Intro: The key point to note about the balance of payments is that they always balance. Whenever a country runs a current account deficit it does so by accumulating financial liabilities, or drawing down its own assets. When a country runs a current account surplus, it accumulates overseas assets or pays down its own liabilities.
The balance of payments is broken down into the current account balance and the financial and capital account balance (usually just referred to as the financial account). The former pertains to flows that reflect money that a country earns (or spends), while the latter pertains to money that a country lends (or borrow). Flows are usually measured in dollars but the money could be in any currency.
The current account balance contains four sections:
The Trade Balance: Goods exports minus imports
The Services Balance: Services exports minus imports.
The Income Balance: Earnings on overseas investment assets (dividends, interest payments, and royalties), minus payments on overseas liabilities.
The Transfers Balance: Receipts of remittances and government grants minus payments of remittances and government grants.
The financial account balance contains five sections:
FDI: The balance of foreign direct investment inflows and outflows.
Portfolio: The balance of financial investment flows into stocks and bonds.
Other: The balance of loans and trade credits.
Derivatives: The balance of derivative books used by banks for hedging purposes.
Reserves: Flows of international reserves used largely for currency stabilisation.
The balance of payments can never be positive or negative. It is always 100% balanced. Whenever a country runs a current account surplus, say because it exports more than it imports, it must also run an equal and offsetting financial account deficit reflecting the fact that the dollars it receives have been invested in some form or another.
Likewise, any country that runs a current account deficit, spending more money than it is bringing in, can only do so by drawing down its stock of external savings or increasing external indebtedness. Either way, this is reflected in a surplus in the financial account as dollars are flowing into the country. A country’s currency acts as a fulcrum shifting to align inflows with outflows.
Of course, the businesses and consumers who received the inflows from a current account surplus could spend those dollars on imports, but in that case, imports would rise and the current account surplus would close again. The recipients of the dollar could also just leave them in their current form in cash or in the bank, rather than investing the money overseas. This would still represent an outflow in the financial account. Indeed, the money does not have to go anywhere. The balance of payments is not about the location of the money, but about ownership.
The Role of Reserves
Sometimes the reserves category of the financial account can be calculated as a separate account. This is often the case in emerging markets where reserves are constantly used to counteract exchange rate fluctuations. Reserve inflows reflect the deliberate action by a country’s central bank to create money and use it to buy dollars as a form of protection against future exchange rate depreciation. Conversely, a reduction in reserves reflects the central bank selling reserves in exchange for buying local currency to prevent or cushion exchange rate depreciation. The balance of payments is not something that should be thought of in isolation from the rest of the economy. It is a function of broader economic conditions and relates directly to the balance of savings relative to investment .