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Investment - Balance of Payments
A country needs to document all economic transactions. The balance of payments gives crucial information to examine and comprehend economic dealings with other countries.
Imports and exports are crucial components of a country’s balance of payments.
The balance of payments tracks transactions between a country and the rest of the globe over a period of time, usually a year. It depicts the flow of money in and out of a country as a result of exports and imports. It also reflects financial transactions and financial transfers between resident and non-resident economic entities, such as individuals, firms, governments, and government agencies.
The balance of payments contains two accounts: the current account and the capital and financial account.
Current Account
The current account reflects how much the country spends and invests (outflows) contrasted with how much it gets (inflows). It is primarily driven by the trade of products and services with the rest of the globe, so exports and imports.
Capital and Financial Account
The capital and financial account records the ownership of assets. In particular, it reflects investments by domestic entities in foreign entities and investments by foreign entities in domestic entities. These investments can be the acquisitions of production facilities or the purchases and sales of financial securities, such as debt and stock.
Analysing a country’s balance of payments supports an understanding of the country’s macroeconomic climate. The balance of payments quantifies a country’s levels of consumption and savings. It can also provide insight into a country’s degree of reliance on foreign cash to fuel its consumption and investments.
In theory, the total of the current account and the capital and financial account is zero. In other words, the balance of payments should sum to zero. Before explaining why this is the case, we need to understand what drives each account.
Current Account
The exhibit below displays the current account’s three components:
Products (commonly referred to as products in this context) and services
Income
Current transfers
Components of the Current Account
Current Account Goods and Services
Exports – Imports = Net exports = Balance of Trade Income
Salaries + Income on financial investments
Current Transfers
Unilateral transactions, such as presents or workers' remittance
Components of the Current Account
The goods and services account is usually the largest component of a country’s current account. It reflects the flow of money in and out of a country as a result of the trade of products and services; in other words, the inflow of money (a positive number) from exporting products and services to foreign entities, and the outflow of money (a negative number) from importing products and services.
The difference between exports and imports of items and services is called net exports, commonly referred to as the balance of trade or trade balance.
Balance of trade may be used by some to refer exclusively to the difference between exports and imports of goods. When we refer to balance of commerce, we include both products and services.
If the value of exports is equal to the value of imports — if net exports are zero — the country’s commerce is balanced, which in practice is rarely the case. If the value of exports is higher than the value of imports, which means net exports are positive, the country has a trade surplus. Alternatively, if the value of exports is lower than the value of imports, making net exports negative, the country has a trade deficit.
The income account depicts the movement of money in and out of the country from salaries and from the income received from financial investments. For example, if a domestic company has a debt or equity investment in a foreign company, any income, such as interest payments on the debt securities it holds or dividend payments on the equity securities it holds, received by the domestic company is included in income in the country’s current account.
In this case, the interest or dividend payments are recorded as inflows since they represent money pouring into the country from other countries.
The third current account, the current transfers account, comprises unilateral transactions, such as gifts and workers’ remittances. Gifts of aid from one country are outflows for that country and inflows for the receiving country. Money sent home by migrant workers, or workers’ remittances, is an outflow from the nation where they work and an inflow to the country to which the money is remitted.
A country’s current account balance is the total of the goods and services account, the revenue account, and the current transfers. A positive balance is called a current account surplus, whilst a negative balance is called a current account deficit. For most countries, the goods and services account are higher than the combination of the income account and the current transfer's account; the trade balance tends to dominate.
Countries that have a trade surplus because they export more than they import tend to have a current account surplus. In contrast, countries that have a trade deficit because they import more than they export tend to have a current account
A current account surplus suggests that the country is saving. That is, the country has more inflows than outflows, providing it the opportunity to lend to or invest in other countries. As can be seen in the above, Germany, Japan, China, the Netherlands, Switzerland, and Russia had the highest current account surpluses in 2019.
By contrast, a country that is running a current account deficit spends more than it earns, thus it needs to borrow or accept investments from other countries. As seen in the table, the United States, the United Kingdom, Kenya, Brazil, Ireland, and Canada had the greatest current account deficits in 2019.
Capital and Financial Account
As the name suggests, the capital and financial account refers to the merging of two accounts. The capital account generally reports capital transfers between domestic entities and international entities, such as debt forgiveness or the transfer of assets by migrants entering or leaving the country. The financial account reflects the investments domestic entities make in foreign entities and the investments foreign entities make in domestic entities.
In essence, the capital and financial account tells us how a country with a current account surplus is investing its savings, or how a country with a current account deficit is supporting its necessities.
