Understanding Balance of Payments | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Today, we’re diving deep into the world of the balance of payments system. We’ll explore its components, the relationship with national economic accounts, and make it easier to digest.

Balance of Payments Explained

The balance of payments is a bookkeeping system that records a country’s economic transactions with the rest of the world for a specific period. It consists of three main components:

1. Current Account: Measures the flow of goods and services.
2. Capital Account: Measures transfers of capital.
3. Financial Account: Records investment flows.

Components of the Balance of Payments

Let’s break down each component of the balance of payments into its sub-accounts:

Current Account Sub-Accounts

• Merchandise Trade: Records import and export transactions of all commodities and manufactured goods.
• Services: Includes tourism, transportation, engineering, and business services, as well as fees from patents and copyrights on new technology, software, books, and movies.
• Income Receipts: Includes income derived from ownership of assets, such as dividends and interest payments.
• Unilateral Transfers: Refer to one-way transfers of assets, such as worker remittances from abroad and foreign direct aid or gifts.

Capital Account Sub-Accounts

• Non-Produced, Non-Financial Assets: Records imports and exports of rights to natural resources and intangible assets like patents, copyrights, trademarks, franchises, and leases.
• Capital Transfers: Includes debt forgiveness and assets that migrants bring or take with them.

Financial Account Sub-Accounts

• Financial Assets Abroad: Divided into official reserve assets, government assets, and private assets, including gold, foreign currencies, securities, direct foreign investment, and claims on foreign entities.
• Foreign-Owned Financial Assets: Divided into official assets and other foreign assets, including government and corporate bonds issued by the reporting country, direct investment, and liabilities to foreign entities.

Now that we’ve covered the components, let’s look at some crucial points to remember:

• Imports and exports of most goods and services are recorded under the current account.
• Sales and purchases of non-produced, non-financial, and intangible assets are recorded under the capital account.
• Ownership of foreign bonds and ownership of local bonds by foreign entities, as well as claims against foreign entities and foreign claims on local entities, are recorded under the financial account.

Double-Entry System and Recording Transactions

Every transaction in the balance of payments involves both a debit and credit, so theoretically, the total amount of debits must equal the total amount of credits for the same period. In essence, a debit represents an increase in a country’s assets or a decrease in its liabilities, while a credit is the opposite.

Let’s see how transactions with foreign countries are recorded in the balance of payments system:

• Imports: Increase assets, so they are recorded as a debit transaction.
• Exports: Decrease assets, so they are recorded as a credit transaction.
• Purchases of Foreign Bonds: Increase assets, so they are recorded as a debit transaction.
• Sales of Foreign Bonds: Decrease assets, so they are recorded as a credit transaction.
• Foreign Purchases of Local Bonds: Increase liabilities, so they are recorded as a credit transaction.
• Foreign Sales of Local Bonds: Decrease liabilities, so they are recorded as a debit transaction.
• Increased Claims on Foreign Entities: Increase assets, so they are recorded as a debit transaction.
• Decreased Claims on Foreign Entities: Decrease assets, so they are recorded as a credit transaction.
• Increased Foreign Claims on Local Entities: Increase liabilities, so they are recorded as a credit transaction.
• Decreased Foreign Claims on Local Entities: Decrease liabilities, so they are recorded as a debit transaction.

Double-Entry Accounting Example

Understanding Trade Deficits and Surpluses

A country with a trade deficit imports more than it exports, resulting in a current account deficit. This deficit must be balanced by a net surplus in the capital and financial accounts. Conversely, countries with more exports than imports have a current account surplus, which is offset by purchases of foreign physical assets or debt instruments.

National Economic Accounts and Current Account Surplus or Deficit

Recall the fundamental relationship between government deficit, private saving over private investment, and trade surplus: (G-T) = (S-I) (X-M)

Rearranging the equation, we get: (X-M) = (T-G) + S – I

Current Account Surplus/Deficit = Government Savings + Private Savings – Private Investments

This relationship tells us that a current account deficit is the result of lower national savings than private investments. Two scenarios can lead to a current account deficit:

1. Low savings: High government spending and private consumption lead to borrowing from foreign countries to finance high consumption. This scenario may result in difficulties paying off the debt in the future.
2. High private investments: Adequate national savings, but borrowing from foreign countries is used to invest in domestic capital. This scenario is less concerning, as the investments may increase future productive power and eventually produce income to repay the debt.

Wrapping Up Balance of Payments

Phew! That certainly wasn’t one of the easier lessons. Don’t worry if you can’t fully understand balance of payments, as it’s rather isolated and shouldn’t affect most other parts of the CFA curriculum. We’ve covered the components of balance of payments, the double-entry system, and how trade deficits and surpluses relate to national economic accounts.