What the balance of payments records
Countries trade goods and services. Their people earn income abroad, send gifts home and buy assets in other countries. The balance of payments (BOP) is the accounting system that records all of these international transactions for one country over a stated period, such as a year or a quarter.
The BOP has two parts:
- the current account (CA), which records trade in goods and services, income and one-way transfers;
- the capital and financial account (CFA), which records purchases and sales of assets between countries and transfers of financial capital.
Every entry is either a credit or a debit:
- A credit (+) is any transaction that makes money flow into the country. Example: a foreign family pays for a holiday in your country.
- A debit (−) is any transaction that makes money flow out of the country. Example: your country’s firms pay for imported fuel.
A good test: ask “Who pays whom?” If a foreigner pays someone in your country, it is a credit. If someone in your country pays a foreigner, it is a debit.
The current account (CA)
The current account has three parts.
- Net exports (the balance of trade) = exports of goods and services − imports of goods and services. This is the same net exports (X − M) you met in GDP. If exports are bigger than imports, there is a trade surplus; if imports are bigger, there is a trade deficit. Some news reports quote a “trade balance” for goods only; in this course the balance of trade covers goods and services.
- Net income from abroad = income your residents earn from abroad − income foreigners earn in your country. It includes interest, dividends and profits on assets owned in other countries, and wages of workers who earn in one country while living in another.
- Net unilateral transfers = one-way payments received from abroad − one-way payments sent abroad. “Unilateral” means nothing is given back in return. Examples: money that migrant workers send home to their families (remittances), foreign aid and gifts.
CA = net exports + net income from abroad + net unilateral transfers
The current account does not have to balance. A positive total is a current account surplus; a negative total is a current account deficit. The balance of trade can be in surplus or deficit too, and it can have a different sign from the CA as a whole.
The capital and financial account (CFA)
The capital and financial account records purchases and sales of assets between countries and transfers of financial capital. The assets include:
- real assets, such as factories, firms, land and buildings (when a firm builds or buys a factory abroad, this is called foreign direct investment);
- financial assets, such as shares, government and company bonds, loans and bank deposits.
Two flows matter:
- Foreigners buy assets in your country (or lend to you). Money flows in, so it is a credit. This is a financial capital inflow.
- Your residents buy assets abroad (or lend abroad). Money flows out, so it is a debit. This is a financial capital outflow.
CFA = foreign purchases of domestic assets − domestic purchases of foreign assets
Like the CA, the CFA does not have to balance. A CFA surplus means a net financial capital inflow: foreigners bought more of your assets than you bought of theirs. A CFA deficit means a net financial capital outflow.
Watch the direction. When your residents buy a foreign asset, you gain an asset but money leaves the country, so it is a debit. Many students get this backwards because “gaining something” sounds like a plus.
A note on names: some textbooks and statistics offices split this account into a small “capital account” and a larger “financial account”. This course combines them into one CFA. When a central bank buys or sells foreign currency or foreign bonds, that is also a purchase or sale of assets between countries, so here it belongs in the CFA.
Why CA + CFA = 0
Every international transaction has two sides: something is bought, and it is paid for. The BOP records both sides, so the total of all credits equals the total of all debits:
BOP = CA + CFA = 0
The intuition is simple. Suppose Valdoria buys more goods, services and income from the rest of the world than it earns from them (a CA deficit). It still has to pay for the difference. It can only do that by selling assets to foreigners or borrowing from them, which is a CFA surplus of exactly the same size. In the other direction, a country with a CA surplus earns more foreign money than it spends on current items, and it uses the extra to buy assets abroad: a CFA deficit.
So:
- CA deficit ⟺ CFA surplus (net financial capital inflow), of equal size;
- CA surplus ⟺ CFA deficit (net financial capital outflow), of equal size.
In real published statistics the recorded credits and debits never match exactly, because some transactions are missed or measured with error, so statisticians add a balancing item. In this course you can assume the accounts are complete, so CA + CFA = 0 exactly.
Our fictional economies: Valdoria and Kestria
Valdoria is the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD). Kestria is its fictional trading partner; its currency is the kesta (KS). All figures below are fictional and in billions of valdas (VD bn).
Worked example 1: calculating the CA, the CFA and the BOP
Question. Use Valdoria’s international transactions for one year to calculate (a) the balance of trade, (b) net income from abroad and net unilateral transfers, (c) the current account balance, (d) the capital and financial account balance, and (e) check the BOP.
| Transaction | VD bn |
|---|---|
| Exports of goods | 180 |
| Exports of services | 60 |
| Imports of goods | 230 |
| Imports of services | 40 |
| Interest, dividends and wages received from abroad | 25 |
| Interest, dividends and wages paid to foreigners | 35 |
| Remittances received from Valdorians working abroad | 18 |
| Foreign aid given by Valdoria’s government | 6 |
| Foreign purchases of Valdorian assets | 75 |
| Valdorian purchases of foreign assets | 47 |
(a) Balance of trade. Exports = 180 + 60 = 240. Imports = 230 + 40 = 270. Net exports = 240 − 270 = −30: a trade deficit of VD 30 bn.
(b) Other current account items. Net income from abroad = 25 − 35 = −10. Net unilateral transfers = 18 − 6 = +12.
(c) Current account. CA = −30 + (−10) + 12 = −28: a current account deficit of VD 28 bn.
(d) Capital and financial account. CFA = 75 − 47 = +28: a CFA surplus, that is, a net financial capital inflow of VD 28 bn.
