Chapter 70: The structure of the balance of

payments (3.3)
Key concepts
The purpose of the balance of payments
Current account
Capital account
Balance of payments equilibrium
The meaning of the balance of paymentsOutline the role of the balance of payments
Distinguish between debit items and credit items in the balance of paymentsThe
components of the balance of payments accountsExplain the four components of the
current account, specifically the balance of trade in goods, the balance of trade in services,
income and current transfers
Distinguish between a current account deficit and a current account surplus
Explain the two components of the capital account, specifically capital transfers and
transaction in non-produced, non-financial assets
Explain the three main components of the financial account, specifically, direct
investment, portfolio investment and reserve assetsThe relationships between the
accountsExplain that the current account balance is equal to the sum of the capital
account and financial account balances
Examine how the current account and the financial account are interdependent
Intro questions:
If the visible trade balance is -15 and the sum of capital and financial accounts is 15, then
! tourist from Italy visitin" #han"hai $ill affect both countries% Bo&' ()plain ho$'
()plain ho$ outflo$s from financial account mi"ht mean future inflo$s in current account'
*o$ $ill the follo$in" events affect the +K Bo&
The , is considered undervalued'
The Bo( lo$ers r'
-elative infl in (uroland rises and tourism flo$s s$erve accordin"ly
+K raises profit ta)es
+K #-side policies increase efficiency in +K relative to trade partners
Bo( supports the , by .ore) operations
The +K "ovt offers a /one-off0 ta) reduction on +K-based 12Cs for repatriatin" incomes from abroad'
*34 The , depreciatesand the sum of &(5) plus &(5m is 67'86'
+K 5evelopment Ban9 lends ,: bn to ;hana'
;hanaian "ovt pays interest on the loan
! family from Ban"ladesh $or9in" in <orserchestshestershropshire sends money bac9 to the family in
Ban"ladesh'
The purpose of the balance of payments
2o, $ron" 3ed"er'
The =purpose% of the balance of payments is to account for all money flo$s to and from the forei"n sector
arisin" from the trade of "oods and services, investments and income thereof, and other currency flo$s
arisin" due to loans, deposits and currency speculation' It pinpoints a nation%s competitive stren"ths or
$ea9nesses in the international sector and is an indicator of both a nation%s economic solidity in the lon"
run and of the underlyin" stren"th of the currency' Basically, a country runnin" a solid current account
surplus must have increased its net forei"n assets and vice versa if there is a current account deficit' The
balance of payments also pinpoints $here the money is comin" from> $here it is going to> and why'
Current account
1
Moving on to a bit more depth, figure 70.1 below gives the balance of payments for Ireland in 2011. The
current account has been sub-divided into two main components:
The visible trade balance [3] comprised of merchandise exports [1] and imports [2]; and the invisible
trade balance [13] which in turn is comprised of net flows in services [6], income [9] and transfers [12].
Please note that the balance of payments is an end-of-game snapshot picture of total flows which have
1
I once a"ain have a debit in my personal current account to the Central #tatistics ?ffice of Ireland @An
Phromh-Oifig Staidrimh in IrishA' The balance of payments fi"ures for national income vary enormously
from country to country and can be immensely difficult to plou"h throu"h' I o$e 1ary Bour9e a fe$ pints
for ta9in" the time to help a confused e)patriate #$ede $ith the numbers'
Definition: alance of payments!
The balance of payments is a record of all in- and outflo$s of money in a country arisin" from
economic activity $ith forei"n countries durin" a "iven time period' The balance of payments
consists of the current account, capital account and financial account'
!ny inflo$ into current, capital and financial accounts are termed credit items' !ny outflo$s
are termed debit items'
Definition: Current account!
The current account sho$s all money flo$s to and from a country arisin" from exports and
imports of "oods and services, plus transfers of income @repatriated profits, interest and
dividendsA and other net transfers @$or9ers abroad sendin" money home, "overnment
=membership% fees to +2B(+, development aidA'
occurred during a time period, e.g. over the course of a year.
"i#ure 70.$ Irelan%&s balance of payments for '0$$
Current, Capital and Financial Account 2011 (millions EUROs)
Current account Capital account
m m
1 Exports of goods 85,258
1
5
Net capital
transactions (transfers
plus acquisition of non-
produced/non-fnancial
assets) -42
2 Imports of goods 8,8!2
Financial account
3 !isi"le trade "alance #$,#%
1
6 "et #$I %o&s '(,)!8

1
7 "et portfolio in*estment 28,'8!
4 Exports of ser*ices +),(8
1
8 "et ,t-er fnancial %o&s -.2,'(8
5 Imports of ser*ices 82,2)'
1
9 /eser*e assets .'

