Mmm BoP! Balance of Payments

The balance of payments, comprised of the current account and the capital account (and an error value), is a means of accounting transactions between one country and all other countries with whom it trades.  "The Economist web site defines this term as "the total of all the money coming into a country from abroad less all of the money going out of the country during the same period."

The current account is the balance of trade (X-M) + net factor income (interest/dividends) + net transfer payments (i.e. foreign aid), and "The Economist" web site states "the current account includes:

*visible trade (known as merchandise trade in the United States), which is the value of exports and imports of physical goods;

*invisible trade, which is receipts and payments for services, such as banking or advertising, and other intangible goods, such as copyrights, as well as cross-border dividend and interest payments;

*private transfers, such as money sent home by expatriate workers;

*official transfers, such as international aid".

The capital account includes the net purchase and sale of all assets between countries.  As per the famous "The Economist" web site : "The capital account includes:

*long-term capital flows, such as money invested in foreign firms, and profits made by selling those investments and bringing the money home;

*short-term capital flows, such as money invested in foreign currencies by international speculators, and funds moved around the world for business purposes by multinational companies."

Simplified example of US (2005) BoP (from FTE Program Curriculum) :

CONSEQUENCES...of a current account deficit

- countries use reserves of foreign currencies to control current account deficits, but these may run out even for the largest economy.
- if foreigners are investing largely in a country and that country's people are buying foreign g/s, then the country is susceptible to changes in foreign behavior which could turn sour.  Furthermore, foreigners can have considerable economic power over the country (i.e. China and US).
- if countries borrow from abroad with high-interest loans, then they can end up owning other countries billions of dollars.  This can lead to instability and possible default which would wreak havoc on the economy.

CONSEQUENCES...of current account surpluses

-a country with a current account account surplus funded by sales of its g/s may face a surge in protectionsist practices from those with current account deficits.
- a current account surplus tends to correspond with currency appreciation (see post on advantages and disadvantages of a strong currency). 

From "The Economist" web site:

"As bills must be paid, ultimately a country's accounts must balance (although because real life is never that neat a balancing item is usually inserted to cover up the inconsistencies).

A"Balance of payments crisis" is a politically charged phrase. But a country can often sustain a current account deficit for many years without its economy suffering, because any deficit is likely to be tiny compared with the country's national income and wealth. Indeed, if the deficit is due to firms importing technology and other capital goods from abroad, which will improve their productivity, the economy may benefit. A deficit that has to be financed by the public sector may be more problematic, particularly if the public sector faces limits on how much it can raise taxes or borrow or has few financial reserves.

For instance, when the Russian government failed to pay the interest on its foreign debt in August 1998 it found it impossible to borrow any more money in the international financial markets. Nor was it able to increase taxes in its collapsing economy or to find anybody within Russia willing to lend it money. That truly was a balance of payments crisis.

In the early years of the 21st century, economists started to worry that the United States would find itself in a balance of payments crisis. Its current account deficit grew to over 5% of its GDP, making its economy increasingly reliant on foreign credit."