One of the central features of a modern economic system is that we allow for countries to borrow (to smooth consumption and investment shortfalls) and lend (to earn higher rates of return) to eachother. Details of these transactions are recorded in the Balance of Payments, where the Current Account is primarily concerned with resource exchanges that involve goods and services that may need to be financed by the Financial Account which is primarily concerned with transactions that involve capital flows.1

When modelling such behaviour in an open-economy model, we note that in the presence of perfect (or near perfect) capital mobility, households are able to smooth consumption over time (regardless of the path of output). This is a major departure from closed-economy models, in which consumption would reflect the variability of the aggregate endowment. The main policy implication of such a model is that a country should finance temporary negative shocks through foreign borrowing. However, where the open-economy experiences a permanent negative shock, it should seek to embark on a structural adjustment programme. This simple lesson is often ignored by countries in a futile attempt to finance permanent negative shocks, which may result in unsustainable levels of foreign debt.2

One reason why the concept of current account balance is economically important is that it reflects a country’s net borrowing needs. For example, when a domestic country runs a current account deficit, it will require that a foreign country must lend an equivalent amount to the domestic country. In this way, the current account is related to changes in a country’s Net International Investment Position (NIIP).3

During the early-to-mid 1980s South Africa encountered significant current account deficits during a period of political turmoil (which resulted in the declaration of a state of emergency) and the “Debt Crisis” of 1985. During this period of time South African demand for foreign resources was much greater than our supply of resources to the rest of the world, and foreign providers of capital were concerned about our ability to repay the huge loans that we had taken out (which meant that we were only able to raise further foreign capital at extremely high interest rates). In addition, since the demand for South African currency decreased over this period of time, our exchange rate came under pressure, which meant that the value of our debt (which was largely denominated in U.S. dollars) increased in terms of our nominal domestic currency.

Figure 1: Current Account to Output (South Africa)

Figure 1 shows the South African current account as a percentage of GDP, where we note that South Africa has again started to generate a sizeable current account deficit once again. While many of you would be particularly interested in the current account deficit of South Africa, it is worth noting that the current account balances of other countries vary considerably. Figure 2 shows the countries with the five largest current account surpluses and deficits. In addition, we also include the current account balances for South Africa.4 Essentially this graph suggests that the United States (U.S.) is largely responsible for purchasing the resources of other countries, while Germany, Japan and China is providing the U.S. with the capital to purchase these goods.

Figure 2: Current Account Balances (source: CIA World Factbook)

Given the extent of these imbalances, one may want to investigate what are the determining factors that influence the potential size of these deficits or surpluses. One potential reason that may not be a determining factor is geographic location, where it is noted in Figure 3 that countries that are running either deficits or surpluses are dispursed all around the world.

Figure 3: Global Current Account Imbalances (source: IMF World Economic Outlook)

When we consider the scale of these imbalances, it is not surprising to note that several economists are concerned by the immense size of the U.S. current account deficit. Figure 4 shows the U.S. current account balance since 1976 along with a measure of the nation’s net international investment position. The U.S. had accumulated substantial foreign wealth by the early 1980s when a sequence of current account deficits of proportions unprecedented in the twentieth century opened up. In 1987, it became a net debtor to foreigners for the first time since World War I. The U.S. current account deficits did not stop in the 1990s and by the end of that decade, it had become the world’s biggest foreign debtor. These deficits continued during the new millennium, and the net international investment position of the U.S. is now an extremely large number. As a result, many economist are not sure whether the observed trend in the net foreign investment position is sustainable.5 This concern stems from the fact that several countries with large external debt to GDP ratios, have experienced sudden reversals in international capital flows that were followed by costly financial and economic crises.6 In addition, the 2008 global financial crisis, which highlighted the fragility of economic and financial systems, has brought this issue to the fore once again.7

Figure 4: US Current Account and NIIP (source: FRED)

A further important concern relates to the extent of the global surpluses, as the current account surpluses in Germany, Japan and China are extremely large. These imbalances will continue to place the stability of the global economic system at risk, where if these imbalances were to unravel quickly (i.e. if China were to recall a large portion of U.S. debt), then we would witness a dramatic decrease in the value of the U.S. dollar. This would place the world’s largest economy under extreme pressure, particularly with the additional concerns relating to a potential trade war.

