To buy foreign goods and services, the firms and individuals need to buy the currencies of the foreign countries. Similarly they need to purchase the currency of domestic country while paying for goods and services to foreigners.
The balance of payments is the method used by countries to monitor all their international transactions.
The Federal Reserve Board (FRB) defines a country’s balance of payments as the record of transactions between its residents and foreign residents over a specified period. Any transaction that causes money to flow into a country is a credit to its BOP account, and any transaction that causes money to flow out is a debit.
The accounts are grouped into three major categories: current account, capital account, and financial account. The current account measures the flow of goods and services, the capital account consists of capital transfers and the acquisition and disposal of non-produced, non-financial assets; and the financial account records investment flows.
Let’s look at the components of each of these accounts.
The current account is composed of four sub-accounts:
Merchandise and Services: Merchandise consists of all raw materials and manufactured goods bought, sold or given away. Services include tourism, transportation, engineering and business services, such as law, management consulting and accounting, fees from patents and copyrights on new technology, software, books and movies.
Income receipts: Foreign income derived from ownership of assets, such as dividends on holdings of stock and interest on securities.
Unilateral transfers: One-way transfers of assets, such as worker remittances from abroad and direct foreign aid. In the case of aid or gifts, the capital account of the donor nation is debited.
The capital account has two sub-accounts:
Capital transfers include debt forgiveness and goods and financial assets accompanying migrants as they leave or enter the country. It also includes the transfer of title to fixed assets and the transfer of funds linked to the sale or acquisition of fixed assets, gift and inheritance taxes, death duties, uninsured damage to fixed assets and legacies.
Acquisition and disposal non-financial assets: This includes the sales and purchases of non-produced assets, such as the rights to natural resources, and the sales and purchases of intangible assets, such as patents, copyrights, trademarks, franchises and leases.
The financial account is made up of two sub-accounts:
U.S.-owned assets abroad: Include official reserve assets, government assets and private assets. These assets include gold, foreign currencies, foreign securities, reserve position in the International Monetary Fund, U.S. credits and other long-term assets, direct foreign investment and U.S. claims reported by U.S. banks.
Foreign-owned assets in the United States: Include foreign official assets and other foreign assets in the United States. These assets include U.S. government, agency, and corporate securities; direct investment; U.S. currency; and U.S. liabilities reported by U.S. banks.
Deficit and Surplus
The current account should balance with the capital plus the financial accounts, and the sum of the balance of payments statements should be zero. In each account, there can be surplus or deficit. For example, when the United States imports more goods and services than it exports, there will be a current account deficit. The difference must be financed by borrowing, or by selling more capital assets than it buys, which will lead to a capital account surplus.
If a country has a persistent current account deficit, it is, in effect, exchanging capital assets for goods and services. A large trade deficit means that the country is borrowing from abroad.