What Are the Balance of Payments and How Are They Used Globally?

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The balance of payments, or BOP, is a core component of understanding the state and health of a nation's economy. This record, which has been tracked in same shape or form since the 16th century, is a point of reference for a wide variety of people, ranging from individual investors and business owners, to lawmakers and economists.

What Are Balance of Payments?

The BOP is the record of all financial transactions that a country's residents makes. Typically, the BOP will show the transactions over the course of a calendar year or on a quarterly basis. This method is all-encompassing, tracking transactions of individual citizens, companies, and government entities. All kinds of transactions from both the public and private sectors are tracked, ranging from imports and exports, transfer payments and more. The BOP is important for discerning whether a country is at a deficit or surplus.

What Are the Components of Balance of Payments?

The balance of payments can be divided into three separate accounts, all of which track different aspects of a country's transactions. Understanding the different components is essential to grasping the greater significance and purpose of the BOP. Keep in mind that even within these accounts, there are subdivisions that drill down even further on each transaction.

1. Current account

The current account measures the total imports and exports of a country. This is one of the largest accounts under the BOP and can be a key to determining whether a country has a trade deficit or surplus. It is often compared against the financial account to determine how a country is spending the dollars provided to it by another nation.

Some examples of transactions you might find in a current account include:

  • Trade of goods and services
  • Net income (for example, profits from an international business or inflow of income from migrants)
  • Net transfers (for example, foreign military aid)

2. Capital account

The capital account records all incoming and outgoing sales or transfers of small, fixed assets. The capital account tends to be the smallest of the three BOP components. In fact, it is sometimes lumped into the financial account altogether. Some of these international sales or transfers include:

  • Debt forgiveness
  • Inheritance taxes
  • Death duties
  • Selling tangible assets (for example, buildings or factories)
  • Selling intangible assets (for example, land)
  • Selling nonfinancial assets (for example, patents)

3. Financial account

The financial account records all changes in the ownership of international assets and liabilities. This includes a country's ownership of foreign assets and foreign ownership of a country's assets. For example, the financial account would track if a foreign entity began purchasing U.S. treasury bonds in the United States.

While the financial account may sound similar to the capital account, there is one major difference: the capital accounts only measures capital assets, while the financial account measures other types of assets.

This includes the following types of assets:

  • Portfolio investments (for example, bonds and shares)
  • Foreign direct investments (FDI)
  • Currency or gold reserves

If a country has a surplus in its financial account, this means that a country is investing more money into its own country than making foreign investments. Conversely, a deficit indicates that more money is moving out of the country, so it might be attempting to increase its foreign investments.

Why Are Balance of Payments Important?

Since the BOP essentially serves as the financial ledger and source of truth around a country's financial transactions on all fronts, you can imagine that it is incredibly important. The BOP can reveal the economic health of a nation and help economists postulate its future economic landscape. It is used to inform a wide variety of people, including investors, investment managers, business owners and policymakers.

The BOP can be a key point of reference at the heart of many major decisions a country makes, both financial and non-financial. For example, businesses may examine a country's BOP if they are searching to potentially expand into foreign markets or an investor may look to a country's BOP to help them decide if they want to invest in foreign currency.

How Is Balance of Payments Used Globally?

One of the most important and prevalent uses of the BOP is to inform fiscal and international policy. Typically, policies of this nature will be created to meet a specific objective that is considered desirable by a country. These policies aren't just informed by the BOP, but can also have a large impact on the BOP in the long term. This includes core policies like inflation control, stimulus packages, innovation incentives, and more.

For example, if a country has a large trade deficit, policymakers may place tariffs on foreign goods in an attempt to balance out the deficit. Outside of the economy, these policies can also impact the relationships between nations.

What Is the History of Balance of Payments?

Historically, BOP was incredibly difficult to track. However, the amount of international trade was so minuscule that there was hardly a need for a BOP. It wasn't until the dawn of mercantilism in 16th century Europe that the world began to feel a need for this sort of national ledger.

From the 16th to 18th centuries, the primary goal of fiscal and foreign policy was aimed at creating a positive inflow of assets and transactions into the BOP. However, this approach produced low economic growth in the long term, as many countries would discourage international trade and simply accumulate assets.

The BOP has seen many different variations over time, beginning in 1820 when the idea of mercantilism was challenged by Adam Smith and other economists of the time who favored free trade. Since this date, free trade and the use of the BOP has evolved over time depending on the cultural ideas, technologies and overall economic ideas of the time.