To consider the adjustment processes relating to the balance of payments, we need a clear idea of the concept of a balance of payments. In addition, we also need to understand the content of the statistical data that is provided by these measures. This information is summarised in much of what follows in this chapter.

1 Balance of Payments

Although the various national presentations look different, all obey a common set of accounting rules and definitions, which can be given a general treatment. To enable the international comparison of these statistics, the International Monetary Fund (IMF) has, in cooperation with experts from national and international institutions, developed a framework for compiling the balance of payments and the international investment position, the Balance of Payments and International Investment Position Manual. This contains the recommended concepts, rules, definitions, and practices that guide member countries when making their regular reports on the balance of payments, as stipulated in the IMF’s Articles of Agreement.

The latest edition is the sixth (the first was published in 1948), released by the International Monetary Fund (2009) (henceforth referred to as the Manual and often referred to as BPM6 in some IMF documentation). This last edition takes into account important developments that occurred in the global economy since the release of the fifth edition, such as: the increased use of cross-border production processes, the complex international company structures, the international labour mobility and financial innovation. Furthermore, where possible, the IMF publishes the balances of payments of all member countries in a standardized presentation that is titled the “Balance of Payments Statistics Yearbook” and the data is also available through the International Financial Statistics, in accordance with the classification scheme of the Fund’s Manual.8 All of this data is made available on the IMF website and one of the easiest ways of getting access to this data is through the imfr package that has been written in R.

In what follows we explain some of the general principles of the standard classification scheme, which would allow us to understand what the balance of payments represents. In addition, it will also hopefully allow us to obtain information on any country’s balance of payments through the IMF data publications (these, it should be noted, contain references to the original national sources, to which all those interested in a particular country can turn). For uniformity of presentation, the Yearbook data are expressed in U.S. dollars, although you should be able to find that most of the important statistics are presented in terms of national domestic currency as well. For countries that do not report in U.S. dollars, balance of payments data are converted using normally the average domestic exchange rates for the relevant period taken from the International Financial Statistics (IFS).

1.1 Definitions in the Balance of Payments

The balance of payments of a country is a systematic record of all economic transactions that have taken place during a given period of time between the residents of the reporting country and residents of foreign countries (also called, for brevity, “nonresidents”, “foreigners”, or “rest of the world”).

In this case, the term economic transaction relates to the transfer of economic value from one economic agent (individual, business, etc.) to another. It includes both real and financial transfers (where some may be quid pro quo). Examples of such transactions would include: the purchase or sale of goods and services, the exchange of goods and services, the exchange of financial items, etc. Note also that a transaction is deemed to be international when it takes place between a resident and a nonresident, where illegal transactions are treated in the same way as legal transactions.

It is also important to note that the term resident does not coincide with that of citizen, though they often overlap. Residents are those whose general centre of interest is considered to rest in that economy other than on a temporary basis (i.e. consume goods and services, participate in production, etc.). This definition is not particularly clear and as such the IMF Manual has a set of rules to solve possible doubtful cases. These would include those for students, tourists, commercial travellers, official diplomatic and consular representatives, members of the armed forces, etc.

This record is normally kept in terms of the domestic currency of the compiling country. Note also that as the balance of payments refers to a given time period, it is a “flow” concept (which reflects the change in the stock value of a variable).

1.2 Components of the Balance of Payments

The balance of payments has three main components, which are classified according to the nature of the economic resources provided and received. These include the current account, the capital account and the financial account. The current account deals with international trade in goods and services and with earnings on labour and investments. The financial account records transfers of financial capital and non-financial capital (including changes in the country’s international reserves). The capital account consists of capital transfers and the acquisition and disposal of non-produced, non-financial assets. These components are usually expressed with the aid of an accounting identity:

Current account = Capital account + Financial account

1.3 Current Account

The current account includes flows of goods, services, primary income, and secondary income between residents and nonresidents. When considering the flows of goods, these would include all the exports and imports of goods that are regarded as the “visible”" items of trade, where the Manual seeks to maintain a degree of uniformity with regards to the valuation of these items. Exports and imports of services are termed the “invisible” items of trade that may include commercial services, maintenance and repair, freight services, and other similar items. Primary income, which is also recorded in the Current Account represents the return that accrues directly from work, financial assets and natural resources; while, secondary income includes current transfers between residents and nonresidents (i.e. personal income transfers, remittances, etc.).

