The Balance of Payments shows a countries transactions with the rest of the world. It notes inflows and outflows of money and categorises them into different sections. The two sections of the Balance of Payments are:
- Current Account. – Trade in goods/services/investment incomes/transfers)
- Financial (Capital) account. – Foreign direct investment, capital flows, portfolio investment
Balance of payments equilibrium
In a floating exchange rate, the current account will mirror the financial account.
If there is a deficit on importing goods – there will be a surplus on the financial account.
Further reading – equilibrium in balance of payments
Current Account Balance of Payments
The current account measures:
- Net export-imports for goods (trade balance) – used to be called trade in visibles.
- Net export-imports of services – used to be trade in invisibles. Examples including paying for insurance, tourism.
- Investment incomes. For example, a UK firm that invested in Japan, if profit comes back to the UK, this counts as a credit on current account
- Transfers. For example, if the UK send money to the EU, this is a debit on the current account
The current account comprises the trade balance (which is trade in goods) and also includes the balance for trade in services.
When people refer to a balance of payments deficit they usually mean a current account deficit
Further reading – Current account balance of payments
Financial Account (Capital) Balance of Payments
The financial account measures inflows of capital both short term and long term. this includes
- Foreign direct investment
- Purchase of securities by investors
Further reading – financial/capital account
Balance of Payments Crisis
This occurs when the current account deficit cannot be maintained. It means there will be a fall in foreign exchange reserves as the country can no longer attract sufficient capital flows to finance the current account deficit.
The solution to a balance of payments crisis is usually to devalue the currency and slow down consumer spending on imports, usually by causing a recession.
Russia experienced a balance of payments crisis in 1998, leading to devaluation of Rouble.