Balance of Payments, Its Components, and Deficit vs. Surplus

 

Balance Of Payments:

Definition:

The balance of payments is the record of all international trade and financial transactions made by a country's residents. 

The balance of payments has three components—the current account, the financial account, and the capital account. Current accounts measure international trade, net income on investments, and direct payments. The financial account describes the change in international ownership of assets. The capital account includes any other financial transactions that don't affect the nation's economic output

What It Means

A country's balance of payments tells you whether it saves enough to pay for its imports. It also reveals whether the country produces enough economic output to pay for its growth. The BOP is reported for a quarter or a year. 

A balance of payments deficit means the country imports more goods, services, and capital than they export. It must borrow from other countries to pay for its imports.

It's like taking out a school loan to pay for education. Your expected higher future salary is worth the investment.²

In the long-term, the country becomes a net consumer, not a producer, of the world's economic output. It will have to go into debt to pay for consumption instead of investing in future growth. If the deficit continues long enough, the country may have to sell its assets to pay its creditors. These assets include natural resources, land, and commodities.

A balance of payments surplus means the country exports more than it imports. It provides enough capital to pay for all domestic production. The country might even lend outside its borders.

A surplus boosts economic growth in the short term. There are enough excess savings to lend to countries that buy its products. The increased exports boost production in its factories, allowing them to hire more people. In the long run, the country becomes too dependent on export-driven growth. It must encourage its residents to spend more.

A larger domestic market will protect the country from exchange rate fluctuations. It also allows its companies to develop goods and services by using its own people as a test market.

 

Current Account

The current account measures a country's trade balance plus the effects of net income and direct payments. When the activities of a country's people provide enough income and savings to fund all their purchases, business activity, and government infrastructure spending, then the current account is in balance.¹

Current Account: Deficit

A current account deficit is when a country's residents spend more on imports than they save. Other countries lend funds or invest in, the deficit country's businesses To fund that national deficit. The lender country is usually willing to pay for the deficit because its businesses profit from exports to the deficit country. In the short run, the current account deficit is a win/win for both nations.

But if the current account deficit continues for a long time, it will slow economic growth. Foreign lenders will begin to wonder whether they will get an adequate return on their investment. If demand falls off, the value of the borrowing country's currency may also decline. This fall in currency value leads to inflation as import prices rise. It also creates higher interest rates as the government must pay higher yields on its bonds.¹

Current Account: U.S. Deficit

The U.S. current account deficit reached a record $806 billion in 2006.⁵ That created concern about the sustainability of such an imbalance. It fell during the recession but is now growing again.

The Congressional Budget Office warned about the danger of the current account deficit. It also proposed several solutions.⁶ First, Americans should cut back on credit card spending and increase their savings rate. That will help to fund domestic business growth. Second, the government must reduce its health care spending. The best way to do that is to lower the cost of health care. That was the goal of the Affordable Care Act.

If these solutions don't work, it could lead to inflation, higher interest rates, and a lower standard of living.

Current Account: Trade Balance

The trade balance measures a country's imports and exports. This portion is the largest component of the current account, which is itself the largest component of the balance of payments. Most countries try to avoid a trade deficit, but it's a good thing for emerging market countries. It helps them grow faster than they could if they maintained a surplus.

Trade Balance: U.S. Imports and Exports

In 2019, the United States traded $5.2 trillion with foreign countries. That was $2.5 trillion in exports and $2.9 trillion in imports. It's the third-largest exporter but the top importer.⁷

With its size and wealth, it should be exporting more. One of the major challenges to increasing U.S. exports is that other countries have lower costs of living. They can make things more cheaply because they pay their workers less.

Domestic manufacturing would cost a lot more. Most people aren't willing to pay more to save U.S. jobs.  U.S. imports cost less than domestically-made products. America imports more than half of its goods from just five countries.

Current Account: Trade Deficit Definition

A trade deficit is a result of a country's importing more than it exports. Imports are any goods and services produced in a foreign country, even if these are produced overseas by a domestic company.

A trade deficit can then occur even if all the imports are being sold by, and sending profit to, a domestic firm. With the rise of multinational corporations and job outsourcing, trade deficits are on the rise.

Current Account: U.S. Trade Deficit

America's reliance on foreign oil causes a large part of the U.S. trade deficit. When oil prices rise, so does the trade deficit. America also imports a lot of automobiles and consumer products. U.S. exports include many of the same things, but not enough to outweigh the deficit. 

In 2017, the United States outranked 20 countries by racking up the highest trade balance deficit by far, approximating $862.21 billion. Dependence on foreign oil, high import consumption, increase in multinational corporations, and job outsourcing increases that trade deficit.

Financial Account

The financial account measures changes in domestic ownership of foreign assets and foreign ownership of domestic assets. If foreign ownership increases more than domestic ownership does, it creates a deficit in the financial account. This increase means the country is selling its assets, like gold, commodities, and corporate stocks, faster than the nation is acquiring foreign assets.

Capital Account

The capital account measures financial transactions that don't affect a country's income, production, or savings. For example, it records international transfers of drilling rights, trademarks, and copyrights. Many capital account transactions rarely happen, such as cross-border insurance payments. The capital account is the smallest component of the balance of payments.