(e) BOP. CA + CFA = −28 + 28 = 0. ✓
Check by credits and debits. Credits (money in) = 180 + 60 + 25 + 18 + 75 = 358. Debits (money out) = 230 + 40 + 35 + 6 + 47 = 358. They match.
Interpretation. Valdoria spent VD 28 bn more on imports, income payments and transfers than it earned from the rest of the world. It paid for that gap because foreigners bought, on balance, VD 28 bn of Valdorian assets.
Worked example 2: classifying transactions
Question. For each transaction, state the account (CA or CFA), whether it is a credit or a debit for Valdoria, and which part of the account it belongs to.
| Transaction | Account | Credit or debit | Part |
|---|---|---|---|
| (i) A Kestrian school buys textbooks from a Valdorian publisher. | CA | Credit | Exports (goods) |
| (ii) A Valdorian family pays for a holiday in Kestria. | CA | Debit | Imports (services) |
| (iii) A Kestrian bank pays interest to Valdorians who hold its bonds. | CA | Credit | Net income from abroad |
| (iv) A Kestrian nurse working in Valdoria sends part of her pay to her parents in Kestria. | CA | Debit | Net unilateral transfers |
| (v) A Valdorian pension fund buys shares in a Kestrian company. | CFA | Debit | Valdorian purchases of foreign assets (outflow) |
| (vi) A Kestrian firm buys a hotel in Valdoria. | CFA | Credit | Foreign purchases of Valdorian assets (inflow) |
Reasoning, using “Who pays whom?”
- In (i) a foreigner pays a Valdorian, so money flows in: credit. Textbooks are goods, so this is an export.
- In (ii) a Valdorian pays a foreigner: debit. A holiday is a service bought from abroad, so this is an import, even though nothing is shipped into Valdoria.
- In (iii) the bond purchase happened earlier and was a CFA entry. The interest it now earns is income, so it goes in the CA.
- In (iv) the nurse’s pay is earned in Valdoria; the gift to her parents is a one-way payment out of Valdoria: a debit transfer.
- In (v) the pension fund gains an asset, but money leaves Valdoria: debit.
- In (vi) money comes into Valdoria to pay for the hotel: credit.
Check. The bonds in (iii) and the shares in (v) show the most common trap. Buying or selling the asset itself goes in the CFA. The income the asset later pays (interest, dividends) goes in the CA.
Worked example 3: how a change in one account shows up in the other
Question. Start from the year in worked example 1 (CA = −28, CFA = +28). Explain the effect on Valdoria’s CA and CFA of each change, considered separately.
(a) Kestrian tourists spend an extra VD 8 bn in Valdorian hotels. The hotels keep the kestas they receive in accounts at Kestrian banks. (b) A Kestrian carmaker buys a Valdorian factory for VD 12 bn. The Valdorian seller uses the kestas to buy machinery from Kestria.
(a) Tourist spending is an export of services: a CA credit of 8, so the CA moves towards surplus, from −28 to −20. The hotels now hold more deposits in Kestrian banks. A deposit abroad is a foreign asset, so this is a Valdorian purchase of a foreign asset: a CFA debit of 8. The CFA falls from +28 to +20. Check: −20 + 20 = 0.
(b) The factory sale is a foreign purchase of a Valdorian asset: a CFA credit of 12, so the CFA rises from +28 to +40. The machinery is an import of goods: a CA debit of 12, so the CA falls from −28 to −40. Check: −40 + 40 = 0.
What to take from this. A change that moves one account towards surplus moves the other towards deficit by the same amount. If an exam question tells you only one side, the other side follows from CA + CFA = 0.
Common misconceptions
- “The balance of trade and the current account are the same.” Net exports are only one of the three parts of the CA.
- “Buying a foreign asset is a credit because we gain something.” Money flows out, so it is a debit in the CFA.
- “A CFA surplus means the country is lending to the world.” It means the opposite: foreigners are buying more of the country’s assets (or lending to it) than it is buying abroad. That is a net inflow of financial capital.
- “Interest and dividends go in the CFA.” Buying the asset is a CFA entry; the income it pays is a CA entry (net income from abroad).
- “Remittances are exports.” Nothing is sold in return, so they are unilateral transfers.
- “The BOP balances, so every account balances.” Only the total is zero. The CA and the CFA can each be in surplus or deficit, with opposite signs.
- “A current account deficit means the country is losing money and must be in trouble.” It means the country is paying for extra imports or income by selling assets or borrowing. Whether that is a problem depends on what the inflows pay for; it is not automatically bad.
- Forgetting signs. Write every balance as + (surplus) or − (deficit) and add the signed numbers.
Where this leads
International transactions need foreign currency: Kestrians need valdas to buy Valdorian goods and assets, and Valdorians need kestas to buy Kestrian ones. Topic 6.2 starts that story with exchange rates, and later topics link changes in exchange rates and interest rates back to the CA and the CFA. If this topic connected to the policy debates in Unit 5, you can look back at Topic 5.7, Public Policy and Economic Growth. Try the practice questions now, then use the revision notes and the checklist to consolidate.
Quick questions
Is the balance of trade the same as the current account?
No. The balance of trade is net exports of goods and services. It is one part of the current account, which also includes net income from abroad and net unilateral transfers.
If the BOP always balances, how can a country have a 'deficit'?
The BOP as a whole sums to zero, but each account can be in surplus or deficit. A country can run a current account deficit, as long as it has a capital and financial account surplus of the same size.