Capital and Financial Account
Capital
Capital transfers between domestic and international entities
Financial
Direct investments + Portfolio investments + Other investments + Reserve account
Direct Investments
Direct investments are long-term investments between domestic entities and international entities. If a Brazilian firm purchases a production facility in the United Kingdom, the transaction will be reported as an inflow to the financial account in the United Kingdom because it is money flowing in from another country.
The same transaction will be reported as an outflow from the financial account in Brazil because it is money sent outside.
Portfolio Investment
Portfolio investments indicate the purchases and sells of securities, such as debt and equity securities, between local entities and foreign entities.
Other Investments
Other investments are generally made up of loans and deposits between domestic firms and international entities.
Reserve Account Reserve accounts represent the transactions made by the monetary authorities of a country, often the central bank.
Relationship between the Current Account and the Capital and Financial Account
The capital and financial flows travel in the opposite direction of the goods and services flows in the current account that give rise to them. We indicated that the total of the current account balance and the capital and financial account balance should in theory be equal to zero.
If a country has a current account surplus, it should have a capital and financial account deficit of the same magnitude; the country is a net saver and thus ends up being a net lender to the rest of the world.
Alternatively, if a country has a current account deficit, it should have a capital and financial account surplus of the same magnitude, implying the country is a net borrower from the rest of the world in order to pay its deficit.
In practice, however, the capital and financial account balance does not exactly offset the current account balance because of measurement inaccuracies. All the components included in the balance of payments are measured independently using different sources of data. Data are collected from customs officials on exports and imports, from surveys on tourist numbers and expenditures, and from financial institutions on capital inflows and outflows. Some of the inputs are based on sampling methodologies, therefore the figures are estimates.
Because measuring the items reported in the balance of payments is complex, it is in reality rare, if not impossible, to wind up with a capital and financial account balance that perfectly offsets the current account balance. As a result, there is a need for a ‘plug’ figure that makes the sum of the flows in and out equal to zero. This plug figure is termed errors and omissions.
Why Does a Country Run a Current Account Deficit and How Does It Affect Its Currency?
We observed earlier that some countries, such as the United States, the United Kingdom, Brazil, India, and Canada, have huge current account deficits.
Is running a current account deficit a bad indicator, and should all countries try to maximise their current account balance? The answer to both queries is not necessarily. The aggregate of the current account balances of all countries is, by definition, equal to zero.
In other words, an influx for one country equals an outflow for another country. Accordingly, it is impossible for all countries to have a current account surplus.
A current account deficit must be put in context before reaching conclusions. A developing country may have a current account deficit because it needs to import various things, such as machinery and equipment, and services, such as communication services, to enable its economy evolve. As the initial period of heavy investment ends and the economy gets stronger, the developing country may experience a decline in imports and an increase in exports, steadily reducing or even eliminating the current account deficit. This situation can also apply to countries in transition that are shifting from a socialistically managed economy to a market economy, in which case the current account deficit may be transient.
Alternatively, a mature country may have a current account deficit because its spending greatly surpasses its production and its ability to export. Thus, when analyzing the economic forecast for a country running a current account deficit, an investment professional must factor in the country’s stage of economic development and comprehend what is driving the current account balance.
There is a long-standing discussion over the risk to a country for maintaining a sustained current account deficit. As discussed before, a current account deficit means that the government spends more than it gets and makes up the difference by borrowing or receiving investments from other countries.
Some economists claim that having a current account deficit does not matter as long as foreign entities hold the assets and the currency of the country running the deficit. But what would happen if foreign entities were hesitant to hold the assets and currency?
Consider the example of the country operating the highest current account deficit, the United States. Because the United States has a big trade deficit with several countries, those countries hold US currency. These US dollars can be maintained as bank deposits in the United States, or they can be invested. For example, foreign corporations may use their US dollars to acquire US companies, or they may invest in debt and equity instruments produced by US companies. Other governments may also invest in the bonds issued by the US government, termed Treasuries
But if other countries decide that they want to minimize their exposure to the United States, they may start selling US assets, which will have a negative influence on the price of those assets. In addition, they may elect to convert their US dollars into other currencies, which will cause a devaluation of the US dollar relative to other currencies. The US dollar will get weaker, and a unit of the US currency will buy fewer units of a foreign currency.
In other words, foreign currencies will get stronger relative to the US dollar, or they will appreciate relative to the US dollar. To entice entities in other countries to invest in the United States, the US Central Bank, the Federal Reserve Board (which is sometimes called the Fed), may increase interest rates. An increase in interest rates would increase the cost of funding for individuals, companies, and the government in the United States.
The combination of lower asset prices, a weaker US dollar, and higher interest rates would definitely harm the US economy, potentially leading to a lower GDP, maybe even a recession, and a higher unemployment rate.
