Chapter 3

The Balance of Payments

Abstract

In general, the balance of payments records a country’s trade in goods, services, and financial assets with the rest of the world. Such trade is divided into useful categories that provide summaries of a nation’s trade. A distinction is made between private (individuals and business firms) and official (government) transactions. This chapter shows that the balance of payments is based on double-entry bookkeeping, providing examples of entries made as credits and debits. The current account is defined as including the value of trade in merchandise, services, primary income, and secondary income. The chapter examines the recent history of US international capital flows, looking at direct investment, security purchases, bank claims and liabilities, foreign official assets in the United States, and US government assets abroad. In order to provide better understanding of transaction classification, the chapter analyzes six transactions and their placement in a simplified US balance of payments. Finally, the chapter considers balance of payments equilibrium and in particular the US foreign debt.

Keywords

Balance of payments; balance of payments equilibrium; balance of trade; current account; fixed exchange rate; foreign debt; official settlements balance; special drawing rights

We have all heard of the balance of payments. Unfortunately, common usage does not allow us to discuss the balance of payments because there are several ways to measure the balance, and the press often blurs the distinctions among these various measures. In general, the balance of payments records a country’s trade in goods, services, and financial assets with the rest of the world. Such trade is divided into useful categories that provide summaries of a nation’s trade.

In June 2014, the US Bureau of Economic Analysis released comprehensively restructured international economic accounts. The restructuring was done to closer align with the latest revision of the International Monetary Fund’s (IMF) Balance of Payments and International Investment Position Manual, 6th edition. Most countries in the world have followed the IMF update, resulting in international economic accounting that is almost identical across countries. Therefore the following discussion applies equally to the United States as well as other countries. Fig. 3.1 presents the general categories of the balance of payments for the United States. This figure uses the general categories to make it easier to identify the popular summary measures of the balance of payments. Table 3A in the appendix presents the detailed balance of payments for a country, in this case for Brazil. Because most countries follow the IMF directive for balance of payments, the particular country does not matter. In this chapter we will discuss several summary measures of the balance of payments, pointing out their uses as well as their drawbacks.

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Figure 3.1 US international transactions in billions of dollars.
Note that the capital account has been removed to simplify the table. The capital account balance is negligible. Bureau of Economic Analysis, International Transactions, March 17, 2016.

Table 3A

Detailed international transactions for Brazil (US dollar millions)

 2015
AugSepOct
Current account2,6063,0664,166
 Balance on goods and services−264−273−920
  Balance on goods2,3622,6411,879
  Services−2,626−2,914−2,799
   Manufacturing services on physical inputs owned by others−00−0
   Maintenance and repair services n.i.e.72323
   Transport−346−398−435
   Travel−827−774−549
    Business−110−93−52
    Personal−717−681−497
     Health-related00−0
     Education-related−70−69−47
     Other, including tourism−648−612−449
   Construction692
   Insurance and pension services−78−38−13
   Financial services−2123−8
   Charges for the use of intellectual property n.i.e.−425−488−281
   Telecommunications, computer, and information services−172−151−177
   Operating leasing services−1,380−1,696−1,971
   Other business services, including architecture and engineering728681761
   Personal, cultural, and recreational services−32−25−29
   Government goods and services n.i.e.−86−81−122
 Primary income−2,570−3,000−3,523
  Compensation of employees263023
  Investment income−2,596−3,030−3,546
  Other primary income
 Secondary income228207277
  General government12−25−37
  Financial corporations, nonfinancial corporations, households, and NPISHs216232314
Capital account643013
Financial account: Net lending (+)/net borrowing (−)2,1782,6463,581
 Direct investment−4,942−7,267−6,713
  Net acquisition of financial assets308−1,231−0
  Net incurrence of liabilities5,2506,0376,712
 Portfolio investment1,5091,8683,502
  Net acquisition of financial assets−8168369
  Net incurrence of liabilities−1,590−1,800−3,133
 Financial derivatives (other than reserves) and employee stock options397403−386
  Net acquisition of financial assets−1,861−2,707−1,832
  Net incurrence of liabilities−2,258−3,111−1,446
 Other investment4558 903335
  Net acquisition of financial assets3,73511,1482,616
  Net incurrence of liabilities3,2802,2452,281
  Other equity
  Currency and deposits1,2119,579−1,539
  Loans−1,544−436165
  Insurance, pension, and standardized guarantee schemes−4−5−7
  Trade credit and advances868−1771,719
  Other accounts receivable/payable−76−58−3
  Special drawing rights (Net incurrence of liabilities)
 Reserve assets403−6,553−318
  Monetary gold
  Special drawing rights−0−00
  Reserve position in the IMF65−144−0
  Other reserve assets338−6,409−319
Net errors and omissions364391572

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Source: Banco Central Do Brazil, December 2015, authors’ calculation.

The balance of payments is an accounting statement based on double-entry bookkeeping. Every transaction is entered on both sides of the balance sheet, as a credit and as a debit. Credit entries are those entries that will bring foreign exchange into the country, whereas debit entries record items that would mean a loss of foreign exchange. In Fig. 3.1, debit entries enter the balance of payments as a negative value. For instance, suppose we record the sale of a machine from a US manufacturer to a French importer and the manufacturer allows the buyer 90 days credit to pay. The machinery export is recorded as a credit in the merchandise account, whereas the credit extended to the foreigner is a debit to the financial account. Thus, credit extended belongs in the same broad account with stocks, bonds, and other financial instruments of a short-term nature.