We could decompose the Current Account further into the following components:

Current Account Balance = Trade Balance + Income Balance + Net Unilateral Transfers

In this case the Trade Balance, or Balance on Goods and Services, is the difference between exports and imports of goods and services. The Merchandise Trade Balance, or Balance on Goods, keeps record of net exports of goods, and the Services Balance keeps record of net receipts from items such as transportation, travel expenditures, and legal assistance.

In the Income Balance, Net investment Income is the difference between income receipts on foreign assets that are owned by domestic residents and income payments by domestic residents on foreign-owned assets. Net Investment Income includes items such as international interest and dividend payments and earnings of domestically owned firms operating abroad. The second component of the Income Balance, Net International Compensation to Employees, includes, as positive entries compensation receipts from (1) earnings of domestic residents employed temporarily abroad, (2) earnings of domestic residents employed by foreign governments, and (3) earnings of domestic residents employed by international organisations in the domestic country; this is the largest of the three categories. Negative entries to Net International Compensation to Employees may include domestic compensation payments to (1) Foreign workers (usually from bordering countries) who commute to work, (2) foreign students, (3) foreign professionals with temporary residence, and (4) foreign temporary workers.

The third component of the current account, Net Unilateral Transfers, keeps record of the difference between gifts, that is, payments that do not correspond to purchases of any good, service, or asset, received from the rest of the world and gifts made by the home country to foreign countries. One big item in this category is private remittances. For example, payments by a South African resident to relatives residing in Uganda would enter with a minus in Net Unilateral Transfers. Another prominent type of unilateral transfer relates to developed world Government Grants, which represent transfers of real resources or financial assets to foreigners for which no repayment is expected.

1.4 Financial Account

The Financial Account incorporates the items that involve the financing (usually by way of capital transfers or transactions in financial instruments) of real resource flows (which would include items in the Current Account). It records international transactions that involve financial assets and liabilities. It includes direct investment, portfolio investment, financial derivatives (other than reserves), employee stock options, other investment, reserves, etc. These transactions are usually categorised as either long-term and short-term instruments (which may have different maturity structures) and would also potentially include foreign financing of government or the central bank.

The reserves comprise of assets available to central authorities of a country to meet balance of payments financing needs and such assets would be subject to frequent revaluations to account for the fluctuations in their price and changes due to reserve creation.

The Financial Account has two main components:

Financial Account = Increase in foreign-owned assets in the domestic economy

- Increase in domestic-owned assets abroad

Foreign-owned assets in the domestic economy include domestic securities held by foreign residents, domestic currency held by foreign residents, domestic borrowing from foreign banks, and foreign direct investment in the domestic economy. Foreign assets that are owned by domestic residents would include foreign securities, domestic bank lending to foreigners, and domestic direct investment abroad.

1.5 Capital Account

The capital account shows (1) capital transfers receivable and payable between residents and nonresidents and (2) the acquisition and disposal of nonproduced, nonfinancial assets between residents and nonresidents. In some of the earlier economic literature, “capital account” is often used to refer to what is called the financial account in the IMF Manual and in the National Accounts. The use of the term “capital account” in the Manual is designed to be consistent with the National Accounts, which distinguishes between capital transactions and financial transactions.

Although this item is usually insignificant in developed-world economies it may contribute a significant amount to low-income countries, since it includes debt relief or debt-forgiveness, foreign aid, migrant transfers, etc.

Before concluding this section we note that an international transaction does not necessarily have to give rise to one entry in the current account and one entry in the financial account. It can be the case that it gives rise to two entries in the financial account or two entries in the current account. For example, purchase of foreign shares that are paid for in domestic currency generates a positive and negative entry in the financial account. Alternatively, a unilateral transfer in goods would give rise to two entries in the current account.