A country needs to document all economic transactions. The balance of payments gives crucial information to examine and comprehend economic dealings with other countries.
Imports and exports are crucial components of a country’s balance of payments.
The balance of payments tracks transactions between a country and the rest of the globe over a period of time, usually a year. It depicts the flow of money in and out of a country as a result of exports and imports. It also reflects financial transactions and financial transfers between resident and non-resident economic entities, such as individuals, firms, governments, and government agencies.
The balance of payments contains two accounts: the current account and the capital and financial account.
Current Account
The current account reflects how much the country spends and invests (outflows) contrasted with how much it gets (inflows). It is primarily driven by the trade of products and services with the rest of the globe, so exports and imports.
Capital and Financial Account
The capital and financial account records the ownership of assets. In particular, it reflects investments by domestic entities in foreign entities and investments by foreign entities in domestic entities. These investments can be the acquisitions of production facilities or the purchases and sales of financial securities, such as debt and stock.
Analysing a country’s balance of payments supports an understanding of the country’s macroeconomic climate. The balance of payments quantifies a country’s levels of consumption and savings. It can also provide insight into a country’s degree of reliance on foreign cash to fuel its consumption and investments.
In theory, the total of the current account and the capital and financial account is zero. In other words, the balance of payments should sum to zero. Before explaining why this is the case, we need to understand what drives each account.
Current Account
The exhibit below displays the current account’s three components:
Products (commonly referred to as products in this context) and services
Income
Current transfers
Components of the Current Account
Current Account Goods and Services
Exports – Imports = Net exports = Balance of Trade Income
Salaries + Income on financial investments
Current Transfers
Unilateral transactions, such as presents or workers' remittance
Components of the Current Account
The goods and services account is usually the largest component of a country’s current account. It reflects the flow of money in and out of a country as a result of the trade of products and services; in other words, the inflow of money (a positive number) from exporting products and services to foreign entities, and the outflow of money (a negative number) from importing products and services.
The difference between exports and imports of items and services is called net exports, commonly referred to as the balance of trade or trade balance.
Balance of trade may be used by some to refer exclusively to the difference between exports and imports of goods. When we refer to balance of commerce, we include both products and services.
If the value of exports is equal to the value of imports — if net exports are zero — the country’s commerce is balanced, which in practice is rarely the case. If the value of exports is higher than the value of imports, which means net exports are positive, the country has a trade surplus. Alternatively, if the value of exports is lower than the value of imports, making net exports negative, the country has a trade deficit.
The income account depicts the movement of money in and out of the country from salaries and from the income received from financial investments. For example, if a domestic company has a debt or equity investment in a foreign company, any income, such as interest payments on the debt securities it holds or dividend payments on the equity securities it holds, received by the domestic company is included in income in the country’s current account.
In this case, the interest or dividend payments are recorded as inflows since they represent money pouring into the country from other countries.
The third current account, the current transfers account, comprises unilateral transactions, such as gifts and workers’ remittances. Gifts of aid from one country are outflows for that country and inflows for the receiving country. Money sent home by migrant workers, or workers’ remittances, is an outflow from the nation where they work and an inflow to the country to which the money is remitted.
A country’s current account balance is the total of the goods and services account, the revenue account, and the current transfers. A positive balance is called a current account surplus, whilst a negative balance is called a current account deficit. For most countries, the goods and services account are higher than the combination of the income account and the current transfer's account; the trade balance tends to dominate.
Countries that have a trade surplus because they export more than they import tend to have a current account surplus. In contrast, countries that have a trade deficit because they import more than they export tend to have a current account
A current account surplus suggests that the country is saving. That is, the country has more inflows than outflows, providing it the opportunity to lend to or invest in other countries. As can be seen in the above, Germany, Japan, China, the Netherlands, Switzerland, and Russia had the highest current account surpluses in 2019.
By contrast, a country that is running a current account deficit spends more than it earns, thus it needs to borrow or accept investments from other countries. As seen in the table, the United States, the United Kingdom, Kenya, Brazil, Ireland, and Canada had the greatest current account deficits in 2019.
Capital and Financial Account
As the name suggests, the capital and financial account refers to the merging of two accounts. The capital account generally reports capital transfers between domestic entities and international entities, such as debt forgiveness or the transfer of assets by migrants entering or leaving the country. The financial account reflects the investments domestic entities make in foreign entities and the investments foreign entities make in domestic entities.
In essence, the capital and financial account tells us how a country with a current account surplus is investing its savings, or how a country with a current account deficit is supporting its necessities.