6
&alance o' trade in
ser(ices -#,20%
2
0
Financial Account
"alance %,#)

7
Income receipts from
a0road 5!,..
8 Income pa1ments a0road 88,5)+

2
1
2alancing item/stat3
discrepanc1 ("et errors
and omissions) -%,0)%
9
Net income 'rom
a"road
-
#2,1$#

1
0
4urrent transfers from
a0road ,).!
1
1
4urrent transfers paid
a0road 5,8.8

1
2
Net trans'ers 'rom
a"road -02

1
3
&alance on in(isi"les
(items 6, 9, 12)
-
#$,2%2

1
4
Current account
"alance
12% 2
2
Capital and *nancial
account "alance
-12%
(items '5 and 2( minus
2')
!+,+&-E .RA/E &A-ANCE
When an Irish good is sold to a foreigner, goods flow out and money flows in, while goods from abroad
sold in Ireland create money outflows. One calls an inflow a credit in current account and an outflow a
debit. (I will use credit and debit initially, so that you recognise the terms in other literature, but will
thereafter confine myself to the use of inflow and outflow.)
Exports: When my Irish friend Joe Collins in Tanzania gets homesick for Ireland and his wife goes down
to the local liquor store in Dar es Salaam for a bottle of Irish whisky, the effect is to credit (+) the Irish
current account in merchandise exports [1]. When the Collins family goes home to Ireland and visits his
fathers pub, there will also be a credit in Irish exports since Joe lives and earns money in Tanzania rather
than Ireland.
2

Imports: When Joes father, Michael, buys foreign beers for the pub in Ireland, there is a debit (-) in the
Irish current account in merchandise imports [2].
Adding up all the other millions of visible trade transactions with the foreign sector during 2011, i.e. the
sum total of exports [1] minus the sum total of imports [2] we get a visible trade balance [3] of 36,397
million. This is a (visible) trade surplus. Basically, the Irish have earned more from exports of goods than
they have spent on imported goods.
+N!+,+&-E .RA/E &A-ANCE
The same principles as in the examples in merchandise trade above hold true for trade in services and other
invisible (i.e. intangible) goods. The invisible trade balance is comprised of a variety of flows arising
when money passes a border for reasons other than for the payment of merchandise.
Tourism/services: Tourist services are exported whenever they are being bought by foreign
money, for example when Uwe from Germany stays at OLearys Bed and Breakfast in Adare or
when Hiroshi from Japan takes a boat trip in Dingle Bay to see Fungi the dolphin. Other services
are when Irelands Allied Irish Banks (AIB) sells financial services in New York, or when Ryan
Air sells flights to French people both will entail service export income for Ireland.
Flow of incomes generated abroad: Irish economic activity abroad will generate foreign earnings.
When these are repatriated (= brought home to the mother country)
3
the Irish current account is
credited.
o When Irish firms make a profit abroad and repatriate it, there is an inflow of money. A
foreign firm in Ireland repatriating profits is of course an outflow in current account.
o This is also the case when Irish savings abroad generate incomes which are repatriated,
2
In actual fact, Joe gets a rather good price on food and drink there.
C
I%ve al$ays $ondered if /repatriate to the mother country0 is a contradiction in terms'
Definition: Tra%e balance!
The sum of visible e)port revenue minus the sum of visible import e)penditure equals the
@visibleA trade balance' ! ne"ative value is called a trade deficit $hile a positive value is a
trade surplus'
such as dividends from foreign shares and interest payments on foreign bank accounts
and bills/bonds. Naturally, there will be outflows from Ireland as foreigners repatriate
incomes generated by their ownership of Irish capital.
The net sum of these outflows is shown by the net income paid abroad [9] of - 32,163
million.
Net transfers: Ireland will have a number of additional money flows which are recorded in the
current account.
o For example, if my friend Joe in Tanzania sends some of his income home to his parents
every month, this remittance is shown as an inflow in the invisibles section of the Irish
current account. Basically, Ireland has exported labour in the form of an IB math/physics
teacher. (See Applied economics below.)
o Other inflows to Ireland are farm subsidies from the EU and project grants from
various international organisations.
o Naturally Ireland will also have an outflow of transfers: government dues to the EU and
UN; grants to Irish students overseas; aid monies paid directly and indirectly to
recipient countries etc.
The net outflow of these transfers [12] was - 902 million in 2011.
CURREN. ACCOUN. &A-ANCE
The sum of the visible trade balance [3] of 36,397 plus the invisible trade balance [13] of -36,272 shows
the net in- and outflows of money to Ireland in current account during 2011. Ireland shows a net inflow
(credit) of 127 million during the year, in other words a current account surplus.
Capital account
:

The other side of the balance of payments shows what Ireland has done with the 127 million in the
current account surplus. The capital account is a rather small part of the balance of payments (about 0.6%
of overall net flows in this example) and consists of two parts:
Capital transfers; primarily government and non-government debt forgiveness and the transfer of
:
.or details on this rather tric9y subDect, see the I1. standardisation at
http4BB$$$'imf'or"Be)ternalBnpBstaBbopBB?&man'pdf
Definition: In(isible tra%e balance!
The net sum of the trade in invisibles, e'"' services, incomes and transfers, equals the invisible
trade balance'
Definition: Current account balance!
The sum of the visible and invisible trade balances equals the current account balance in the
balance of payments' ! positive value means there is a current account surplus $hile a
ne"ative value indicates a current account deficit'
assets due to immigration and emigration.
Acquisition or disposal of non-produced and non-financial assets; transfers of funds for the
purchasing or selling of land and the transfer of funds relating to royalties, patents and other forms
of intellectual property rights.
.inancial account
The financial account shows all other forms of money flows not arising due to trade, income and returns on
foreign assets. Broadly speaking, the financial account tallies (= counts) investment and savings flows
between the domestic economy and foreign countries. In the case with Ireland in 2011, there needs to be a
net outflow in capital + financial account to make up for the net inflow of 127 million in current account.
The cardinal rule here is that the sum of the current, capital and financial account is always zero!
Current account balance + capital account balance + financial account balance = zero!
A plus sign (credit or inflow) in the capital/financial account means that money has flowed into
your economy and that there has been a decrease in net foreign assets.
A minus sign (debit or outflow) in the capital/financial account therefore means that net foreign
assets have increased.
Recall that Ireland had a current account surplus of 127 million during 2011, i.e. a net inflow. The capital
and financial accounts show where that additional 127 million went to in effect, which assets the Irish
are buying abroad. It is important to realise that all the values given in the capital/financial accounts are net
values and that total in- and outflows over the course of 2011 were hundreds of times larger.
Net foreign direct investment (FDI): Investment abroad is either direct investment or indirect
investment.
5
An Irish company building a plant or buying an existing factory in Germany entails direct
investment. The positive value of 10,968 [16] here shows that more direct investment money is flowing in
to Ireland than abroad.
Net portfolio investment: If an Irish company/resident buys German shares, bills or bonds, one speaks of
portfolio investment abroad; if a German buys Irish shares there is an inflow (credit) in the Irish financial
account. The 28,186 billion net inflow from Ireland [17] means that Irish firms/residents have increased
their foreign holdings.
Net other financial flows: The Irish will deposit some of their savings in foreign banks; Irish banks will
lend money to foreigners; and Irish financial institutions will place short term monies abroad in order to
earn a higher rate of interest, or simply speculate that a certain currency will increase in value. These are
short term investments and the 7,389 million in net financial inflows [18] signifies a net decrease in short
term foreign assets for the Irish which is the same as an increase in short term liabilities to foreigners. In
other words, the net balance in financial inflows of +7,389 billion shows an increase in foreigners short
term holdings in Ireland.
5
The rule for Ireland bein" that if shares in a firm account for more than 17E of the total value of shares, it
is direct investment rather than indirect portfolio investment' #ee details at the Irish Central #tatistics
?ffice4 http4BB$$$'cso'ieBenBmediaBcsoieBreleasespublicationsBdocumentsBeconomyBF711BbopGq:F711'pdf
Definition: Capital an% financial accounts!
The capital and financial accounts are the mirror ima"e of the current account, sho$in" ho$
capital transfers flo$ to and from other countries' The capital account sho$s the chan"e in net
