Definition, Components & Examples | (2024)

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Imagine a fictional country called "TradeLand" that exports toys and imports electronics. When TradeLand sells toys to other countries, it earns money, which goes into its current account. When it buys electronics from other countries, it spends money, which also affects the current account. The capital account reflects the sale or purchase of assets like real estate, while the financial account covers investments and loans. By tracking these transactions, the balance of payments offers a clear picture of TradeLand's economic health and its relationship with the global economy.

Components of the balance of payments

Balance of payments comprises three components: current account, capital account and financial account.

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.

Debt forgiveness refers to when a country cancels or reduces the amount of debt it has to pay.

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.

UK balance of payments graph

Explore the UK balance of payment graphs to understand the nation's economic performance over time. This section features two insightful graphs, with the first illustrating the UK's current account from Q1 2017 to Q3 2021, and the second providing a detailed breakdown of the current account components within the same period. Designed for students, these visual representations offer an engaging way to analyze the UK's international transactions and economic trends.

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 gross domestic product (GDP) percentage.

As the graph illustrates, the UK’s current account always records a deficit, except 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 surplus cancels the deficit.

2. The breakdown 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, except from 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

Net means the value after accounting for all expenses and costs.

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.

Balance of payments example: a closer look

Explore the balance of payment with a real-life example that will help you better grasp the concept. Let's examine the United States as our case study. The US Balance of Payments for 2022 reveals crucial insights into the nation's economic health and its interactions with the global economy. This table presents a concise summary of the main components, including the current, capital, and financial accounts, to provide a comprehensive understanding of the country's financial position.

Source: BEA, U.S. International Transactions, 4th Quarter and Year 2022¹

The current account saw a widening deficit, primarily driven by an increase in the trade of goods and secondary income, indicating that the US imported more goods and paid more income to foreign residents than it exported and received. Despite the deficit, an increase in the trade of services and primary income shows some positive signs for the economy, as the country earned more from services and investments. The current account is a key indicator of a nation's economic health, and a growing deficit may signal potential risks, such as reliance on foreign borrowing and potential pressure on the currency.

The capital account experienced a minor decrease, reflecting changes in capital-transfer receipts and payments, such as infrastructure grants and insurance compensation for natural disasters. Although the capital account's overall impact on the economy is relatively small, it helps to provide a comprehensive picture of the country's financial transactions.

The financial account reveals that the US continued borrowing from foreign residents, increasing financial assets and liabilities. An increase in financial assets shows that US residents are investing more in foreign securities and businesses, while the growth in liabilities indicates that the US relies more on foreign investments and loans. This reliance on foreign borrowing can affect the economy, such as increased vulnerability to global market fluctuations and potential impacts on interest rates.

In summary, the US Balance of Payments for 2022 highlights the country's widening current account deficit, a minor decrease in the capital account, and continued reliance on foreign borrowing through the financial account

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.

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