The Current Account

• The Balance of Payments: A summary of all the transaction between the people of one country and the rest of the world, including the purchase of goods and services, the transfer of income, other transfers such as gifts, and the purchase of real and financial assets

• Current Account: records a country’s transactions with the rest of the world concerning goods, services, income, and current transfers

Components of Positive Current Account (A+)

• Exports of Goods

• Export of Services

• Income Transfers: Remittances from home country nationals working abroad, Interest earned by home savers abroad, profits from home companies abroad transferred home

• Current transfers: Gifts from foreign entities to domestic entities

Components of Negative Current Account (B-)

• Import of Goods

• Import of Services

• Income Transfers: Remittances from foreign workers at home back to the foreign country, foreign firms’ profits are repatriated to the foreign country, interest earned by foreign savers in domestic banks

• Current transfers: Gifts from domestic government or households to foreigners

Surplus vs. Deficit

• Surplus: when A > B

• Deficit: when B > A

Importance

The Current Account is crucial for assessing a country’s economic health, influencing exchange rates, and indicating the sustainability of its trade and investment relationships.

The Financial (Capital) Account

• the financial account records transactions that involve the ownership of financial assets and liabilities across borders

• reflects how a country finances its current account deficit or how it invests its current account surplus

Components of Positive Capital Account (C+)

• Investment by foreigners in domestic assets

• Foreign Direct Investments (FDI): when a foreign firm invests in at least 10% of a firm

• when foreign firms build factories or acquire physical capital in the domestic industry

• Portfolio Investment: stocks, govt bonds, corporate bonds, real estate or land

• Changes in Official Reserve of Foreign Exchange: A current account deficit leads to a decrease in official reserves, and a positive in the financial account

Components of Negative Capital Account (D-)

• Investment by domestic entities in foreign assets

• Foreign Direct Investments (FDI): when a domestic firm invests in at least 10% of a firm or build factories abroad

• Portfolio Investment: when domestic investors buy stocks, govt bonds, corporate bonds, real estate or land abroad

• Changes in Official Reserve of Foreign Exchange: A current account surplus leads to an increase in official reserves, a negative in the financial account

Surplus vs. Deficit

• Surplus: when C > D

• Deficit: when D > C

The Relationship Between the Accounts

• If A > B (current account surplus), then D > C (financial account deficit)

• If B > A (current account deficit), then C > D (financial account surplus)

• (A + B) current account + (B + C) financial account = 0 as balance