If, for any particular account, the value of the credit entries exceeds the debits, we say that a surplus exists. On the other hand, where the debits exceed the credits, then a deficit exists. Note that a surplus or deficit can apply only to a particular area of the balance of payments, since the sum of the credits and debits on all accounts will always be equal; in other words, the balance of payments always balances. This will become apparent in the following discussion. Let us consider some of the popular summary measures of the balance of payments.

Current Account

The current account deals primarily with trade in goods and services, and is defined as including the value of trade in merchandise, services, primary income, and secondary income. Merchandise is the export and import in tangible commodities. The services category refers to trade in the services of factors of production: land, labor, and capital. Included in this category are travel, tourism, royalties, transportation costs, and insurance premiums. The primary income account (formerly known as investment income) reflects investment income and compensation to employees. The payment for the services of capital, or the return on investments, is recorded as investment income. The amounts of interest and dividends paid internationally are large and are growing rapidly as the world financial markets become more integrated. The final component of the current account is labeled secondary income (formerly known as unilateral transfers). This category includes items that are transferred in one direction, e.g., US foreign aid, gifts, and retirement pensions. The United States usually records a large deficit on these items.

Summing up the debits and credits shows the balance on a subsection of the international transactions. The balance of payments entries in Fig. 3.1 actually end at line 29. Lines 30–35 are summaries drawn from lines 1 to 28. The summaries come from drawing lines in the balance of payments at different places. A line is drawn in the balance of payments schedule and then the debit and credit items above such a line are summed. For example, if we draw a line at the current account balance items ending with secondary income (line 16) and sum all credit and debit entries above, this would give us the current account surplus/deficit. A current account deficit implies that a country is running a net surplus below the line and that the country is a net borrower from the rest of the world.

Returning to Fig. 3.1, line 30 shows that there was a current account surplus of $2.3 billion in 1970 and a deficit of $484.1 billion in 2015. The $484.1 billion current account deficit of 2015 is the sum of a $759.3 billion merchandise trade deficit, a $219.6 billion services surplus, a $191.3 billion primary income surplus, and a $135.6 billion secondary income deficit. In 1970, the United States ran a merchandise trade surplus of $2.6 billion. Following a $2 billion deficit in 1971, the merchandise account has been in deficit every year since, except 1973 and 1975.

Fig. 3.2 illustrates how the current account has changed over time. The current account is shown as a fraction of GDP, to control for inflation and the growth of the US economy over the time period. The current account deficit growth of the 1980s was unprecedented at the time, but has since been dwarfed by the deficits of recent years. The current account deficit peaked in 2005–2006 with the current account fraction of GDP exceeding 6%, and has settled at 2.5–3.0% in recent years.

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Figure 3.2 Current account as a fraction of GDP. Federal Reserve of St. Louis FRED 2 database, authors’ calculation.

The current account excludes financial account transactions—purchases and sales of financial assets. Since the items below the line of the current account must be equal in value (but opposite in sign) to the current account balance, we can see how the current account balance indicates financial activity (below the line) as well as the value of trade in merchandise, services, primary and secondary income that are recorded above the line. In a period (year or quarter) during which a current account deficit is recorded, the country must borrow from abroad an amount sufficient to finance the deficit.

Since the balance of payments always balances, the massive current account deficits of recent years are matched by massive financial account surpluses. This means that foreign investment in US assets, such as securities, has been at very high levels. Some analysts have expressed concern over the growing foreign indebtedness of the United States. The end of the chapter reviews the issue.

FAQ: How big is the US current account deficit compared to other countries?

The US current account deficit is the largest in the world in absolute size. However, the dollar amount of the current account deficit can be deceiving, because the United States is the largest economy in the world. A better comparison is to compare the size of the current account deficit/surplus to a country’s GDP. By doing this we put the deficit in comparable terms across countries. The following figure shows the current account deficit/surplus for selected countries in 2015. The figure shows that the United States does not have the largest current account deficit as a fraction of GDP. The United Kingdom has one of the largest current account deficits with a 5.2% of GDP. That is almost twice the US current account deficit. In contrast, some other European countries have very large current account surpluses. The Netherlands and Germany have gigantic surpluses due to the weak Euro, and Norway and Sweden also have large surpluses. Note that China has a much more reasonable surplus at 2.7%.

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Data are for 2015 from the IMF and Eurostat as compiled by Tradingeconomics.com, April 30, 2016.

Financing the Current Account

The offsetting financial account is named the Financial Account (formerly called Capital Account).1 Large current account deficits imply large financial account surpluses. The financial account transactions are recorded below the current account items in the balance of payments. Referring back to Fig. 3.1, lines 19–28 record financial account transactions. We see that financial account transactions include both official and private transactions.