1.6 Balance of Payments Accounting Principles

The basic convention of a Balance of Payments statement is based on the double entry accounting system, where every transaction is represented by two entries of equal value. If, for example, an exporter receives foreign currency in payment for goods, a credit entry would be recorded in the Current Account for the export of goods and an offsetting debit entry would be recorded in the Financial Account for the exporter’s increase in foreign currency bank balances (or other form of foreign currency asset). In the traditional accounting form, these entries would be recorded as:

Exchange of goods for foreign currency assets
Credit Debit
Current Account: Goods 100
Financial Account: Foreign currency assets 100

From the perspective of the financial account, payments from the rest of the world are recorded as credit entries, when a country runs a current account deficit. While payments to the rest of the world are to be recorded as debit entries in the financial account.

Hence, in the Balance of Payments accounting framework, a credit entry is recorded for exports of goods and services, income receivable, increases in liabilities, or reductions in financial assets. A debit entry is recorded for imports of goods and services, income payable, reductions in liabilities, or increases in financial assets.

The accounting system requires that both entries for a transaction be recorded at uniform values and in the same time period. To satisfy this requirement, transactions are recorded at market value, and the time that it is recorded is typically the point at which a change of ownership occurs. One of the primary objectives of the Manual is to maintain uniformity in the valuation of all these assets valuation. For example, in the case of exports and imports, all items should be valued on a free on board basis (i.e. excluding the cost of insurance and freight).

1.7 Surplus and Deficits

Under double-entry bookkeeping, the balance of payments always balances and the terms surplus and deficit qualify whether or not a country is indebted to the rest of the world as a result of the international transactions that it has made during a particular year. For example, if the Trade Balance is negative, where the domestic economy imports more than exports, then it runs a Trade Balance deficit. If all the other items in the Current Account net to zero then the country will be running a Current Account deficit. In such a case the Financial (or in certain cases the Capital Account) would need to be in surplus, where borrowing exceeds the amount lent to foreigners. Note that these statistics could be subject to some interpretation, as there may be slight differences in the Balance of Payments that are reported by individual countries. As such they are not necessarily comparable between countries or over time.

2 Net International Investment Position

In addition to the balance of payments, there also exists the balance of indebtedness (also called by the Manual the international investment position). The sixth edition of the Manual is characterized by an increasing role of balance sheets (reflected in the international investment position). This is due to the growing recognition of balance sheet analysis in understanding sustainability and vulnerability, including currency mismatches, sector and interest rate composition of debt, and the effect of the maturity structure on liquidity.

In general, the balance of indebtedness records the outstanding claims of residents on nonresidents and the outstanding claims of nonresidents on residents at a given point in time, such as the end of the year. Therefore this balance is concerned with stocks, unlike the balance of payments, which refers to flows. The classification of the International investment position components is consistent with that of the financial account of the balance of payments.

Various balances of indebtedness can be reported according to the claims considered. One considers only the stock of foreign assets and liabilities of the central authorities; another considers the direct investment position, etc.

3 Multi-country models

When two-country (or \(n\)-country) models are used, it is often expedient to use the constraint that the sum of the balances of payments (measured in terms of a common unit) of all countries is zero; this is also called an international consistency condition. It should however be added that this condition holds true insofar as no reserve creation (as defined in section 1.5) occurs. Therefore, the reader should bear in mind that, when we use this constraint in what follows, we shall implicitly assume that no reserve creation is taking place.

In any case, whichever type of balance one uses, a necessary constraint or international consistency condition Mundell (1968) is

\[\begin{eqnarray} \sum_{i=1}^{n} B_{i}=0 \tag{3.1} \end{eqnarray}\]

namely the balance of payments of all countries (of course the same type of balance, and expressed in a common monetary unit) must algebraically sum up to zero. This follows from the fact that the surplus of one country must necessarily be matched by a corresponding deficit of one or more other countries, provided that no reserve creation takes place (more generally, the sum of the balances of payments of all countries, i.e., the world balance of payments, equals the increase in net world reserves - see Mundell (1968)).

From equation (3.1) it follows that only \(n-1\) balances of payments can be independently determined. For example, a maximum of \(n-1\) countries can independently set balance-of-payments targets: the \(n\)th country has to accept the outcome or the system will be inconsistent.

