Balance of Payments

The balance of payments refers to the accounts that sum up a country’s financial position relative to other countries.

Balance of payments accounts record debits or credits to an account that summarizes a nation’s (or currency’s) financial transactions with all foreign countries over a defined period of time, such as a quarter (i.e., three calendar months) or an entire calendar year. The balance of payments account is essentially akin to a type of national balance sheet.

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The balance sheet typically uses accumulated data for assets and liabilities at some specific point in time. This is useful because it gives one single number representing the nation’s total assets minus its liabilities.

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

Current Account

The current account includes the trade balance – exports minus imports – as well as income transfers.

The balance of payments is often presented in a table format, with the current account balance on the left and the capital account balance on the right.

Capital Account

The capital account includes the net change in physical asset and financial asset ownership.

Financial Account

The financial account includes net international (i.e., non-resident) ownership of financial assets, including reserve assets, direct investment, and portfolio investment.

 

Transactions included in the balance of payments

Put a different way, the balance of payments is the balance of all of the transactions between people and organizations in a particular country (or currency) and the rest of the world.

These transactions include purchases of:

  • goods
  • services
  • financial assets and
  • other payments

For example, consider a transaction where a country has to buy oil.

In order to buy oil, some type of payment – money (to settle the transaction) or credit (a promise to pay) – would have to be given up to get the oil.

When a country’s balance of payments situation gets worse it’s like when a person’s financial condition gets worse because its inflows – revenue/income and credit it gets – go down relative to outflows (expenditures).

When the balance of payments improves, the reverse is true and inflows exceed outflows.

Balance of payments accounts serve two basic purposes:

1) to measure the financial position of a country or currency, and

2) to provide a regular indicator of economic health and performance.

A balance of payments accounts for each country are typically prepared on a quarterly basis by national statistical offices, central banks, and ministries of finance.

Upon receipt of data from tax offices, customs departments, social insurance agencies, and other officials that track balance sheet activities resulting from international transactions in goods and services, income payments and transfers, etc., these balance sheets get updated with information that reflects changes in ownership rights that have occurred over that measurement period (quarter or year).

 

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 often weaken to rectify the imbalance.

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 their populations. 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).

For example, a country can get a trade deficit down by:

  • importing less
  • exporting more
  • buying things on credit
  • printing money to fill the gap
  • selling FX reserves

These may or may not be accompanied by a fall in its exchange rate relative to other currencies (or relative to something like gold).

The Relationship between the Balance of Payments and Interest Rates

It is well understood among traders, investors, economists, and other market participants that central banks face a trade-off between output and inflation when they change interest rates and the amount of liquidity in the financial system.

However, what’s not as well understood is that this trade-off is more difficult to manage when money is leaving the country and there’s a balance of payments deficit.

And conversely, it’s easier to manage when money is flowing into the country (BOP surplus).

When capital moves out, the central bank’s job becomes more difficult. Less growth is achieved per each unit of inflation. These outflows flows can cause:

  • the currency to depreciate
  • FX reserves to decline, and/or
  • interest rates to rise

Balance of Payments Imbalances

How Traders Can Profit

The reason why a country or currency’s balance of payments is of interest to traders and investors is because the most common way to rebalance the BOP 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.

balance of payments

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 works to lower the unemployment rate and increase incomes, 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.

However, the rise in yields is not good for bonds. Higher real yields are generally bad for commodities and may hit equities as well. Cash becomes more attractive to hold.

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.

In this case, a country’s components (people, organization, government(s)) don’t have enough buying power in global markets to meet its needs. In a balance of payments crisis, a country has essentially run out of money and credit.

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.

The end result is that a country has essentially run out of cash and credit, so it cannot adequately service its debt or pay for essential imports.

How Balance of Payments Crises Are Resolved

A key determinant of how balance of payments and currency crises play out is how policymakers respond to the adverse capital flow situation:

That is:

a) they allow a tightening of financial conditions to occur, or

b) print money to make up for shortfall caused by the capital leaving

Option A is economically, politically, and socially painful, but usually necessary to resolve the crisis.

Option B can be inflationary.

Countries without reserve currencies often opt for something closer to Option A while those that have reserve currencies often go with Option B.