Balance of Payments

The trade of goods and services is an important factor when it comes to the balance of payments, which indeed, is very important for every country’s economy. What is the balance of payments and how does foreign trade affect it? Let’s learn about the balance of payments, its components, and why it is important for every nation.

What is the balance of payments?

The Balance of Payments (BOP) summarises a nation’s economic transactions, such as exports and imports of goods, services, and financial assets, along with transfer payments with the rest of the world. It is also known as the balance of international payments and it includes all the transactions among individuals, corporations, and governments between countries. The BOP helps in monitoring the flow of money and developing the economy.

The balance of payments has three components: the current account, the capital account, and the financial account. You can see them in Figure 1.

Fig. 1 - Balance of Payments

Current account

The current account indicates the country’s economic activity. The current account is divided into four main components, which record the transactions of a country's capital markets, industries, services, and governments. The four components are:

1. Balance of trade in goods. Tangible items are recorded here.
2. Balance of trade in services. Intangible items like tourism are recorded here.
3. Net income flows (primary income flows). Wages and investment income are examples of what would be included in this section.
4. Net current account transfers (secondary income flows). Government transfers to the United Nations (UN) or European Union (EU) would be recorded here.

The current account balance is calculated using this formula:

Current Account = Balance in trade + Balance in services + Net income flows + Net current transfers

The current account can either be in a surplus or deficit.

Capital account

The capital account refers to the transfer of funds associated with buying fixed assets, such as land. It also records transfers of immigrants and emigrants taking money abroad or bringing money into a country. The money the government transfers, such as debt forgiveness, is also included here.

Financial account

The financial account shows the monetary movements into and out of the country.

The financial account is split into three main parts:

1. Direct investment. This records the net investments from abroad.
2. Portfolio investment. This records financial flows such as the purchasing of bonds.
3. Other investments. This records other financial investments such as loans.

The balance of payments and goods and services

What is the relationship between the balance of payments and goods and services? The BOP records all the trades of goods and services conducted both by the public and private sectors, to determine the amount of money flowing into and out of the country.

The trade of goods and services determines whether the country has a deficit or surplus balance of payments. If the country is able to export more goods and services than it imports, this means that the country is experiencing a surplus. On the contrary, a country that must import more than it exports is experiencing a deficit.

Examples of the balance of payments

Understanding the BOP will be much easier if we consider a few examples.

We will look at two parts of the UK’s BOP: the current account and the financial account from 2017 to 2021.

1. The current account of the UK from the first quarter of 2017 to the third quarter of 2021:

Fig. 2 - UK’s current account as a percentage of GDP. Created with data from the UK Office for National Statistics, ons.gov.uk

Figure 2 above represents the UK’s current account balance as a percentage of gross domestic product (GDP).

As the graph illustrates, the UK’s current account always records a deficit, with the exception of the fourth quarter in 2019. The UK has had a persistent current account deficit for the past 15 years. As we can see, the UK always runs a current account deficit, mainly because the country is a net importer. Thus, if the UK’s BOP is to balance, its financial account must run a surplus. The UK is able to attract foreign investment, which allows the financial account to be in a surplus. Therefore, the two accounts balance out: the deficit is cancelled by the surplus.

2. The break down of the UK's current account from the first quarter of 2017 to the third quarter of 2021:

Fig. 3 - UK’s current account breakdown as a percentage of GDP. Created with data from the UK Office for National Statistics, ons.gov.uk

As mentioned earlier in the article, the current account has four main components. In Figure 3 we can see the breakdown of each component. This graph illustrates the loss of competitiveness of UK goods and services, as they always have a negative value, with the exception of 2019 Q3 to 2020 Q3. Since the de-industrialisation period, UK goods have become less competitive. Lower wages in other countries also fuelled the decline in the competitiveness of UK goods. Because of that, fewer UK goods are demanded. The UK has become a net importer, and this causes the current account to be in a deficit.

How to calculate the balance of payments

This is the balance of payments formula:

Balance of Payments = Net Current Account + Net Financial Account + Net Capital Account + Balancing Item

Let's take a look at an example calculation.

In this example, the BOP equals zero. Sometimes it might not equal zero, so don’t be put off by that. Just ensure that you have double-checked your calculation.

Practise with the flashcards to better your understanding of the Balance of Payments. If you feel confident, go on to read more about the BOP Current Account and the BOP Financial Account in more depth.

Sources

1. Ludwig Von Mises, The Theory of Money and Credit, 1912.