Balance of Payments: Categories and Definitions

 

The Balance of Payments (BoP) records all transactions that cross a country’s borders. The simplest way to think about it is as a record of all payments going out to foreigners (with the reasons for those payments), and all payments coming into the country from foreigners (with the reasons for those payments). We give the payments coming in a plus sign, and the payments going out a minus sign.

 

There are various ways that these payments can be categorized and organized.  This discussion is revised to reflect the categories on your spreadsheets, which use IMF data.

 

Most BoP presentations give you two large categories: a Current Account, which includes trade, and a Capital Account, which includes sales and purchases of assets.  Several other kinds of payments are usually stuck in the Current Account.  For an example of a typical textbook presentation, see our e-reserve reading on the BoP or this Wikipedia article. 

 

The IMF uses this basic division, but they call the Capital Account the “Financial Account,” so they have a Current Account and a Financial Account.  Fair enough.  What’s not fair is that they have named one of the more obscure sub-categories of the Financial Account the “Capital Account.”  So what the IMF calls the capital account is not what most textbooks call the capital account.  Worse, they keep moving it -- in the very latest set of figures, their little "capital account" moves out of the large "financial account" category and into its own space between current and financial account.  Sigh.  Happily, the stuff captured in the IMF's "Capital account" category is typically very small in proportion to the overall BoP, so for this class, you can almost certainly ignore it.  (This is funny: since the last time I checked the link the Wikipedia article has been updated to a reflect the IMF's divergent usage, and now cites this humble page.)

 

So below I’m going to follow the presentation on your spreadsheets, but add explanation.  There are a couple of documents out there on the web that provide clear explanations of BoP items, so when they have nice wording I quote them.  
 

 

Current Account

 

“The current account measures all transactions (other than those in financial assets and liabilities) that involve economic values and occur between resident and non-resident entities. It also includes offsets to current economic values provided or acquired without something of economic value in exchange.” (Central Bank of New Zealand p. 6)

 

 

Goods are tangible, real stuff like wheat and steel and cars.  The term “merchandise” is also used for “goods.”

 

 

 

Goods: Exports f.o.b.

 

Goods sold to foreigners. 

(+) They require that foreigners make payments to us so they take a plus sign.

Macro Note: since exports are a source of total aggregate demand for nationally-produced goods, changes in exports will produce corresponding changes in national income. If other countries’ incomes rise, they will likely import more of our goods, raising our exports.  If your country's exports are dominated by commodities like oil or coffee, they will be affected by swings in the prices of those things.  This means that in the short run, the volume of a country's exports depends mainly on foreign events.  Over the longer run, look for patterns of capital investment in export industries. 

Always remember that most exports are produced by private firms.  We may say "the United States exports wheat" but what is actually going on is that a private seller of wheat in the U.S. hooks up with a private buyer in another country.

(FOB means "free on board, meaning what it costs to get the goods to the boat (or equivalent).  The alternative is CIF which means "cost, insurance, freight, and includes additional costs to get the good to the foreign customer.)

 

 

 

Goods: Imports f.o.b.

 

Goods purchased from foreigners. 

 

(-) They require that we make payments to foreigners so they take a minus sign.

 

Macro Note: Generally imports will rise or fall as total national income rises or falls, since they will represent part of national demand for goods. When income rises, both demand for imports and demand for locally-made goods will rise. Additionally, some countries may have export industries that require significant amounts of imports.  Always remember that imports  are imported because particular people or firms within your country decide to buy them from particular sellers located abroad.

 

 

Services are purchases and sales of intangible items like tourism or transportation.  You don’t have to ship them and you can’t store them.

 

“In a broad sense services are products other than physical goods. There are two differences

between goods and services:

there is no physical object over which ownership rights can be established

a service cannot be traded separately from its production.

The production of a service is linked to an arrangement made between a producer in one economy and a consumer in another economy prior to the time that production occurs.” (Central Bank of New Zealand p. 45)

 

Usually, when people talk about “exports” they mean goods exports plus service exports, and then they say “imports” they mean goods plus service imports.  Trade balances are usually computed for both goods and services trade.  But sometimes you will see people writing about the “merchandise trade balance,” and then they’re not including services.

 

 

 

Services: Credit   (service exports)

 

Services sold to foreigners.

 

(+) They require that foreigners make payments to us so they take a plus sign.   (“Credit” is accounting terminology meaning “someone’s gotta pay us for this.”)