For ease of understanding, Table 3.1 provides a summary of US financial account transactions from 2003 to 2015. In this table, the debit and credit items are entered separately so that we can identify the sources of changes in net financial flows (financial inflows less financial outflows). For instance, in 2015 we see that US private portfolio investment purchases abroad totaled $186.3 billion. This is a financial account debit entry because it involves foreign exchange leaving the United States. Note that this corresponds to the line 21 in Fig. 3.1. Table 3.1 indicates that private portfolio investment purchases in the United States by foreigners totaled $493.7 billion in 2015. This is a credit item in the financial account since it brings foreign exchange to the United States. Note that this is different from line 26 in Fig. 3.1, because the liabilities in the financial account include both private and official liabilities. In Table 3.1 the private and official liabilities have been separated.

Table 3.1

US financial account transactions (flows, in billions of dollars)

Year Direct Investment Portfolio Investment Other Investment Reserve Foreign Official
Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities
2003 197.2 111.3 133.1 301.1 44.3 215.4 −1.5 278.1
2004 378.1 207.9 192.0 496.5 495.5 493.0 −2.8 397.8
2005 61.9 138.3 267.3 597.2 257.2 278.2 −14.1 259.3
2006 296.1 294.3 493.4 682.7 549.8 651.3 −2.4 487.9
2007 532.9 340.1 380.8 714.7 658.6 647.7 0.1 481.0
2008 351.7 332.7 −284.3 −53.2 −381.8 −380.1 4.8 554.6
2009 313.7 153.8 375.9 −95.5 −609.7 −220.2 52.3 480.2
2010 354.6 259.3 199.6 424.7 407.4 305.1 1.8 397.2
2011 440.4 257.4 85.4 117.7 −45.3 358.6 15.9 243.3
2012 377.9 232.0 238.8 358.0 −453.7 −371.3 4.5 397.1
2013 399.2 287.2 476.2 254.4 −228.4 191.0 −3.1 309.5
2014 357.2 131.8 538.1 613.7 −99.5 131.5 −3.6 100.4
2015 345.1 409.9 186.3 493.7 −282.9 −367.6 −6.3 −109.9

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Source: BEA, March 17, 2016 release, Tables 1.1 and 9.1; authors’ calculation.

Before interpreting the recent history of US international financial flows, we will consider the definitions of each of the individual financial account items.

ent Direct investment: Private financial transactions that result in the ownership of 10% or more of a business firm.

ent Portfolio investment: Private sector net purchases of equity (stock) and debt securities.

ent Other investment: Currency, deposits, loans, insurance technical reserves, trade credit, and advances.

ent Reserve assets: Changes in US official reserve assets (gold, SDRs, foreign currency holdings, and reserve position in the IMF).

ent Foreign official liabilities: Net purchases of US government securities, obligations of US government corporations and agencies, securities of US state and local governments, and changes in liabilities to foreign official agencies reported by US banks.

Some financial account transactions are a direct result of trade in merchandise and services. For instance, many goods are sold using trade credit. The exporter allows the importer a period of time—typically 30, 60, or 90 days—before payment is due. This sort of financing will generally be reflected in other investment assets, because such transactions are handled by the exporter’s bank. Portfolio management by international investors would result in changes to the portfolio investment account. Official transactions involve governments and are motivated by a host of economic and political considerations.

The recent financial account transactions are very interesting from an economic viewpoint. In general, one can see that globalization is evident in the sharp increases in the overall size of the transactions. In most years the US direct investment abroad has exceeded the direct investment by foreigners in the United States. Note also that even throughout the recent banking crisis, the direct investment continued. However, the portfolio investment account tells a different story. In the 2000s, the foreign purchases of US securities have far outweighed the US purchases of foreign securities. In 2008 during the “Great Recession” the portfolio investment turned negative for both US residents and foreign residents. Fortunately it has since recovered. Similarly, the foreign official purchases of US assets far outpace the US government’s purchases of foreign assets. Thus, foreign central banks are increasing their holdings of US assets at a rapid pace.

Table 3.1 also provides an interesting account of the US financial crisis in 2008. Before the crisis one can see substantial purchases of US securities, both by foreign central banks and by private citizens. Note that in 2005–2007 private purchases of US liabilities averaged around $660 billion dollars, and approximately an additional $400 billion was purchased annually by official sources. Thus, over a trillion dollars was added to the US economy annually from 2005 to 2007, providing ample supply of investment capital in the United States. In 2008 this source of funds completely disappeared from foreign private sources, with only official purchases remaining. However, US purchases abroad also became negative, indicating that US investors sold foreign securities to bring home almost $300 billion in liquidity. Similarly, both US and foreign international investors sold other investment assets, with both entries taking on substantial negative values. The negative values in other investment assets continued through 2015, implying that banking assets were still sensitive a long time after the 2008 crash. Note also that direct investment stayed steady throughout and after the Great Recession of 2008. Thus, the volatility from year to year in the financial accounts comes primarily from other investment assets and liabilities.