Capital and Financial Account
Capital
Capital transfers between domestic and international entities
Financial
Direct investments + Portfolio investments + Other investments + Reserve account
Direct Investments
Direct investments are long-term investments between domestic entities and international entities. If a Brazilian firm purchases a production facility in the United Kingdom, the transaction will be reported as an inflow to the financial account in the United Kingdom because it is money flowing in from another country.
The same transaction will be reported as an outflow from the financial account in Brazil because it is money sent outside.
Portfolio Investment
Portfolio investments indicate the purchases and sells of securities, such as debt and equity securities, between local entities and foreign entities.
Other Investments
Other investments are generally made up of loans and deposits between domestic firms and international entities.
Reserve Account Reserve accounts represent the transactions made by the monetary authorities of a country, often the central bank.
Relationship between the Current Account and the Capital and Financial Account
The capital and financial flows travel in the opposite direction of the goods and services flows in the current account that give rise to them. We indicated that the total of the current account balance and the capital and financial account balance should in theory be equal to zero.
If a country has a current account surplus, it should have a capital and financial account deficit of the same magnitude; the country is a net saver and thus ends up being a net lender to the rest of the world.
Alternatively, if a country has a current account deficit, it should have a capital and financial account surplus of the same magnitude, implying the country is a net borrower from the rest of the world in order to pay its deficit.
In practice, however, the capital and financial account balance does not exactly offset the current account balance because of measurement inaccuracies. All the components included in the balance of payments are measured independently using different sources of data. Data are collected from customs officials on exports and imports, from surveys on tourist numbers and expenditures, and from financial institutions on capital inflows and outflows. Some of the inputs are based on sampling methodologies, therefore the figures are estimates.
Because measuring the items reported in the balance of payments is complex, it is in reality rare, if not impossible, to wind up with a capital and financial account balance that perfectly offsets the current account balance. As a result, there is a need for a ‘plug’ figure that makes the sum of the flows in and out equal to zero. This plug figure is termed errors and omissions.
Why Does a Country Run a Current Account Deficit and How Does It Affect Its Currency?
We observed earlier that some countries, such as the United States, the United Kingdom, Brazil, India, and Canada, have huge current account deficits.
Is running a current account deficit a bad indicator, and should all countries try to maximise their current account balance? The answer to both queries is not necessarily. The aggregate of the current account balances of all countries is, by definition, equal to zero.
In other words, an influx for one country equals an outflow for another country. Accordingly, it is impossible for all countries to have a current account surplus.
A current account deficit must be put in context before reaching conclusions. A developing country may have a current account deficit because it needs to import various things, such as machinery and equipment, and services, such as communication services, to enable its economy evolve. As the initial period of heavy investment ends and the economy gets stronger, the developing country may experience a decline in imports and an increase in exports, steadily reducing or even eliminating the current account deficit. This situation can also apply to countries in transition that are shifting from a socialistically managed economy to a market economy, in which case the current account deficit may be transient.
Alternatively, a mature country may have a current account deficit because its spending greatly surpasses its production and its ability to export. Thus, when analyzing the economic forecast for a country running a current account deficit, an investment professional must factor in the country’s stage of economic development and comprehend what is driving the current account balance.
There is a long-standing discussion over the risk to a country for maintaining a sustained current account deficit. As discussed before, a current account deficit means that the government spends more than it gets and makes up the difference by borrowing or receiving investments from other countries.
Some economists claim that having a current account deficit does not matter as long as foreign entities hold the assets and the currency of the country running the deficit. But what would happen if foreign entities were hesitant to hold the assets and currency?
Consider the example of the country operating the highest current account deficit, the United States. Because the United States has a big trade deficit with several countries, those countries hold US currency. These US dollars can be maintained as bank deposits in the United States, or they can be invested. For example, foreign corporations may use their US dollars to acquire US companies, or they may invest in debt and equity instruments produced by US companies. Other governments may also invest in the bonds issued by the US government, termed Treasuries
But if other countries decide that they want to minimize their exposure to the United States, they may start selling US assets, which will have a negative influence on the price of those assets. In addition, they may elect to convert their US dollars into other currencies, which will cause a devaluation of the US dollar relative to other currencies. The US dollar will get weaker, and a unit of the US currency will buy fewer units of a foreign currency.
In other words, foreign currencies will get stronger relative to the US dollar, or they will appreciate relative to the US dollar. To entice entities in other countries to invest in the United States, the US Central Bank, the Federal Reserve Board (which is sometimes called the Fed), may increase interest rates. An increase in interest rates would increase the cost of funding for individuals, companies, and the government in the United States.
The combination of lower asset prices, a weaker US dollar, and higher interest rates would definitely harm the US economy, potentially leading to a lower GDP, maybe even a recession, and a higher unemployment rate.
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