What Is The Balance Of Payments?

The balance of payments (BOP) is the method countries use to monitor all international monetary
transactions at a specific period of time. Usually, the BOP is calculated every quarter and every
calendar year. All trades conducted by both the private and public sectors are accounted for in the
BOP in order to determine how much money is going in and out of a country. If a country has
received money, this is known as a credit, and, if a country has paid or given money, the
transaction is counted as a debit. Theoretically, the BOP should be zero, meaning that assets
(credits) and liabilities (debits) should balance. But in practice this is rarely the case and, thus, the
BOP can tell the observer if a country has a deficit or a surplus and from which part of the
economy the discrepancies are stemming.
The Balance of Payments Divided
The BOP is divided into three main categories: the current account, the capital account and the
financial account. Within these three categories are sub-divisions, each of which accounts for a
different type of international monetary transaction.

The Current Account

The current account is used to mark the inflow and outflow of goods and services into a country.
Earnings on investments, both public and private, are also put into the current account.

Within the current account are credits and debits on the trade of merchandise, which includes
goods such as raw materials and manufactured goods that are bought, sold or given away
(possibly in the form of aid). Services refer to receipts from tourism, transportation (like the levy
that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business
service fees (from lawyers or management consulting, for example), and royalties from patents
and copyrights. When combined, goods and services together make up a country's balance of
trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes
up total imports and exports. If a country has a balance of trade deficit, it imports more than it
exports, and if it has a balance of trade surplus, it exports more than it imports.

Receipts from income-generating assets such as stocks (in the form of dividends) are also
recorded in the current account. The last component of the current account is unilateral transfers.
These are credits that are mostly worker's remittances, which are salaries sent back into the
home country of a national working abroad, as well as foreign aid that is directly received.

The Capital Account

The capital account is where all international capital transfers are recorded. This refers to the
acquisition or disposal of non-financial assets (for example, a physical asset such as land) and
non-produced assets, which are needed for production but have not been produced, like a mine
used for the extraction of diamonds.

The capital account is broken down into the monetary flows branching from debt forgiveness, the
transfer of goods, and financial assets by migrants leaving or entering a country, the transfer of
ownership on fixed assets (assets such as equipment used in the production process to generate
income), the transfer of funds received to the sale or acquisition of fixed assets, gift and
inheritance taxes, death levies, and, finally, uninsured damage to fixed assets.

The Financial Account

In the financial account, international monetary flows related to investment in business, real
estate, bonds and stocks are documented.

Also included are government-owned assets such as foreign reserves, gold, special drawing
rights (SDRs) held with the International Monetary Fund, private assets held abroad, and direct
foreign investment. Assets owned by foreigners, private and official, are also recorded in the
financial account.
The Balancing Act
The current account should be balanced against the combined-capital and financial accounts.
However, as mentioned above, this rarely happens. We should also note that, with fluctuating
exchange rates, the change in the value of money can add to BOP discrepancies. When there is
a deficit in the current account, which is a balance of trade deficit, the difference can be borrowed
or funded by the capital account. If a country has a fixed asset abroad, this borrowed amount is
marked as a capital account outflow. However, the sale of that fixed asset would be considered a
current account inflow (earnings from investments). The current account deficit would thus be
funded.

When a country has a current account deficit that is financed by the capital account, the country
is actually foregoing capital assets for more goods and services. If a country is borrowing money
to fund its current account deficit, this would appear as an inflow of foreign capital in the BOP.

Liberalizing the Accounts

The rise of global financial transactions and trade in the late-20th century spurred BOP and
macroeconomic liberalization in many developing nations. With the advent of the emerging
market economic boom - in which capital flows into these markets tripled from USD 50 million to
USD 150 million from the late 1980s until the Asian crisis - developing countries were urged to lift
restrictions on capital and financial-account transactions in order to take advantage of these
capital inflows. Many of these countries had restrictive macroeconomic policies, by which
regulations prevented foreign ownership of financial and non-financial assets. The regulations
also limited the transfer of funds abroad. But with capital and financial account liberalization,
capital markets began to grow, not only allowing a more transparent and sophisticated market for
investors, but also giving rise to foreign direct investment. For example, investments in the form
of a new power station would bring a country greater exposure to new technologies and
efficiency, eventually increasing the nation's overall gross domestic product by allowing for
greater volumes of production. Liberalization can also facilitate less risk by allowing greater
diversification in various markets.

What Does Current Account Mean?

The difference between a nation's total exports of goods, services and transfers, and its total
imports of them. Current account balance calculations exclude transactions in financial assets
and liabilities.

Investopedia explains Current Account

The level of the current account is followed as an indicator of trends in foreign trade

Understanding The Current Account In The Balance Of

Payments
The balance of payments (BOP) is the place where countries record their monetary transactions
with the rest of the world. (For more on the BOP, see this article.) Transactions are either marked
as a credit or a debit. Within the BOP there are three separate categories under which different
transactions are categorized: the current account, the capital account and the financial account.
In the current account, goods, services, income and current transfers are recorded. In the capital
account, physical assets such as a building or a factory are recorded. And in the financial
account, assets pertaining to international monetary flows of, for example, business or portfolio
investments are noted. In this article, we will focus on analyzing the current account and how it
reflects an economy's overall position.

