Balance of Payments
The balance of payments refers to the accounts that sum up a country’s financial position relative to other countries.
The balance of payments can best be understood in terms of an equation, involving all financial transactions made between one country and the rest of the world over a specified period of time:
Current Account = Capital Account + Financial Account
The current account includes the trade balance – exports minus imports – as well as income transfers.
The capital account includes the net change in physical asset and financial asset ownership.
The financial account includes net international (i.e., non-resident) ownership of financial assets, including reserve assets, direct investment, and portfolio investment.
Balance of Payments: Implications for Day Traders
A country’s balance of payments has important implications for its currency.
A trade deficit – which typically manifests in an overall current account deficit – is generally a sign that a currency is overvalued. A trade deficit signifies that its goods are more expensive relative to other countries. To decrease the deficit, its currency will need to weaken.
But this isn’t always true. Some countries lack resources and goods to export and must import more products to serve the needs and wants of its population. It may also relate to relative business competitiveness and cultural differences between countries or jurisdictions (e.g., greater willingness to take on debt to finance consumption).
Balance of Payments Imbalances
How Traders Can Profit
The most common way to rebalance the balance of payments is via the exchange rate mechanism. A trade deficit indicates a potential overvaluation of the currency while a trade surplus denotes a potential undervaluation of the currency.
Another potential balancing mechanism involves a domestic shifting of prices to affect demand. For example, for a country with a currency account deficit, one option is to ease monetary policy through the central bank’s expansion of legal reserves and/or lowering of interest rates in order to increase the money supply. An increase in the supply of the currency will work to weaken it.
Lower interest rates make savings less attractive, increases private and public sector investment, and cheapens exports. Some of this investment goes into human capital, which lowers the unemployment rate, making the country wealthier as a whole. This will help to eventually push up inflation through greater demand for goods and services.
The current account is taken as the excess of earnings over spending. Or, put another way, the excess of savings over investment:
Current account = Net savings – Net investment
Traditionally, if a country is running a current account deficit, it can either decrease the amount of legal reserves in circulation or indirectly by increasing interest rates, which influences private sector credit creation. This is also commonly referred to as “tightening” monetary policy.
As interest rates rise, there is a higher return on savings. Taking the economy as a whole, debt becomes more expensive and credit creation slows. This helps to bring savings back in line with investment and increases the current account figure. Ceteris paribus, this increases the value of the currency.
Predicting these maneuvers ahead of time can allow traders to anticipate and profit from movements in the currency ahead of the market.
Famous examples of balance of payments crises include the 1994 Mexican peso devaluation, 1997 Asian crisis, and 1998 Russian default.
Balance of payment crises are also frequently associated with an unwinding of carry trades, where long positions in higher-yielding emerging market currencies are liquidated resulting in a flight to safety to “safe haven” currencies (i.e., generally developed market currencies or gold). Given that carry trades are usually done with leverage, these events can cause major dislocations in global currency markets.
It’s also important to note that only the current account feeds into a nation’s calculation of its output, or GDP. The capital and financial account do not. Therefore, a higher current account is associated with an increase in GDP, again holding all else equal. This is associated with a rise in the currency.
Balance of Payments Crises
When foreign investment is weak or there are high outflows from a country due to economic hardship or deterioration in a country’s financial infrastructure, balance of payments crises can develop.
This means that a country cannot adequately service its debt or pay for essential imports. This is accompanied by a rapid devaluation in the nation’s currency.
Balance of payments crises are generally preceded by a wave of foreign investment inflows due to higher prospective returns. Debts and loans associated with these inflows are often denominated in another currency – to enhance their soundness and to eliminate foreign exchange risk – despite revenues being derived from mostly domestic operations.
When investors begin pulling their money and the currency depreciates due to lower demand for it, it becomes harder to service foreign debts because the domestic currency no longer goes as far.
The country’s central bank will attempt to ease the pain by selling foreign exchange reserves to buy domestic currency to help prop up its value. Nonetheless, foreign currency reserves are finite. Once they’re depleted, policy options are limited and generally inadequate.
Central banks can increase interest rates to raise yields and stem outflows. But this usually doesn’t improve investors’ confidence and exacerbates the pain by increasing debt servicing costs. In turn, this further undermines economic activity through an increase in defaults and subsequent compression of consumption and investment activity.