Additional Summary Measures

So far we have focused primarily on the current account of the balance of payments. In terms of practical importance to economists, government policymakers, and business firms, this emphasis on the current account is warranted. However, there are other summary measures of balance of payments phenomena. Within the current account categories, the balance on merchandise trade is often cited in the popular press (because it is reported on a monthly basis by the United States). The balance of trade (line 3 less line 11 in Fig. 3.1) records a surplus when merchandise exports exceed imports. Domestic business firms and labor unions often use the balance of trade to justify a need to protect the domestic market from foreign competition. When a country is running a large balance of trade deficit, local industries that are being hurt by import competition will argue that the trade balance reflects the harm done to the economy. Because of the political sensitivity of the balance of trade, it is a popularly cited measure.

The official settlements balance measures changes in financial assets held by foreign monetary agencies and official reserve asset transactions. The official settlements balance serves as a measure of potential foreign exchange pressure on the dollar, in that official institutions may not want to hold increasing stocks of dollars but would rather sell them, which would drive down the foreign exchange value of the dollar. Yet if there is a demand for the dollar, official stocks of dollars may build without any foreign exchange pressure. Furthermore, in the modern world it is not always clear whether official holdings are what they seem to be, since (as we will see in a later chapter) the Eurodollar market allows central banks to turn official claims against the United States into private claims. Still, monetary economists have found the official settlements account to be useful because changes in international reserves are one element on which the nation’s money supply depends.

Because it is hard to distinguish official and private liabilities, the Bureau of Economic Analysis only reports the combination in Fig. 3.1. In Table 3.1 the foreign official liabilities have been calculated so that an official settlements balance can be computed. The official settlements balance in Table 3.1 is the difference between the last two columns. In the 2000s and 2010s the official settlements balance has been substantially negative, but the foreign official liabilities have been reduced in 2014 and even turned negative in 2015, as the dollar strengthened.

The foreign monetary agency holdings of the liabilities of most countries are trivial, so that the official settlements balance essentially measures international reserve changes. In the case of the United States, the official settlements balance primarily records changes in short-term US liabilities held by foreign monetary agencies. This demand for dollar-denominated short-term debt by foreign central banks is what allows the United States to finance current account deficits largely with dollars. Other countries must finance deficits by selling foreign currency, and, as a result, they face a greater constraint on their ability to run deficits as they eventually deplete their stocks of foreign currency.

Transactions Classifications

So far we have defined the important summary measures of the balance of payments and have developed an understanding of the various categories included in a nation’s international transactions. The actual classification of transactions is often confusing to those first considering such issues. To aid in understanding these classification problems, we will analyze six transactions and their placement in a simplified US balance of payments.

First, we must remember that the balance of payments is a balance sheet, so, at the bottom line, total credits equal total debits. This means that we use double-entry bookkeeping—every item involves two entries, a credit and a debit, to the balance sheet. The credits record items leading to inflows of payments. Such items are associated with a greater demand for domestic currency or supply of foreign currency to the foreign exchange market. The debits record items that lead to payments outflows. These are associated with a greater supply of domestic currency or demand for foreign currency in the foreign exchange market. Now consider the following six hypothetical transactions and their corresponding entries in Table 3.2.

1. A US bank makes a loan of $1 million to a Romanian food processor. The loan is funded by creating a $1 million deposit for the Romanian firm in the US bank. The loan represents a private financial outflow and is recorded as a debit to private financial. The new deposit is recorded as a credit to the private financial account, since an increase in foreign-owned bank deposits in US banks is treated as a financial inflow.

2. A US firm sells $1 million worth of wheat to the Romanian firm. The wheat is paid for with the bank account created in (1). The wheat export represents a merchandise export of $1 million, and thus we credit merchandise $1 million. Payment using the deposit results in the decrease of foreign-owned deposits in US banks; this is treated as a financial outflow, leading to a $1 million debit to the private financial account.

3. A US resident receives $10,000 in interest from German bonds she owns. The $10,000 is deposited in a German bank. Earnings on international foreign investments represent a credit to the primary income account. The increase in US-owned foreign bank deposits is considered a financial outflow and is recorded by debiting the private financial account in the amount of $10,000.

4. A US tourist travels to Europe and spends the $10,000 German deposit. Tourist spending is recorded in the services account. The US tourist spending abroad is recorded as a $10,000 debit to the services account. The decrease in US-owned foreign deposits is considered a private financial inflow and is recorded by a $10,000 credit to the private financial account.

5. The US government gives $100,000 worth of grain to Nicaragua. The grain export is recorded as a $100,000 credit to the merchandise account. Since the grain was a gift, the balancing entry is secondary income; in this case, there is a debit of $100,000 to secondary income.

6. The Treasury Department of the government of Japan buys $50 million worth of US government bonds paid for with a deposit in a US bank. Foreign government purchases of US government securities are recorded as an official financial inflow so we credit the official financial account $50 million. The reduction in foreign-owned deposits in US banks is treated as a financial outflow; but, since the deposit was owned by a foreign government, there is a $50 million debit to the official financial account.

Table 3.2

Balance of payments

 Credit (+)Debit (−)Net balance
Merchandise$1,000,000 (2)  
 100,000 (5)  
Services $10,000 (4) 
Primary income10,000 (3)  
Secondary income 100,000 (5) 
Current account  $1,000,000
Official financial$50,000,000 (6)$50,000,000 (6) 
Private financial1,000,000 (1)1,000,000 (1) 
 $10,000 (4)1,000,000 (2) 
  $10,000 (3) 
Financial account  −$1,000,000
Total$52,120,000$52,120,000 

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Note: The numbers in parentheses refer to the six transactions we have analyzed.