foreign assets of a country due to forei"n direct investment @.5IA, portfolio investment @shares,
bills, bondsA, currency flo$s, loans, and deposits' ! current account surplus means that there
must be a net outflo$ in capital H financial account, e'"' an increase in net forei"n assets'
Foreign reserves: All countries central banks hold an amount of foreign currencies and, traditionally,
gold. The positive value of 341 million [19] means rather confusingly that reserves at the Bank of
Ireland have fallen by this amount. Somewhat simplified, foreign reserves have been used to buy up
EUROs, shown in the balance of payments as an inflow (credit) in net foreign reserves. In any case, using a
positive value in the financial account to show a decrease in foreign reserves is in keeping with standard
bookkeeping procedures; a net inflow in capital/financial accounts means that domestic holdings of foreign
assets have fallen.
Balancing item: The millions of daily money transactions between Ireland and other countries is an almost
impossible task to precisely account for. There will be statistical errors, time lags in accounting, and a
number of money flows which simply will not show up due to tax/tariff avoidance, parallel markets and
illegal trade. Since the balance of payments must always balance, a balancing item or statistical
discrepancy (the bit missing) of -7,389 million [21] has been subtracted.
Balance of payments equilibrium
The Irish current account surplus of I1F8 means that Irish households and firms have increased
their net forei"n holdin"s by the same amount> the sum of the capital and financial accounts
sho$s a net outflo$ of -I1F8 to the forei"n sector'
I finish this chapter by giving a few schematic examples of balance of payments flows between two
countries. Lets look at the Irish and Australian economies which are now happily trading goods and
service instead of prisoners and colonial taxes.
6
Assuming that the two countries only trade with each other,
here is a selection of economic transactions taking place between the two economies during a few months
(using country-neutral dollars):
[1] A distiller in Ballyragget, Ireland, sells $2,500 worth of Top a The Mornin Whiskey to a pub in
Cootamundra, Australia.
[2] Goanna-Mick from Meekathurra, Australia, on vacation in County Mayo, Ireland, rents a cottage
overlooking lots of sheep in Ballyhaunis for a week at $2,000.
[3] Mary Bourke from Ballydehob, Ireland, tires of all the silly requests she gets working at the Central
Statistics Office and puts $6,000 into starting a subsidiary legal firm in Sydney, Australia.
[4] Bruce from Kingoonya, Australia, is prolonging adolescence at university in Galway (just west of
Ballinasloe), Ireland. He receives a $3,000 student grant from an unwitting municipal council back
home.
[5] Sean from Ballyroan, Ireland, buys shares in the Areyonga Shipyard for $3,500. (Sean really needs
to get a good map of Australia.)
[6] Alice from Three Springs, Australia, puts $6,500 into a bank account in Ballycanew, Ireland.
[7] Mrs Bourke in Ballydehob, Ireland (from [3] above), repatriates $500 in profits from her first
customer (an Irish descendant of the McGee Clan out on bail) in Sydney.
[8] Bush Tucker International Delicatessen in Bulgroo, Australia, sells $5,000 worth of sliced baby
koala and pickled platypus nibbles to the local Greenpeace chapter in Ballyconnell, Ireland.
These international flows of money between the two countries are shown in figure 70.3 where I have
6
Thousands of Irish troublemakers and convicts were evicted from Ireland and sent as forced colonisers to
Australia in the 19
th
century. This popular export commodity has resulted in tens of thousands of present-
day Irish descendants in Australia with names like my Australian editor; McAuliffe (which in fact reads,
son of Olaf, which means he is actually a Scandinavian descendant!).
simply left out the account as it really doesnt mean much. Following the flows, it is clear that any outflow
(debit) of money from Ireland leads to a corresponding inflow (credit) in Australia, and vice versa. Irish
exports of Whiskey and tourist services are inflows to the visible and invisible trade balances in the Irish
current account which are of course outflows in the Australian trade balances in the Australian current
account. Irish investment in Australia gives outflows of money in the Irish financial account and concurrent
