What’s it: A balance of payment is a double-entry bookkeeping system that summarizes a country’s economic transactions with the rest of the world over a specific period. The two components of the balance of payments are the current account and the capital account.
Balance of payments formula
Theoretically, the current account plus the capital account must equal zero.
But, that’s difficult to achieve in practice. Different data sources and recording methods often result in inconsistent final figures. Therefore, the economist adds a statistical discrepancy in the equation.
So, mathematically, the balance of payments formula is as follows:
Current account + Capital account + Statistical discrepancy = 0
Balance of payments components
The balance of payments comprises two components, namely:
- Current account represents the country’s net income
- Capital account represents net changes in ownership of national assets
Some literature might categorize the balance of payments into three components and separate capital account into capital account and financial account.
Current account consists of:
- Trade balance
- Net investment income
- Net unilateral transfer
The current account is usually more susceptible to changes in the trade balance than other components. That’s because the trade balance usually accounts for a more significant portion.
Well, let’s discuss the components of a current account one by one.
The trade balance is the difference between export value and import value. We often refer to it as net exports.
Export-import involves goods and services.
Goods transaction comprises general merchandise, non-monetary gold, and net exports of goods under merchanting.
Meanwhile, service transactions consist of various services, ranging from manufacturing services, maintenance and repair services, transportation services, travel services, to financial services.
Overall, if exports’ value exceeds imports, an economy runs a trade surplus (the positive trade balance). The opposite is a trade deficit (the negative trade balance) where exports are lower than imports.
Net investment income includes compensation for the services of production factors such as interest and dividend payments. We call this reward as factor income.
Factor income is a key component of differentiating gross national product (GNP) from the gross domestic product (GDP). We can calculate GNP by adding net factor income to GDP.
GNP = GDP + Net factor income from abroad
Another term for the net investment income is the primary income.
Net unilateral transfers consist of international payments other than to acquire goods, services, or assets. Examples are donations, direct assistance, gifts, and labor remittances.
Capital account records all transactions related to the sale and purchase of assets. It is the opposite of a current account. I mean, if the current account is positive, the capital account must be negative. Conversely, if the current account is positive, the capital account must be negative. Thus, the sum of the two will be zero.
Say, a country is running a current account deficit. It needs incoming funds to cover and finance the current account deficit. As a result, the capital account will be a surplus. And, a surplus indicates the country is a borrower from all over the world.
Capital account components consist of:
- Capital transfers and net sales of nonproduced nonfinancial assets. Examples of nonproduced nonfinancial assets are contracts, leases, licenses, and marketing assets.
- Financial account consists of transactions for direct investment, portfolio investment, financial derivatives, and other investments.
Why is the balance of payments important
The balance of payments shows you how a country participates in the world’s economy. Changes in its components reflect changes in supply and demand, not only for goods and services, but also in the country’s currency and asset.
The balance of payments component has a close relationship with other economic variables such as exchange rates, inflation, interest rates, and economic growth.
Effects on economic growth
Analyzing the components of the balance of payments is useful in formulating strategies and making decisions. For example, when some countries have current account deficits, it can be an indication that their products are less competitive in international markets.
Or, a deficit can also indicate the economies of those countries are growing. In this case, aggregate demand surpasses aggregate supply (inflationary gap). To cover demand, they have to import more products.
If imports are mostly capital goods, it can be a signal that those countries are increasing their productive capacity. We expect them to increase production and achieve strong economic growth in the future. Therefore, the current account deficit may turn into a current account surplus in the future.
Effects on the exchange rate
Current transactions also relate to exchange rates. Exports and imports involve currencies for payment.
Exports increase the demand for domestic currency. Foreigners need domestic currency to pay. The increase in demand pushes up the domestic currency’s price (exchange rate) against partner countries’ currencies (appreciation).
On the other hand, imports reduce the purchasing power of the domestic currency. Domestic consumers must exchange (sell) the domestic currency with the partner country’s currency to pay for imported goods. The sale caused the domestic currency to fall (depreciation).
Thus, the current account deficit leads to a depreciation in the exchange rate because imports are higher than exports. Conversely, the current account surplus leads to an appreciation in the exchange rate of the domestic currency.
Furthermore, during the current account deficit, for the balance of payments to be equal to zero, the capital account must be positive (foreign capital inflows). Capital inflows increase demand for the domestic currency, leading to an appreciation in the exchange rate.
That’s why, even though a country has had a current account deficit for years, its exchange rate has not depreciated any deeper. The capital surplus offsets the depreciating effect of the current account deficit.
The same concept applies when there is a current account surplus.
What to read next
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