 

 

 

Services: Debit   (service imports)

 

Services bought from foreigners.

 

(-) They require that we make payments to foreigners so they take a minus sign.   (“Debit” is accounting terminology meaning “we’ve gotta pay someone for this.”)

 

 

Income covers two types of transactions between residents and non-residents: (i) those involving compensation of employees, which is paid to non-resident workers or received from non-resident employers and (ii) those involving investment income receipts and payments on external financial assets and liabilities. ... Investment income ... is income derived from ownership of external financial assets and payable by residents of one economy to residents of another economy. It includes interest, dividends, remittances of branch profits, and direct investors’ shares of the retained earnings of direct investment enterprises.” (European Union)

 

In some presentations, “income” is called “factor services” or “factor income.”  That’s “factor” in the sense of “factor of production,” i.e. land, labor, or capital, so you can think of it as a payment in exchange for the use of physical capital or the use of the principal on a loan.  You may think it’s weird that interest payments on a loan go into the current account while principal payments go into the financial account.  But that’s how accountants see the world. 

 

 

 

Income: Credit   (inflows)

 

Payments to us from foreigners that are interest on loans that we made to them, profits from physical capital (like factories) owned by our citizens in foreign countries, and income received by our workers from foreign employers.

 

(+) This requires that foreigners make payments to us and so takes a plus sign.  

 

 

 

Income: Debit   (outflows)

 

Payments by us to foreigners that are interest on loans to us or profits from physical capital that they own in our country, and income paid to foreign workers.

 

(-) This requires that we make payments to foreigners so takes a minus sign.   

 

Macro Note: Countries that borrow a lot will show very large amounts of interest payments going out, sometimes to the extent that half of their exports are going to pay interest on loans. (One reason why interest payments may balloon is that when a country has trouble making payments on debt, it may enter into a "rescheduling" agreement that postpones payments of loan principal (see below) while continuing interest payments. That lets lenders keep the loans on their books as "performing." The macro effect of this debt burden, however, is that the country consumes a lot less than it makes, and this can tend to reduce gross fixed capital formation, crippling prospects for future growth. Not to mention lowering overall consumption, which often hits the poor hardest.

 

 

A transfer is a payment that is not made in exchange for anything. Basically, a gift.  You’re not getting a good or service for it, and you’re not making it to be released from an obligation, like with an interest payment on a loan.  Sometimes you’ll see the words “unrequited transfer” or “unilateral transfer” used for this category.   (For accounting geeks: the transfer is actually the “offsetting entry” for the payment, a sort of imaginary thing that the accountant imagines as whatever the payment was made for.)

 

“Current transfers” are transfers that “directly affect the level of disposable income of the ... donor or recipient.” in the words of the European Union.  The New Zealand Central Bank says:Current transfers directly affect the level of disposable income and influence the consumption of goods and services for the donor and the recipient economies. Capital transfers consist of the transfer of ownership of a fixed asset, the forgiveness of a liability, and the transfer of cash that is linked to, or conditional on, the acquisition or disposal of a fixed asset. The transfers made by migrants as they move to a new country are an example of a capital transfer.”

 

In some presentations of the data, transfers are divided into “official transfers” and “private transfers.” 

 

Official transfers are government-to-government payments, though some may go through international agencies like the United Nations. This can be termed "aid" of various kinds; when the United States, for example, got large payments from Japan and other countries to defray costs involved in the Gulf War, those represented large positive official transfers in the U.S. BoP. For only a few countries, however, are official transfers likely to be a significant part of the overall BoP. 

 

Private (i.e. made at individual initiative) transfers are made by workers who go abroad and send part of their earnings home, e.g. Salvadorans in the U.S., Turks in Germany, Filipinos in Singapore.  So you would expect the United States to show net negative private transfers, and India to show net positive private transfers. For most countries transfers are insignificant compared to trade, but for a few, like El Salvador, they are quite important. 

 

 

 

Current Transfers, n.i.e.: Credit (Inflows)

 

Official Transfers into our country mean that foreign governments (or multilateral agencies) make payments to us. 

 

Private Transfers into our country mean that foreigners make payments to us. (Suppose your uncle in Japan sends you a check.)

 

(+) They require that foreigners make payments to us so they take a plus sign.  

