What are the balance of payments components? Deficit vs. surplus

The balance of payments (BOP) is the record of all international trade and financial transactions made by a country's residents. 

The BOP has three components: the current account, the financial account, and the capital account.

Current accounts measure international trade, net income on investments, and direct payments. The financial account describes the change in international ownership of assets. The capital account includes any other financial transactions that don't affect the nation's economic output.

What is BOP?

- A country's BOP shows whether it saves enough to pay for its imports. It also reveals whether the country produces enough economic output to pay for its growth. The BOP is reported for a quarter or a year. 

- A BOP deficit means the country imports more goods, services, and capital than it exports. It must borrow from other countries to pay for its imports.

- In the long-term, the country becomes a net consumer, not a producer, of the world's economic output.

- If the deficit continues long enough, the country may have to sell its assets to pay its creditors.3 These assets include natural resources, land, and commodities.

- On the other hand, a BOP surplus means the country exports more than it imports. It provides enough capital to pay for all domestic production. The country might even lend outside its borders.

- A surplus may boost economic growth in the short term. There are enough excess savings to lend to countries that buy its products.
The increased exports boost production in its factories, allowing them to hire more people.

- In the long run, the country becomes too dependent on export-driven growth. It must encourage its residents to spend more.

- A larger domestic market will protect the country from exchange rate fluctuations. It also allows its companies to develop goods and services by using its own people as a test market.

Current Account

- The current account (CA) measures a country's trade balance plus the effects of net income and direct payments.

- When the activities of a country's people provide enough income and savings to fund all their purchases, business activity, and government infrastructure spending, then the current account is in balance.

Current Account Deficit

- A current account deficit is when a country's residents spend more on imports than they save. Other countries lend funds or invest in the deficit country's businesses to fund that national deficit.

- The lender country is usually willing to pay for the deficit because its businesses profit from exports to the deficit country. In the short run, the current account deficit is a win-win for both nations.

- But if the current account deficit continues for a long time, it will slow economic growth. Foreign lenders will begin to wonder whether they will get an adequate return on their investment.

- If demand falls off, the value of the borrowing country's currency may also decline. This fall in currency value leads to inflation as import prices rise.

- It also creates higher interest rates as the government must pay higher yields on its bonds.

- The U.S. current account deficit reached a record $816 billion in 2006. That created concern about the sustainability of such an imbalance. The Congressional Budget Office warned about the danger of the current account deficit.

- It also proposed several solutions. First, Americans should cut back on credit card spending and increase their savings rate. That will help to fund domestic business growth.

- Second, the government must reduce its health care spending. The best way to do that is to lower the cost of health care. That was the goal of the Affordable Care Act.

- If these solutions don't work, it could lead to inflation, higher interest rates, and a lower standard of living.

Current Account: Trade Balance

- The trade balance measures a country's imports and exports. This portion is the largest component of the current account, which is itself the largest component of the BOP.

- Most countries try to avoid a trade deficit, but it's a good thing for emerging market countries. It helps them grow faster than they could if they were to maintain a surplus.

- In 2021, the United States traded $5.9 trillion with foreign countries. That was $2.5 trillion in exports and $3.4 trillion in imports, each of which set records.

Trade Deficit Definition

- A trade deficit is a result of a country's importing more than it exports. Imports are any goods and services produced in a foreign country, even if these are produced overseas by a domestic company.

- A trade deficit can then occur even if all of the imports are being sold by, and sending profit to, a domestic firm. With the rise of multinational corporations and job outsourcing, trade deficits are on the rise.

- In 2020, the US outranked 20 countries by racking up the highest trade balance deficit by far, approximating $975.91 billion.

- Trade deficit widens due to dpendence on foreign oil, high import consumption, increase in multinational corporations, and job outsourcing increases.

Financial Account

- The financial account measures changes in domestic ownership of foreign assets and foreign ownership of domestic assets.

- If foreign ownership increases more than domestic ownership does, it creates a deficit in the financial account.

- This increase means that the country is selling its assets, like gold, commodities, and corporate stocks, more quickly than the nation is acquiring foreign assets.

Capital Account

- The capital account measures financial transactions that don't affect a country's income, production, or savings.

- For example, it records international transfers of drilling rights, trademarks, and copyrights. Many capital account transactions rarely happen, such as cross-border insurance payments. The capital account is the smallest component of the BOP.

Source: The Balance