Note that the current account balance is the sum of the merchandise, services, primary income and secondary income accounts. Summing the credits and debits, we find that the credits sum to $1,110,000, whereas the debits sum to $110,000, so that there is a positive, or credit, balance of $1 million on the current account.

The financial entries are typically the most confusing, particularly those relating to changes in bank deposits. For instance, the third transaction we analyzed recorded the deposit of $10,000 in a German bank as a debit to the private financial account of the United States. The fourth transaction recorded the US tourist’s spending of the $10,000 German bank deposit as a credit to the private financial account of the United States. This may seem confusing because early in the chapter it was suggested that credit items are items that bring foreign exchange into a country, while debit items involve foreign exchange leaving the country. But neither of these transactions affected bank deposits in the United States, just foreign deposits. The key is to think of the deposit of $10,000 in a German bank as money that had come from a US bank account. Increases in US-owned deposits in foreign banks are debits whether or not the money was ever in the United States. What matters is not whether the money is ever physically in the United States, but the country of residence of the owner. Similarly, decreases in US-owned foreign deposits are recorded as a credit to private financial, whether or not the money is actually brought from abroad to the United States.

The item called “statistical discrepancy” (line 29) in Fig. 3.1 is not the result of not knowing where to classify some transactions. The international transactions that are recorded are simply difficult to measure accurately. Taking the numbers from customs records and surveys of business firms will not capture all of the trade actually occurring. Some of this may be due to illegal or underground activity, but in the modern dynamic economy we would expect sizable measurement errors even with no illegal activity. It is simply impossible to observe every transaction, so we must rely on a statistically valid sampling of international transactions.

Current Account Disequilibria

So far in this chapter we have studied the accounting procedures and definitions of the balance of payments. Now we want to consider the reasons for why a country would be in a current account surplus or deficit. Using some national income and product accounting (NIPA), we can see what must be true about the domestic economy for the country to be in a current account deficit or surplus.

Let us derive a relationship between the current account and domestic variables. Starting with the definition of GDP:

Y=C+I+G+(XM)

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where Y is GDP, C is our domestic consumption, I is our domestic private investment, G is the government’s consumption, X is our exports, and M is our imports. Our current account is then the net exports, (X − M), in the above relationship. Add the national income relationship:

Y=C+S+T

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where S is the private saving and T are the taxes paid. The national income relationship says that individuals will spend their earnings Y on consumption and taxes, and save the remainder.

Now, set the two equations equal to each other and cancel out the C, and after some rearranging you will be left with:

(SI)+(TG)=(XM)

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In other words, the current account balance depends on the private saving/investment relationship, (S − I), and the government’s fiscal surplus/deficit, (T − G). A current account deficit could come from a fiscal deficit and/or that private investment exceeding private saving, whereas a current account surplus implies a fiscal surplus and/or private saving exceeding private investment. We will look at (S − I) and (T − G) in the case of the US current account deficit.

If the US current account deficit comes primarily from the fiscal deficit then we should see an increase in the current account deficit at the same time that the fiscal deficit increases. Economists have dubbed this case the “twin deficit” explanation. In Fig. 3.3 we can see that the US current account deficit and the US fiscal deficit sometimes move together, but often the two move apart. For example, in the early 1980s, the large fiscal deficit during the Reagan era seems to have been transmitted to the current account also. Interestingly, economists in the 1980s worried about the US current account deficits as unsustainable. However, as we can see the United States has continued to grow with even larger current account deficits than those in the 1980s.

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Figure 3.3 Current account and fiscal surplus/deficit as a fraction of GDP. Federal Reserve of St. Louis FRED 2 database, authors’ calculation.

The second explanation focuses on the investment and saving relationship. If there are interesting investment opportunities in the United States and the private saving is insufficient then a current account deficit is necessary to allow foreigners to supply funds that can be used for investment purposes. In Fig. 3.4 we can see that personal saving has decreased from about 8% during the 1960s and 1970s to a low of 2% in the middle of the 2000s. All else equal the United States would need to cut private investment dramatically due to the slowdown in saving. However, Fig. 3.4 shows that especially after 1990 the current account deficit and the private saving have moved together. This implies that foreign saving is being used to finance US private investment through the current account deficit.

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Figure 3.4 Current account and saving as a fraction of GDP. Federal Reserve of St. Louis FRED 2 database, authors’ calculation.

The evidence in Figs. 3.3 and 3.4 indicates that both the fiscal imbalance and the private saving/investment imbalance are likely to have been the cause of the US current account deficit at different times. Similarly one can look at these two channels to see the cause of a current account surplus. In the case of a surplus a country must have a fiscal surplus and/or have domestic saving that exceed private investment. For example, if a country has a current account surplus and a balanced fiscal budget, then private saving must exceed private investment. In other words the country does not have enough opportunities for investment so saving flows abroad. In the next section we study the implications of a current account imbalance and how current account imbalances can be remedied.

