International Balance of Payments (BOP)

Most countries of the world have their own national currency (a.k.a. domestic currency), which is used as money within the respective countries. Although all currency is money, most of the money of the world is actually stored as electronic information, such as savings and checking accounts, in the databases of banks. Nonetheless, this electronic information always expresses quantity in terms of a certain currency; therefore, hereinafter, we will use the term currency to designate all forms of money that are denominated in the currency.

If a domestic resident wants to buy a foreign product or service, she must first convert the domestic currency into the foreign currency to make the purchase. If a business wants to sell products in a foreign country, then the business will collect foreign currency for those sales. Much of that money will probably remain with the foreign branch of the business to pay local wages and other expenses. However, the business will probably want to bring some of that money home, in which case, it will want to convert the foreign currency into its domestic currency.

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Hence, there is a flow of the world's currencies to virtually every country of the world. The international balance of payments (BOP) is a snapshot of the net result of these international transactions over a specified time period — monthly, quarterly, or annually.

Every international transaction is either a BOP credit or debit. BOP credits are transactions that either increase domestic liabilities or revenues or decrease assets and expenses, while BOP debits are transactions that are opposite of credits — decreases in domestic liabilities or revenues or increases in assets or expenses. So if a United States resident buys an Australian bond, a BOP credit will result from the liability to pay for the bond, and a BOP debit will result from the increase of foreign securities by the United States. If an American business imports goods, the increase in assets results in a BOP debit while the liability to pay for the goods is a BOP credit.

BOP Credits

  • Increases in:
    • Domestic Liabilities
    • Revenues
  • Decreases in:
    • Assets
    • Expenses

BOP Debits

  • Decreases in:
    • Domestic Liabilities
    • Revenue
  • Increases in:
    • Assets
    • Expenses

Current Account and Capital Account

The BOP for United States international transactions is divided into the current account and the capital account. The current account consists of goods, services, and investment earnings. The capital account consists of capital transfers and the acquisition and disposal of real and intangible assets, such as real estate or patents. A subdivision of the capital account, the financial account records transfers of financial capital and direct investments. The BOP is published by the Bureau of Economic Analysis (BEA).

The credits and debits of some transactions are recorded in both the current and the capital account, while others are only recorded in 1 account. For instance, the credit and debit associated with purchasing a foreign bond is recorded only in the financial account while the importation of goods is recorded in both accounts.

The official reserves account, which is part of the financial account, is the foreign currency held by central banks, and is used to pay balance-of-payment deficits. Each account is further divided into sub-accounts.

The Current Account

The trade deficit or surplus is a measure of the desirability of a country's products and services by the rest of the world. The current account includes:

  1. Merchandise trade, which consists of all raw materials and manufactured goods bought, sold, or given away.
  2. Services:
    • travel and tourism,
    • labor,
    • transportation,
    • engineering,
    • business services, such as law, management consulting, accounting, and fees from patents and copyrights on software, books, and movies.
  3. Income receipts include income derived from ownership of assets, such as stock dividends and bond interest.
  4. Unilateral transfers are one-way transfers of assets, such as worker remittances from abroad and direct foreign aid. Aid and gifts count as a debit to the capital account of the donor nation.

The amount of goods and services exported minus the amount imported is known as the balance of trade. However, before mid-1993, the balance of trade only included merchandise trade.

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Capital Account Balance = Balance of Trade = Exported Goods and Services - Imported Goods and Services

A trade surplus exists when exports exceeds imports over a certain time while a trade deficit exists when imports exceeds exports. The measured period is usually by the month or year.

U.S. Merchandise Trade Deficit 1970-2001.
Source: New York Federal Reserve Bank.

The Capital Account

The capital account is equal to capital transfers, and the sale of natural and intangible assets to foreigners, which results in capital inflows, minus the capital transfers, and the purchase of foreign natural and intangible assets by U.S. residents, which results in capital outflows.

Capital Account Balance = Capital Inflows - Capital Outflows

The Financial Account

The financial account, a subdivision of the capital account, consists of financial instruments or investments, including:

Balance of Payments Deficit and Surplus

The current account and the capital account should balance, because every transaction is recorded as both a credit and a debit — double-entry accounting — and since credits must equal debits and the balance of payments is equal to credits minus debits, the sum of the balance of payments statements should be zero. However, because of incomplete or erroneous data, different accounting conventions, and continually changing exchange rates, the BOP balance deviates slightly from zero.

BOP = Current Account + Capital Account = Credits - Debits ≈ 0

For example, when the United States imports more than it exports—a current account deficit—it must finance the difference by borrowing, or by selling more capital assets than it buys, which is a capital account surplus. A country with a persistent current account deficit is, therefore, either borrowing from foreigners or selling its assets to them to pay for its net imports.

The Official Reserve Account

The official reserve account, a subdivision of the capital account, is the foreign currency and securities held by the government, usually by its central bank, and is used to balance the payments from year to year. In the United States, the New York Federal Reserve serves as the Treasury's fiscal agent. The official reserves increases when there is a trade surplus and decreases when there is a deficit. Sometimes the central bank will use it to intervene in the foreign exchange market to set the exchange rate to some objective. However, foreign interventions rarely work because, while central banks only intervene for a short time, market forces are always influencing the exchange rate, so the market equilibrium will soon return after the intervention.

Dollarization

There are some smaller countries and independent territories in the world that do not have their own currency, but use the currency of another country. Although it is known as dollarization,, the currency can be any currency, although it usually is the United States dollar. Therefore, such countries and regions have no balance of payments nor can they conduct their own monetary policy. Countries that are territories or commonwealths of other countries generally use the currency of the main country. For instance, Puerto Rico, a commonwealth of the United States, and the U.S. Virgin Islands, a quasi-independent territory of the United States, use the United States dollar for their currency.

Sometimes a country will adopt a foreign currency because the domestic currency has little or no value. For instance, in March, 2000, the government of Ecuador changed the official currency from the Sucre to the United States dollar to stabilize the economy and to greatly reduce the high inflation that plagued the country in the 1980's and 90's.