The Balance of Payments: the current and financial accounts

The Balance of Payments summarizes the international transactions of a country. These transactions can be broadly categorized into two types – international trade and international investment. They are presented in the two components of the Balance of Payments: the Current Account and the Financial Account.

The Current Account includes data on:

1. Imports and exports of goods.
2. Imports and exports of services – financial, legal, medical, travel, etc.
3. Income on financial assets. For example, if a U.S. mutual fund invests in a Mexican company, the dividends from that investment will be recorded in the current account. Also, if the Chinese government buys U.S. government bonds, then the interest on these bonds will be recorded in the current account.
4. Transfers between countries. This includes, for example, foreign aid, remittances, and international gifts.

The current account could be in surplus if, for example, exports are greater than imports. It could also be in deficit if imports are greater than exports or if, say, the domestic country makes large transfer payments to foreign countries.

The Financial Account includes data on:

1. Foreign direct investment, i.e the purchase or creation of production facilities for the manufacturing of goods or services (e.g. a Toyota plant in the U.S.).
2. Portfolio investment, i.e. the purchases of equity (less than 10% of the value of a firm) and bonds.
3. Other financial transactions such as cross-border bank deposits.

The financial account is in surplus if the foreign investment into the country is greater than the country's investment in other countries. In contrast, the financial account is in deficit if domestic citizens invest more internationally than the amount foreigners invest in the local economy.

Notice on the chart the U.S. current account deficit and the the Chinese current account surplus during the period 2005-2015. In essence, the U.S. buys (imports) more products from the world than the world buys from the U.S. The situation in China is the opposite. China buys less from the world than the world buys from China.

Bookkeeping rules

Which entries in the balance of payments are recorded with a “+” and which ones are recorded with a “–“? A simple rule of thumb is that transactions that require the sale of the local currency for a foreign currency enter with a minus sign.

For example, if a U.S. family goes on a holiday to Mexico, they have to sell dollars and buy peso to make payments in Mexico. This transaction will go with a minus sign in the U.S. Balance of Payments (more specifically in the current account) and with a plus sign in the Mexican Balance of Payments.

The reverse is true for transactions that require the purchase of the domestic currency: these are recorded with a plus sign. For example, a German company that wants to import machinery from the U.S. has to buy dollars to make the payment. That will be recorded with a plus sign in the U.S. Balance of Payments and with a minus sign in the German Balance of Payments.

Double entry for each transaction

Each international transaction creates two entries in the balance of payments. They have the same absolute magnitude but an opposing sign. One entry is with a plus sign and the other is with a minus sign.

For example, a Japanese consumer buys an American car for $10,000. This is recorded as + $10,000 in the U.S. Current Account. To purchase the car, the Japanese consumer buys $10,000 from, say, Citibank.

Now Citibank has $10,000 worth of yen. It uses the yen to buy Japanese government bonds. That purchase enters with a (-) sign in the U.S. Financial Account.

So, we have two transactions of equal absolute magnitude but with opposite signs. Since this is true for each international transaction, when we add up all the “+” entries and all the “-“ entries, we’ll arrive at the same absolute number. Therefore,

Balance of Payments = Current account balance + Financial account balance = 0

In other words, while the current account and the financial account can be in surplus or deficit, the overall Balance of Payments is always in “balance.”


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