Balance of Payments Equilibrium and Adjustment

Let us consider the economic implications of the balance of payments. For instance, since merchandise exports earn foreign exchange while imports involve outflows of foreign exchange, we often hear arguments for policy aimed at maximizing the trade or current account surplus. Is this in fact desirable? First, it must be realized that, because one country’s export is another’s import, it is impossible for everyone to have surpluses. On a worldwide basis, the total value of exports equals the total value of imports—i.e., there is globally balanced trade. Actually, the manner in which trade data are collected imparts a surplus bias to trade balances. Exports are recorded when goods are shipped, while imports are recorded upon receipt. Because there are always goods in transit from the exporter to the importer, if we sum the balance of trade for all nations we would expect a global trade surplus. However, the global current account balance has summed to a deficit in recent years. The problem seems to involve the difficulty of accurately measuring international financial transactions. Merchandise trade can be measured fairly accurately, and the global sum of trade balances is roughly zero; but, service transactions are more difficult to observe, and investment income flows seem to be the major source of global current account discrepancies. The problem arises because countries receiving financial inflows (the debtors) more accurately record the value received than the resident countries of the creditors. For instance, if an investor in Singapore bought shares of stock in Mexico, the government of Mexico is more likely to observe accurately the transaction than is the government of Singapore. Yet even with these bookkeeping problems facing government statisticians, the essential economic point of one country’s deficit being another’s surplus is still true.

Since one country must always have a trade deficit if another has a trade surplus, is it necessarily true that surpluses are good and deficits bad and that one country benefits at another’s expense? In one sense, it would seem that imports should be preferred to exports. In terms of current consumption, merchandise exports represent goods that will be consumed by foreign importers and is no longer available for domestic consumption. As we learn from studying international trade theory, the benefits of free international trade are more efficient production and increased consumption. Imports allow countries to realize a higher living standard than they could by just having domestic production. Children have more toys at Christmas because of imports from China. Bananas and pineapples are readily available due to trade with tropical countries. If trade between nations is voluntary, then it is difficult to argue that deficit countries are harmed while surplus countries benefit by trade.

In general, it is not obvious whether a country is better or worse off if it runs payments surpluses rather than deficits. Consider the following simple example of a world with two countries, A and B. Country A is a wealthy creditor country that has extended loans to poor country B. In order for country B to repay these loans, B must run trade surpluses with A to earn the foreign exchange required for repayment. Would you rather live in rich country A and experience trade deficits or in poor country B and experience trade surpluses? Although this is indeed a simplistic example, there are real-world analogues of rich creditor countries with trade deficits and poor debtor nations with trade surpluses. The point here is that you cannot analyze the balance of payments apart from other economic considerations. Deficits are not inherently bad, nor are surpluses necessarily good.

Balance of payments equilibrium is often thought of as a condition in which exports equal imports or credits equal debits on some particular subaccount, like the current account or the official settlements account. In fact, countries can have an equilibrium balance on the current account that is positive, negative, or zero, depending upon what circumstances are sustainable over time. For instance, a current account deficit will be the equilibrium for the United States if the rest of the world wants to accumulate US financial assets. This involves a US financial account surplus as US financial assets are sold to foreign buyers, which will be matched by a current account deficit. So equilibrium need not be a zero balance. However, to simplify the next analysis, let us assume that equilibrium is associated with a zero balance. In this sense, if we had a current account equilibrium, then the nation would find its net creditor or debtor position unchanging since there is no need for any net financing—the current account export items are just balanced by the current account import items. Equilibrium on the official settlements basis would mean no change in short-term financial assets held by foreign monetary agencies and reserve assets. For most countries, this would simply mean that their stocks of international reserves would be unchanging.

What happens if there is a disequilibrium in the balance of payments—say the official settlements basis? Now there will be reserve asset losses from deficit countries and reserve accumulation by surplus countries. International reserve assets comprise gold, IMF special drawing rights (SDR) (recall from Chapter 2, International Monetary Arrangements, that this is a credit issued by the IMF and allocated to countries on the basis of their level of financial support for the IMF), and foreign exchange. To simplify matters (although this is essentially the case for most countries), let us consider foreign exchange alone. The concept of balance of payments equilibrium is linked to the supply and demand diagram presented in this Chapter 1 and Chapter 2, International Monetary Arrangements. In the case of flexible exchange rates, where the exchange rate is determined by free market supply and demand, balance of payments equilibrium is restored by the operation of the free market. Therefore, the official settlements account will be zero. In contrast, as we have learned in Chapter 2, International Monetary Arrangements, exchange rates are not always free to adjust to changing market conditions. With fixed exchange rates, central banks set exchange rates at a particular level. When the exchange rate is fixed the dollar can be overvalued or undervalued and the central banks must now finance the trade imbalance by international reserve flows. Specifically, in the case of a trade deficit, the Federal Reserve sells foreign currency for dollars. In this case, the US trade deficit could continue only as long as the stock of foreign currency lasts and the official settlements balance will show such an intervention.

Besides these methods of adjusting a balance of payments disequilibrium, countries sometimes use direct controls on international trade, such as government-mandated quotas or prices, to shift the supply and demand curves and induce balance of payments equilibrium. Such policies are particularly popular in developing countries where chronic shortages of international reserves do not permit financing the free-market-determined trade disequilibrium at the government-supported exchange rate.