inflows to the Australian financial account.
"i#ure 70.3 )a*e+belie(e balance of payments for Irelan% an% ,ustralia
Ireland has a current account surplus of $3,000 and thus a corresponding capital/financial account defici.
Once again, do not be confused by the negative value in the Irish capital/financial account! An outflow here
means that Ireland has increased its net foreign assets; Ireland has increased holdings in Australia more
than Australians have increased holdings in Ireland. Australia has a current account deficit, concomitantly.
The $3,000 worth of imports in excess of export revenue has apparently been funded by an inflow of
investment money from Ireland.
I5 6 47//E"8 644,7"8 $E#I4I8 26$ #,/ 6 4,7"8/9:
This is a good question and one which is vociferously (= loudly) debated amongst economists and in the
media. In simple terms the answer is no, not always. A more balanced answer is that since a current
account deficit means a capital/financial account surplus, it depends on why money is coming in on
capital/financial account and what the money is being used for.
It is when loans and speculative monies flow in on capital account to fuel consumption that harmful effects
will show, as the country would in effect be living beyond its means and would someday have to pay back
Irelan%&s balance of payments (-)
J1K @merchandise
e)portA . -'/000
,ustralia&s balance of payments (-)
J1K @merchandise
importA + -'/000
JFK @service e)portA
. -'/000
Current account Cap.1fin. account
JFK @service importA
+ -'/000
JCK @.5I abroadA
+ -2/000
JCK @.5I from
abroadA . -2/000
J:K @transfer inflo$A
. -3/000
J:K @transfer outflo$A
+ -3/000
J5K @portfolio
investment abroadA
+ -3/000
J5K @portfolio
investment from
abroadA . -3/000
JLK @deposit abroadA
+ -2/000
JLK @deposit from
abroadA . -2/000
J8K @repatriation of
profitA . -000
J8K @profits paid
abroadA + -000
Current account Cap.1fin. account
JMK @merchandise
e)portA . -0/000
JMK @merchandise
importA + -0/000
alance: . -3/000 alance: +-3000 alance: + -3/000 alance: .-3000
@-ory4 $e had a neat fla" above each account' !lso, could you 9eep the arro$s colour
coordinated$hatever coloursNA
loans.
7
There are also long run considerations. For example, if foreign companies start pulling out of a
country say, US firms start shutting down in Ireland due to severe recession in the countries where the
FDI is coming from then there could be serious repercussions for the Irish economy. This is exactly what
happened as we shall see in Chapter 72.
8
It%s a bit li9e a household borro$in" money' If the money "oes to rebuildin" the porch and repairin" the roof, then the
house $ill be $orth more in the future, e'"' there is a return on the spendin"' *ence, there is no harm in borro$in"
money' If, ho$ever, the borro$ed money "oes to pay for Christmas presents "o fi"ure'
3ummary an% re(ision
The balance of payments is a record of all in- and outflo$s of money in an economy durin" a
period of time @one yearA arisin" due to economic transactions and financial dealin"s $ith other
economies'
The balance of payments consists of the current, capital and financial account
The balance of payments must al4ays balance, e'"' current account O capital account H financial
account' The sum of the three accounts must equal Pero'
Current account is commonly divided into a visible trade balance @e)port revenue minus import
e)penditureA and an invisible trade balance @net balances of trade in services, net income from
abroad and net transfers from abroadA'
Capital account consists of capital transfers @such as "overnment debt for"iveness and assets
transferred by immi"rationBemi"rationA and acquisition of non-produced and non-financial assets
@land o$nership and intellectual property ri"htsA'
The financial account sho$s the chan"e in net forei"n assetsBliabilities' It consists of the balances of
FD @net chan"e in physical capital such as factories and shopsA, portfolio investment @shares, bills
and bondsA, financial flo$s @such as currency speculation and ban9 depositsA and the foreign
reserves @forei"n currencies, "old and deposits $ith the I1. held by the central ban9A'
The balancin# item @or statistical discrepancyA is a post that is inserted to ensure that the accounts
balance' It is a measure of accountin" uncertainty and error'
! ne#ati(e balance on capital an% financial account means that there is a current account surplus
and vice versa'