4.6.2 Components of the balance of payments Notes

The balance of payments has three components:

1. Current account
2. Capital account
3. Financial account

Calculation: Elements of Balance of Payments

This table below will be utilised throughout the explanation of all components.

Current Account

Balance of trade in goods

1. Exports are the goods produced domestically in Country A and sold to foreign countries.
   1. The payment for these exports are received in the exporting country's currency.
   2. Hence, exports are considered to be credit as it is the inflow of money.
2. Meanwhile, imports are the goods produced in foreign countries which are purchased by Country A.
   1. The payment for these imports are made in the country's currency Country A imports from (increasing supply of Country A's currency).
   2. Hence, imports are considered to be debit as it is the outflow of money.
3. Thereby, the balance of trade in goods can be calculated by:
   1. $\text{Balance of Trade in Goods} = \text{Export of Goods} - \text{Import of Goods}$

Balance of trade in services

The same applies for services.

1. Exports are the services created domestically in Country A and sold to foreigners.
   1. Services include tourism for foreign individuals, consulting, transportation, insurance, etc.
   2. When foreigners buy the following services, it is considered as the export of services.
   3. Hence, exports are considered to be credit as it is the inflow of money.
2. Meanwhile, imports are the services created in foreign countries which are purchased by Country A citizens.
   1. When Country A citizens purchase tourism packages or insurance from foreign firms, it is considered as the import of services.
   2. Hence, imports are considered to be debit as it is the outflow of money.
3. Thereby, the balance of trade in services can be calculated by:
   1. $\text{Balance of Trade in Services} = \text{Export of Services} - \text{Imports of Services}$

Balance of trade in goods & services

Often referred to as "Balance of Trade", it can be calculated by:

$\text{Balance of Trade} = \text{Balance of Trade in Goods} + \text{Balance of Trade in Services}$

Income

Income is considered to be all the inflows and outflows of factor incomes: wages, interest, rent, and profits.

1. Credits are inflows from foreign investments.
   1. This could also refer to Country A's citizens who might earn income from abroad such as having bank accounts which earn interest.
2. Debits are outflows to foreign investors.
   1. This could refer to Country A citizens who might need to pay rent for housing abroad.
3. Therefore, income is:
   1. $\text{Income} = \text{Inflow of Income} - \text{Outflow of Income}$

Current transfers

Current transfers are inflows and outflows of funds for which no goods or services are exchanged.

1. Credits are inflows from foreign aid, transfers from abroad such as remittances (money sent to close family in Country A from abroad) or gifts, and pensions.
2. Debits are outflows for aid or remittances sent abroad.
3. $\text{Current Transfers}$ $=$ $\text{Inflow into Country A}$ $-$ $\text{Outflow out of Country A}$

Balance on Current Account

1. Summing up the components mentioned above provides us the current account balance.
2. If there is a larger quantity of credits than debits, then Country A would have current account surplus.
3. If there is a larger quantity of debits than credits, then Country A would have current account deficit.

Capital Account

Capital Transfers

Capital transfers is the (inflows - outflows of) funds exchanged when an asset changes ownership from one party to another.

1. Examples of capital transfers include: debt forgiveness, investment grants (provided by governments), sale of fixed assets, etc.
2. If there is a large outflow of capital transfers than inflow, then Country A will have negative (-) capital account transfers.
3. If there is a large inflow of capital transfers than outflow, then Country A will have positive (+) capital account transfers.
4. This can be calculated by: $\text{Capital Transfers} = \text{Inflow of transfers} - \text{Outflow of transfers}$

Transactions in non-produced, non-financial assets

1. Transactions in this category mainly are composed of purchases or use of natural resources which cannot/are not produced.
2. This includes: land, mineral rights, forestry rights, airspace, electromagnetic spectrum, etc.
3. As with other components, if there is a large outflow of funds than inflow for such transactions, then Country A will have negative (-) in transactions in non-produced, non-financial assets.
4. If there is a large inflow of funds than outflow for such transactions, then Country A will have positive (+) in transactions in non-produced, non-financial assets.
5. This can be calculated by: $\text{Transactions in non-produced, non-financial assets} = \text{Inflow} - \text{Outflow}$

Balance on Capital Account

1. The sum of the two components mentioned above provides the balance of capital account.
2. If there is a larger quantity of credits than debits, then Country A would have capital account surplus.
3. If there is a larger quantity of debits than credits, then Country A would have capital account deficit.

Financial Account

Foreign Direct Investment (FDI)

1. Foreign Direct Investment (discussed in detail in 4.10) are investments in physical capital such as buildings or factories.
2. As with other components, the final FDI value is calculated by the quantity of credits and debits, which is given in equation below.

$\text{FDI} = \text{foreign investment in Country A} - \text{Country A investment abroad}$

Portfolio Investment

1. Portfolio Investment represents the investments in financial capital such as bonds and stocks in the stock market.
2. This can be calculated by: $\text{FDI} = \text{Foreign investment} - \text{Investment by Country A citizens abroad}$

Reserve Assets

1. Also known as official reserves, it represents the foreign currency reserves that the central bank can buy or sell to adjust the country's currency value.
2. Outflow of the currency will indicate a debit in the financial account.
3. Inflow of the currency will indicate a credit in the financial account.

Official Borrowing

1. This represents the borrowing governments might have from abroad.
2. Inflow of funds represent as borrowing by the government of Country A and appear as credits.
3. Outflow of funds represent provision of loans from Country A to foreign countries and appear as debits.

Balance on Financial Account

1. The sum of the four components mentioned above provides the balance of financial account.
2. If there is a larger quantity of credits than debits, then Country A would have financial account surplus.
3. If there is a larger quantity of debits than credits, then Country A would have financial account deficit.

Clarifications

Errors and Omissions

1. It is quite difficult and is considered impossible to record every possible transaction that a country does with all other countries. Due to this, some transactions go unrecorded.
2. Though, as the surpluses must match the deficits, there needs to be an component which creates the equality.
3. Therefore, there is a component known as errors and omissions which create the equality between the surpluses and deficits.

Capital Account and Financial Account

1. Many economists use the term capital account to refer to both capital account and financial account.
2. Therefore, if the expression 'capital account' is utilised, it could refer to financial account and capital account.

Balance

1. Summing up all the balances of all the different accounts (with errors and omissions if present in the balance of payments table) will provide the final calculation.
2. $\text{Current Account} + \text{Capital Account} + \text{Financial Account} = \text{Balance}
3. The final calculation for balance of payments will always be zero.