The mechanism of adjustment to balance of payments equilibrium is one of the most important practical problems in international economics. The discussion here is but an introduction; much of the analysis of Chapters 12, Determinants of the Balance of Trade, 13, The IS–LM–BP Approach, 14, The Monetary Approach, and 15, Extensions and Challenges to the Monetary Approach, is related to this issue as well.

The US Foreign Debt

One implication of financial account transactions, in Table 3.1, is the net creditor or debtor status of a nation. A net debtor owes more to the rest of the world than it is owed, while a net creditor is owed more than it owes. The United States became a net international debtor in 1986 for the first time since World War I. The high current account deficits of the 1980s were matched by high financial account surpluses. This rapid buildup of foreign direct investment and purchases of US securities led to a rapid drop in the net creditor position of the United States in 1982 to a net debtor status by 1986. Ever since the United States has remained a debtor nation and has gradually increased its debtor position year after year.

The detailed net international investment position is provided in Table 3.3. One can think of Table 3.3 as a sum of Table 3.1, reflecting the net position of the United States vis-à-vis the rest of the world at any given time. In contrast, Table 3.1 provides the flow of goods and service during a particular year. Line 19 in Table 3.3 provides the cumulative net investment position for the United States. It shows that the United States was the largest creditor in the world in the early 1980s, but in the mid-1980s the net position started to deteriorate, and the United States became the biggest debtor nation in the world with a net position in the end of 2015 of −$7,356.8 billion. Thus, foreigners have more than $7 trillion in claims on US assets in excess of the US claims on foreign assets. The detailed accounts are also of interest. There is an enormous amount of claims on foreign assets held by US residents. Over $23 trillion worth of claims on foreign assets are held by US residents, whereas foreigners hold almost $31 trillion in claims. In comparison, the US GDP is estimated to be around 18 trillion in 2015. So the international asset holdings far exceed the US GDP.

Table 3.3

US net international investment position (billions of dollars, March 31, 2016)

Line Type of investment 1980 1985 1990 1995 2000 2005 2010 2015
1 US assets 839.1 1,392.1 2,415.7 4,094.4 7,641.7 13,357.0 21,767.8 23,208.3
2  Assets excluding financial derivatives (sum of lines 5, 6, 8, and 9) 839.1 1,392.1 2,415.7 4,094.4 7,641.7 12,167.0 18,115.5 20,810.6
3  Financial derivatives other than reserves, gross positive fair value (line 7) n.a. n.a. n.a. n.a. n.a. 1,190.0 3,652.3 2,397.6
4 By functional category         
5  Direct investment at market value 297.3 475.7 853.3 1,493.6 2,934.6 4,047.2 5,486.4 6,907.9
6  Portfolio investment 78.0 138.7 425.5 1,278.7 2,556.2 4,629.0 7,160.4 9,534.4
7  Financial derivatives other than reserves, gross positive fair value n.a. n.a. n.a. n.a. n.a. 1,190.0 3,652.3 2,397.6
8  Other investment 292.3 659.7 962.1 1,146.0 2,022.6 3,302.8 4,980.1 3,984.7
9  Reserve assets 171.4 117.9 174.7 176.1 128.4 188.0 488.7 383.6
10 US liabilities 542.2 1,287.8 2,565.2 4,371.9 9,178.6 15,214.9 24,279.6 30,565.1
11  Liabilities excluding financial derivatives (sum of lines 14, 15, and 18) 542.2 1,287.8 2,565.2 4,371.9 9,178.6 14,082.8 20,737.7 28,224.5
12  Financial derivatives other than reserves, gross negative fair value (line 16) n.a. n.a. n.a. n.a. n.a. 1,132.1 3,541.9 2,340.5
13 By functional category         
14  Direct investment at market value 99.9 309.3 661.2 1,135.5 3,023.8 3,227.1 4,099.1 6,513.1
15  Portfolio investment 242.6 473.7 946.8 1,901.0 4,008.5 7,337.8 11,869.3 16,666.2
16  Financial derivatives other than reserves, gross negative fair value n.a. n.a. n.a. n.a. n.a. 1,132.1 3,541.9 2,340.5
17  Other investment 199.7 504.7 957.2 1,335.5 2,146.3 3,517.8 4,769.3 5,045.2
18 US net international investment position (line 1 less line 10) 296.9 104.3 149.5 277.6 −1,536.8 −1,857.9 −2,511.8 −7,356.8

Image

Source: Bureau of Economic Analysis.

Recall from Table 3.1 that the current account deficit results in foreigners adding more claims on US assets. The US net international investment position is a sum of all the past current account deficits and surpluses. Thus, the current account is a useful measure because it summarizes the trend with regard to the net debtor position of a country. For this reason, international bankers focus on the current account trend as one of the crucial variables to consider when evaluating loans to foreign countries.

How Serious Is the US Foreign Debt?

