Unit 10.3 The Balance of Payments

A country’s balance of payments account is a record of all the flows of money between residents of that country and the rest of the world.

The balance of payments deficit is one of the main macroeconomic problems that governments face. A country’s balance of payments account records all the flows of money between residents of that country and the rest of the world. Receipts of money from abroad are regarded as credits and are entered in the accounts with a positive sign. Outflows of money from the country are regarded as debits and are entered with a negative sign.

There are three main parts of the balance of payments account: the current account, the capital account and the financial account. Each part is then subdivided. We shall look at each part in turn, and take the UK as an example.

The current account

The current account records payments for imports and exports of goods and ser­vices, plus incomes flowing into and out of the country, plus net transfers of money into and out of the country. It is normally divided into four subdivisions.

The trade in goods account. This records imports and exports of physical goods (pre­viously known as ‘visibles’). Exports result in an inflow of money and are therefore a credit item. Imports result in an outflow of money and are therefore a debit item. The balance of these is called the balance on trade in goods or balance of visible trade or merchandise balance. A surplus is when exports exceed imports. A deficit is when imports exceed exports.

The trade in services account. This records imports and exports of services (such as transport, tourism and insurance"). Thus the purchase of a foreign holiday would be a debit, since it represents an outflow of money, whereas the purchase by an over­seas resident of a UK insurance policy would be a credit to the UK services account. The balance of these is called the services balance.

The balance of both the goods and services accounts together is known as the balance on trade in goods and services or simply the balance of trade.

Income flows. These consist of wages, interest and profits flowing into and out of the country. For example, dividends earned by a foreign resident from shares in a UK company would be an outflow of money (a debit item).

Current transfers of money. These include government contributions to and receipts from the EU and international organisations, and international transfers of money by private individuals and firms. Transfers out of the country are debits. Transfers into the country (e.g. money sent from Greece to a Greek student studying in the UK) would be a credit item.

The current account balance is the overall balance of all the above four subdivi­sions. A current account surplus is where credits exceed debits. A current account deficit is where debits exceed credits.

The capital account

The capital account records the flows of funds, into the country (credits) and out of the country (debits), associated with the acquisition or disposal of fixed assets (e.g. land), the transfer of funds by migrants, and the payment of grants by the govern­ment for overseas projects and the receipt of EU money for capital projects (e.g. from the Agricultural Guidance Fund).

The financial account

The financial account of the balance of payments records cross border changes in the holding of shares, property, bank deposits and loans, government securities, etc. In other words, unlike the current account, which is concerned with money incomes, the financial account is concerned with the purchase andsale of assets.

Direct investment.

If a foreign company invests money from abroad in one of its branches or associated companies in the UK, this represents an inflow of money when the investment is made and is thus a credit item. (Any subsequent profit from this investment that flows abroad will be recorded as an investment income outflow on the current account.) Investment abroad by UK companies represents an outflow of money when the investment is made. It is thus a debit item.

Portfolio investment.

This is changes in the holding of paper assets, such as company shares. Thus if a UK resident buys shares in an overseas company, this is an outflow of funds and is hence a debit item.

Other financial flows.

These consist primarily of various types of short-term monet­ary movement between the UK and the rest of the world. Deposits by overseas resid­ents in banks in the UK and loans to the UK from abroad are credit items, since they represent an inflow of money. Deposits by UK residents in over­seas banks and loans by UK banks to overseas residents are debit items. They represent an outflow of money.

Short-term monetary flows are common between inter­national financial centers to take advantage of differences in countries’ interest rates and changes in exchange rates.

Flows to and from the reserves.

The UK, like all other countries, holds reserves of gold and foreign currencies. From time to time the Bank of England (acting as the government's agent) will sell some of these reserves to purchase sterling on the foreign exchange market. It does this normally as a means of supporting the rate of exchange (as we shall see below). Drawing on reserves represents a credit item in the balance of payments accounts: money drawn from the reserves represents an inflow to the balance of payments (albeit an outflow from the reserves account). The reserves can thus be used to support a deficit elsewhere in the balance of payments.

Conversely, if there is a surplus elsewhere in the balance of payments, the Bank of England can use it to build up the reserves. Building up the reserves counts as a debit item in the balance of payments, since it represents an outflow from it (to the reserves).

When all the components of the balance of payments account are taken together, the balance of payments should exactly balance: credits should equal debits. If they were not equal, the rate of exchange would have to adjust until they were, or the government would have to intervene to make them equal. When the statistics are compiled, however, a number of errors are likely to occur. As a result there will not be a balance. To ‘correct’ for this, a net errors and omissions item is included in the accounts. This ensures that there will be an exact balance. The main reason for the errors is that the statistics are obtained from a number of sources, and there are often delays before items are recorded and sometimes omissions.

Table UK balance of payments (simplified)

Current account	₤ million
1.Trade in goods (a) Exports of goods (b) Imports of goods Balance on trade in goods	+210,182 - 275,813 - 65,631
2.Trade in services (a) Exports of services (b) Imports of services Balance on trade in services Balance on trade in goods and services	+105,732 - 86,998 +18,734 - 46,897
3. Net income flows (wages and investment income)	+27,408
4. Net current transfers (government and private)	- 12,401
Current account balance	- 31,890
Capital account 5. Net capital transfers, etc: Capital account balance	+2,301 +2,301
Financial account
6.Investment(direct and portfolio) (a) Net investment in UK from abroad (b) Net UK investment abroad Balance of direct and portfolio investment	+221,626 - 219,293 +2,333
7. Other financial flows (mainly short-term) (a) Net deposits in UK from abroad and borrowing from abroad by UK residents (b) Net deposits abroad by UK residents and UK lending to overseas residents Balance of other financial flows	+523,673   - 500,539 +23,134
8. Reserves (drawing on+ adding to-) Financial account balance	+24,811
Total of all three accounts 9. Net errors and omissions	- 4,788 +4,788 0

Net errors and omissions

When all the components of the balance of payments account are taken together, credits should equal debits. In our case,

• current account balance = - 31,890m pounds

• capital account balance = +2,301m pounds

• financial account balance = +24,811m pounds

Total of all three = - 4,788m pounds, which is not ‘zero’ as it is to be. Why?

When the statistics are compiled, a number of errors are likely to occur. As a result, there will not be a balance. To ‘correct’ this, a net errors and omissions item is included in the accounts (+4,788m pounds). This ensures that there will be an exact balance.