 

Macro note: Large incoming transfers will enable a country to import more -- in fact that’s often the intent of foreign aid, and many donors insist that their "aid" be spent on their exports, and the United States has, as a matter of policy, tried to use aid programs to promote consumption of U.S.-grown products, especially wheat. Some have argued that by stimulating imports into the aided country, large aid programs may actually hurt local producers.

 

 

 

Current Transfers: Debit (Outflows)

 

Official Transfers to other countries are simply payments by our government to other countries. 

 

Private Transfers to other countries are simply payments to people in those countries. Suppose you help support your grandparents in Mexico

 

(-) They require that we make payments to foreigners so they take a minus sign.   

 

 

 

Total Current Account, n.i.e.

 

You add up everything above.

 

(N.i.e. means “not including exceptional financing.”  Don’t worry about it.)

 

 

Financial Account

 

“The financial account covers all transactions, including the creation and liquidation of financial claims, associated with change of ownership in international financial assets and liabilities.” (Central Bank of New Zealand)

 

 

See my note at the top on the potential for confusion around the term “Capital Account,” which means different things to different people.  In the IMF’s presentation, “capital account” is mainly capital transfers, which means unrequited transfers of an asset of some kind.  See my note above under “current transfers.”  In the World Bank's definition, capital account includes government debt forgiveness, investment grants in cash or in kind by a government entity, and taxes on capital transfers. Also included are migrants' capital transfers and debt forgiveness and investment grants by nongovernmental entities.”  So basically you have both private capital transfers and public capital transfers.  For most countries this category will be extremely small, if they are reported at all, so it’s highly unlikely that these will be important for any of your research memos.

 

 

 

Capital Account, n.i.e.: Credit

 

 

 

Capital Account: Debit

 

 

Direct Investment means acquiring a significant ownership stake in a foreign business.

 

“Direct investment is investment undertaken by an entity resident in one economy in an

enterprise resident in another economy. The purpose of the investment is to obtain or sustain a lasting interest in the enterprise and exercise a significant degree of influence in its management.”  (Central Bank of New Zealand)

 

According to the IMF’s current criteria, owning ten percent or more of a business qualifies as having a “lasting interest” and “a significant degree of influence in its management  If you own less than ten percent, you’re treated as a portfolio investor. 

 

Direct Investment is divided directionally: foreigners investing in businesses in our country, and our residents investing in businesses abroad.

 

 

 

Direct Investment Abroad  

 

Our residents buying (or selling) ownership stake in foreign businesses in other countries. 

  • When our residents buy ownership stakes in foreign firms from foreigners, they have to make payments to those foreigners, so that will take a minus sign.
  • When our residents sell ownership stakes in foreign firms to foreigners, those foreigners have to make payments to us, so that takes a plus sign.  

 

 

 

Direct Investment in Reporting Economy, n.i.e. 

 

Foreigners buying (or selling) ownership stake in businesses in our country. 

  • When foreigners buy ownership stakes in domestic firms, they have to make payments to us, so that will take a plus sign.
  • When foreigners sell ownership stakes, we make payments to them, so that will take a minus sign.

 

 

Think of portfolio investment as the kind of securities that small investors might acquire: stocks, corporate or government bonds.  You’re acquiring these as part of a portfolio of assets, but you’re not buying enough shares in a company to have a significant ownership stake, in particular the kind of stake that would give you a say in management.

 

“Portfolio investment consists of equity and debt securities that are not classified to either direct investment or reserve assets. Equity securities include shares, stocks, ... or similar documents that usually denote ownership of equity. The level of equity ownership that denotes portfolio investment is taken as being less than 10 percent ownership in an entity. ... Debt securities include tradable instruments such as bonds and notes, debentures (long-term instruments) and money market instruments (short-term instruments such as treasury bills, commercial and financial paper).” (Central Bank of New Zealand)

 

Portfolio Investment is divided directionally: foreigners investing in businesses in our country, and our residents investing in businesses abroad.

 

 

 

Portfolio Investment Assets

 

Our residents’ portfolio investment abroad. 

  • When our residents buy foreign securities, we have to make payments to foreigners, so this will take a minus sign. 
  • When they sell those securities, foreigners have to make payments to us, so that takes a plus sign.

Because those securities are our assets and their liabilities, they’re called assets here.

 

 

 

Portfolio Investment Liabilities, n.i.e.

 

Foreigners’ portfolio investment in our country.