In the last section we concluded that the United States owes $7.4 trillion more than it has in receivables from the rest of the world. How serious is this? We hear a lot about the US federal debt, but rarely about the US international debt situation. Although the net amount sounds enormous, the detailed accounts in Table 3.1 bring some comfort about the debt situation. The types of assets that United States acquires differ from the type of foreign liabilities that the United States has. For example, if we examine the last decade of assets and liabilities we can see from Table 3.1 that the United States acquired in excess of $3.7 trillion in foreign direct investment, whereas direct investment by foreigners in the United States was only about $2.7 trillion. In contrast, foreign central banks acquired $3.3 trillion of US assets while the US reserves almost did not change in the 10-year period. Thus, the United States invests in high-yield assets while much of foreign assets are low yielding. The composition of asset holdings causes the return to assets held by foreigners in the United States to be low relative to the return for US residents’ investments abroad.

In addition to the composition of assets and liabilities, the depreciation of the dollar in the last decade has resulted in a particularly favorable outcome for the US investment income. Gourinchas and Rey (2005) point out that almost all US foreign liabilities are in dollars. In contrast, 70% of US assets are in foreign currency. Therefore a depreciation of the dollar increases the value US-owned foreign assets while keeping the value of the foreign liabilities the same.

In fact, although the United States owes $7.4 trillion more than it has in receivables from the rest of the world, the return on US investment is so much higher that the total net income from assets held by US residents in other countries exceeds the return of US assets held by foreigners. We can see this by looking back at the income receipts and payments in Fig. 3.1. The income receipts in 2015 were $776 billion, line 6, and the payments were $575, line 14. Thus, the United States generated a net income surplus of $201 billion even though the asset base was much smaller for the United States. In conclusion, the international debt is not yet a burden for the United States.

Summary

1. The balance of payments records a country’s international transactions: payments and receipts that cross the country’s border.

2. The balance of payments uses the double-entry bookkeeping method. Each transaction has a debit and a credit entry.

3. If the value of the credit items on a particular balance of payments account exceeds (is less than) that of the debit items, a surplus (deficit) exists.

4. The current account is the sum of the merchandise, services, primary income, and secondary income accounts.

5. Current account deficits are offset by financial account surpluses.

6. The balance of trade is the merchandise exports minus the merchandise imports.

7. The official settlements balance is equal to changes in financial assets held by foreign monetary agencies and official reserve asset transactions.

8. An increase (decrease) in US-owned deposits in foreign banks is a debit (credit) to the US financial account. While an increase (decrease) in foreign-owned deposits in US banks is a credit (debit) to the US financial account.

9. The United States became a net international debtor in 1986.

10. Deficits are not necessarily bad, nor are surpluses necessarily good.

11. With floating exchange rates, the equilibrium in the balance of payments can be restored by exchange rate changes.

12. With fixed exchange rates, the balance of payments will not be automatically restored. Thus, central banks must either intervene to finance current account deficits or impose trade restrictions to restore the equilibrium.

Exercises

1. Explain the principles of double-entry bookkeeping in the balance of payments. In terms of international transactions, what do we count as a debit and a credit?

2. Classify the following transactions and enter them into the US balance of payments.

a. An American tourist travels to Frankfurt and spends $1000 on hotel, bratwurst, and beer. He pays with a check drawn on a Tulsa, Oklahoma, bank.

b. Mercedes-Benz in Germany sells $400,000 of its cars to a US distributor, allowing for 90-day trade credit until payment is due.

c. Herr Schmidt in Germany receives a $100 check, drawn on a US bank, from his grandson in New York as a birthday gift.

d. A resident in Sun City, Arizona, receives a $2000 dividend check from a German company. The check is from a German bank.

e. The US government donates $100,000 worth of wheat to Germany.

3. What is the current account balance in question 2?

4. If a country has a current account deficit, will it be a net lender or borrower to the rest of the world?

5. Should the country be concerned about its current account deficit? Discuss.

Further Reading

1. Bergin P. Should we worry about the large U.S current account deficit? Fed Rev Bank San Francisco Econ Lett 2000; December 22.

2. Clift J. Agent provocateur. Finan Dev. June 2015.

3. Coughlin CC, Pakko MR, Poole W. How dangerous is the U.S current account deficit? Fed Rev Bank St Louis Reg Econ. 2006; April.

4. Freund, C. and Warnock F., 2006. Current account deficits in industrial countries: the bigger they are, the harder they fall. NBER Working Paper No. 11823. December.

5. Glick R. The largest debtor nation. Fed Rev Bank San Franc Wkly Lett. 1986; February 14.

6. Gonelli A. The basics of foreign trade and exchange. Fed Rev Bank N.Y 1993.

7. Gourinchas P, Rey H. From World Banker to World Venture Capitalist: U.S External Adjustment and Exorbitant Privilege. In: Clarida RH, ed. G7 Current Account Imbalances: Sustainability and Adjustment. Chicago, IL: University of Chicago Press; 2007.

8. Marquez J, Workman L. Modeling the IMF’s statistical discrepancy in the global current account. Fed Rev Board Int Finan Div. 2000; July.

9. Motala J. Statistical discrepancies in the world current account. Finan Dev. 1997;24–25 March.


1Technically the Capital Account still exists, but now refers to transactions not related to production, such as debt forgiveness and other transfers not related to production. These transactions were formerly reported in Unilateral Transfers and are fairly minor. Because of the small amounts we do not include the Capital Account in Fig. 3.1.

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