The Current Account

The balance of the current account tells us if a country has a deficit or a surplus. If there is a
deficit, does that mean the economy is weak? Does a surplus automatically mean that the
economy is strong? Not necessarily. But to understand the significance of this part of the BOP, we
should start by looking at the components of the current account: goods, services, income and
current transfers.

• Goods - These are movable and physical in nature, and in order for a transaction to be
recorded under "goods", a change of ownership from/to a resident (of the local country)
to/from a non-resident (in a foreign country) has to take place. Movable goods include
general merchandise, goods used for processing other goods, and non-monetary gold.
An export is marked as a credit (money coming in) and an import is noted as a debit
(money going out).
• Services - These transactions result from an intangible action such as transportation,
business services, tourism, royalties or licensing. If money is being paid for a service it is
recorded like an import (a debit), and if money is received it is recorded like an export
(credit).
• Income - Income is money going in (credit) or out (debit) of a country from salaries,
portfolio investments (in the form of dividends, for example), direct investments or any
other type of investment. Together, goods, services and income provide an economy with
fuel to function. This means that items under these categories are actual resources that
are transferred to and from a country for economic production.
• Current Transfers - Current transfers are unilateral transfers with nothing received in
return. These include workers' remittances, donations, aids and grants, official assistance
and pensions. Due to their nature, current transfers are not considered real resources
that affect economic production.

Now that we have covered the four basic components, we need to look at the mathematical
equation that allows us to determine whether the current account is in deficit or surplus (whether
it has more credit or debit). This will help us understand where any discrepancies may stem from,
and how resources may be restructured in order to allow for a better functioning economy.

Here are the variables that go into the calculation of the current account balance (CAB):

X = Exports of goods and services

M = Imports of goods and services
NY = Net income abroad
NCT = Net current transfers

The formula is CAB=X-M+NY+NCT.

What Does It Tell Us?

Theoretically, the balance should be zero, but in the real world this is improbable, so if the current
account has a deficit or a surplus, this tells us something about the state of the economy in
question, both on its own and in comparison to other world markets.

A surplus is indicative of an economy that is a net creditor to the rest of the world. It shows how
much a country is saving as opposed to investing. What this means is that the country is
providing an abundance of resources to other economies, and is owed money in return. By
providing these resources abroad, a country with a CAB surplus gives receiving economies the
chance to increase their productivity while running a deficit. This is referred to as financing a
deficit.

A deficit reflects an economy that is a net debtor to the rest of the world. It is investing more than
it is saving and is using resources from other economies to meet its domestic consumption and
investment requirements. For example, let us say an economy decides that it needs to invest for
the future (to receive investment income in the long run), so instead of saving, it sends the money
abroad into an investment project. This would be marked as a debit in the financial account of the
balance of payments at that period of time, but when future returns are made, they would be
entered as investment income (a credit) in the current account under the income section.

A current account deficit is usually accompanied by depletion in foreign-exchange assets

because those reserves would be used for investment abroad. The deficit could also signify
increased foreign investment in the local market, in which case the local economy is liable to pay
the foreign economy investment income in the future.

It is important to understand from where a deficit or a surplus is stemming because sometimes

looking at the current account as a whole could be misleading.

Analyzing the Current Account

Exports imply demand for a local product while imports point to a need for supplies to meet local
production requirements. As export is a credit to a local economy while an import is a debit, an
import means that the local economy is liable to pay a foreign economy. Therefore a deficit
between exports and imports (goods and services combined) - otherwise known as a balance of
trade deficit (more imports than exports) - could mean that the country is importing more in order
to increase its productivity and eventually churn out more exports. This in turn could ultimately
finance and alleviate the deficit.

A deficit could also stem from a rise in investments from abroad and increased obligations by the
local economy to pay investment income (a debit under income in the current account).
Investments from abroad usually have a positive effect on the local economy because, if used
wisely, they provide for increased market value and production for that economy in the future.
This can allow the local economy eventually to increase exports and, again, reverse its deficit.

So, a deficit is not necessarily a bad thing for an economy, especially for an economy in the
developing stages or under reform: an economy sometimes has to spend money to make money.
To run a deficit intentionally, however, an economy must be prepared to finance this deficit
through a combination of means that will help reduce external liabilities and increase credits from
abroad. For example, a current account deficit that is financed by short-term portfolio investment
or borrowing is likely more risky. This is because a sudden failure in an emerging capital market
or an unexpected suspension of foreign government assistance, perhaps due to political tensions,
will result in an immediate cessation of credit in the current account.

Conclusion
The volume of a country's current account is a good sign of economic activity. By scrutinizing the
four components of it, we can get a clear picture of the extent of activity of a country's industries,
capital market, its services and the money entering the country from other governments or
through remittances. However, depending on the nation's stage of economic growth, cycle, its
goals, and of course the implementation of its economic program, the state of the current account
is relative to the characteristics of the country in question. But when analyzing a current account
deficit or surplus, it is vital to know what is fueling the extra credit or debit and what is being done
to counter the effects (a surplus financed by a donation may not be the most prudent way to run
an economy). On a separate note, the current account also highlights what is traded with other
countries, and it is a good reflection of each nation's comparative advantage in the global
economy.