  • When foreigners buy securities, they have to make payments to us, so that will take a plus sign.
  • When foreigners sell those securities, we make payments to them, so that will take a minus sign. 

Because these securities are our liabilities and their assets, they’re called liabilities here.

 

 

The IMF says: “Financial derivatives are financial instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded in financial markets in their own right.  Basically, they are a category of more complex financial instruments, and they are often individually tailored to the needs of particular borrowers or lenders.  For the most part, however, it’s unlikely that you will have much data for this category.

 

 

Financial Derivatives Assets

 

Our residents’ purchases or sales of financial derivatives abroad.

 

 

Financial Derivatives Liabilities

 

Foreign residents’ purchases or sales of financial derivatives in our country.

 

The major component in “Other investment” is usually bank loans – specifically, the principal of loans.  The interest goes under “income” in the current account.

 

“The other investment item is a residual category that includes all financial transactions not covered under direct investment, portfolio investment, financial derivatives or reserve assets ... Other investment can be further subdivided into (i) trade credits, (ii) loans/currency and deposits and (iii) other assets/other liabilities.” (European Union)

 

 

 

Other Investment Assets

 

Assuming this is bank lending, this would consist of our banks making loans to foreigners.

  • When our bank makes the loan, it would have to make a payment to the foreigner, so that would take a negative sign. 
  • When a foreigner repays the principal on the loan, they would be paying us, so that takes a plus sign.

The loan is our bank’s asset and the foreigner’s liability. 

 

 

 

Other Investment Liabilities, n.i.e.

 

Assuming this is bank lending, this would consist of our foreign banks making loans to anyone in our country.

  • When the foreign bank makes the loan, it would have to make a payment to our domestic borrower, so that would take a plus sign. 
  • When our resident repays the principal on a loan, they make a payment to a foreigner, so that takes a minus sign.

The loan is our liability and the foreigner’s asset.

 

 

 

Total Financial Account, n.i.e.

 

Add all the Financial Account items up.

 

 

The Current Account plus Financial Account plus Reserve Changes should sum to zero, because they should capture the totality of all transactions across our borders.   If they don’t, somebody missed counting something.  This may mean smuggling of goods in or out.  Sometimes a large negative figure will indicate capital flight -- a lot of domestic residents buying foreign assets without telling their government. 

 

 

Net Errors and Omissions

 

Overall Balance is Current Account plus Financial Account plus net Errors and Omissions

 

 

Overall Balance

 

Finally we get to changes in the quantity of foreign assets held by the Central Bank. 

What’s left over after we sum up the Current Account and Financial Account should be the change in the reserves held by the Central Bank. If all these activities bring in more foreign exchange than they use, the balance should be accounted for by additional foreign assets held by the central bank. We call these assets reserves, so total reserves rise. If all these activities use up more foreign exchange than they bring in, the Central Bank has to fill the gap by selling some of the foreign assets it owns, so total reserves fall. So: 

Current Account + Financial Account = Change in Reserves 

This is a useful way to look at it because using the reserves is a policy choice made by the government. Reserves can be seen as a "savings account" or "war chest" (sometimes literally) of a government; it can spend accumulated reserves to but things abroad that it needs. For example if the harvest of a key export crop is bad, a government can dip into its reserves to maintain imports of essential goods. 

Plus and minus signs: This is a rich source of confusion.  By accounting convention, the reserve account is treated as a stash of assets outside the country that you either spend money on (when you increase reserves) or draw money from (when you sell some of those assets, thereby running down your reserves).  That means that when reserves rise, they are a net use of funds (you're spending money to buy reserves, just like you spend money to buy imports) and take a minus sign.  And when you draw on your reserves they are a net source of funds, and take a plus sign.  It's totally counterintuitive, because the minus sign corresponds to a situation when reserves rise, and the plus sign corresponds to a situation when reserves fall.  We're so used to thinking "plus sign good" that it's hard to wrap the brain around the fact that a big positive number in "changes in reserves" means your country is burning through its precious stash of reserve assets.

One way to reduce cognitive dissonance is to look at "Overall balance"  on the spreadsheet just above. A big negative number means reserves were used up that year, a big positive number means there was money left over to buy more reserve assets.

 

 

Reserves and Related Items

 

 

Reserve Assets

 

This is the standard reserves.

 

 

Use of Fund Credit and Loans

 

If the country drew on IMF assistance, it will show up here.

 

 

Exceptional Financing