3.1 Small and Large Open Economies

When constructing open-economy models one could make use of a number of different assumptions for either two-country or multiple-country characterisations. In a two-country model we could refer to an open-economy structure where the rest-of-the-world is treated as a separate country, while in a multiple-country model we may be more interested in the specific interactions between specific countries.

Note that the expression small-country model, which is now more popularly termed a small open-economy (or SOE) model, refers to the case where the small domestic country under consideration is assumed to have a negligible influence over the variables for the rest-of-the-world (i.e. income, price level, interest rate, etc.). This implies that the rest-of-the-world variables can be treated as exogenous in such a model.

With the expression open-economy or large country model, we refer to a model in which the effect on the rest-of-the-world’s variables would be influenced by the domestic country that is under consideration. It follows that, through the channels of exports and imports of goods and services, and capital movements, the economic events taking place in a large country have repercussions for the other countries, and vice versa.

4 Conclusion

In this chapter we have considered a number of relevant details regarding the construction of the Balance of Payments. The data suggests that several countries, including South Africa, have been running large Current Account deficits. However, the size of this deficit is considerably smaller than that of the U.S., which has also accumulated over time to provide a considerable deficit in its Net International Investment Position.

5 References

Gourinchas, Pierre‐Olivier, and Hélène Rey. 2007. “International Financial Adjustment.” Journal of Political Economy 115 (4): 665–703.

International Monetary Fund. 2009. Balance of Payments Manual. 1st edn. 1948; 2nd edn. 1950; 3rd edn. 1961; 4th edn. 1977; 5th edn. 1993; 6th edn. 2009. IMF.

Lane, Philip R., and Gian Maria Milesi-Ferretti. 2007. “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004.” Journal of International Economics 73 (2): 223–50.

Mundell, R. A. 1968. International Economics. Vol. Ch. 10. New York: Macmillan.

Obstfeld, Maurice, and Kenneth Rogoff. 1996. Foundations of International Macroeconomics. Cambridge, Massachusetts: MIT Press.

  1. Note that contrary to definitions provided by the International Monetary Fund a number of major academic texts, such as Obstfeld and Rogoff (1996), use a definition for the Capital Account that incorporates items from the Financial Account (which is used by the IMF to record the sales of assets to foreigners and purchases of assets located abroad) and the Capital Account (which is used by the IMF to record capital transfers, such as debt forgiveness and migrants transfers). Hence: Capital AccountOR = Financial AccountIMF + Capital AccountIMF.↩︎

  2. Of course it is difficult to characterise a shock as either permanent or temporary at the time of impact.↩︎

  3. The NIIP is a technical term used to refer to a country’s net foreign wealth, that is, the difference between foreign assets owned by domestic residents and domestic assets owned by foreigners. In the absence of valuation changes it may be expressed as, \(CA = \Delta NIIP\).↩︎

  4. Note that these estimates reflect current account balances and are not expressed as a percentage of GDP.↩︎

  5. In the standard Fisher open-economy model, a country would be given access to foreign capital when the expected real growth rate of an economy exceeds the expected future interest rate payments. This would imply that a downward revision to the expected U.S. growth rate would suggest that current level of debt is problematic.↩︎

  6. The list of countries includes many Latin American countries that experienced crises during the 1980s, Mexico, Russian, and several South-East Asian countries in the second half of the 1990s, and Argentina in 2001 (to mention but a few).↩︎

  7. Note that during the period 2002 to 2007, the U.S. was able to increase its Current Account deficit, while its NIIP was largely unchanged. Gourinchas and Rey (2007) and Lane and Milesi-Ferretti (2007) suggest that this was due to valuation changes, where U.S. owned assets that were held abroad (mostly denominated in foreign currency) increased in value by a larger proportion than foreign-owned U.S. assets (mostly denominated in U.S. dollars). These enormous valuations changes came to a abrupt end in 2008 when valuations on world stock markets plummeted. As the net equity position of the U.S. was extremely large at the beginning of 2008, the decline in stock prices in the U.S. (and elsewhere) inflicted large losses on the value of the U.S. equity portfolio; as indicated by the sharp drop in the NIIP during that period of time.↩︎

  8. For further details relating to these statistics, see↩︎