The Balance of Payments

A balance of payments is a statistical summary prepared to indicate the systematic records of economic transactions between residents of a country with non-residents over a certain period, usually a year.

The balance of payments consists of various accounts that record international transactions according to their characteristics and functions. Three main accounts can be listed: Current Account, Capital Account and Financial Account. First, transactions related to international trade, net factor income payments/receipts and net unilateral transfers are recorded under the current account. Second, capital transfers and transactions related to the accumulation of non-financial and non-produced assets are included in the capital account. Finally, transactions related to the exchange of financial assets (financial inflows and outflows) are presented under the financial account.

Countries have several motivations for constructing the balance of payments. First, the balance of payments allows the maintenance of a detailed record of international economic transactions. Therefore, countries use these records to formulate policies for macroeconomic management. Second, the balance of payments shows the improvements and deteriorations in the international payment position. Simply, it indicates whether the country is a net lender or borrower in a given period. This feature of the balance of payments is very critical in economic policymaking. By tracking the balance of payments, governments can assess the risks that emerge from international transactions, such as the risk of a balance of payments crisis, the risk of over-borrowing, and the risks of sudden stops, surges, capital flights, etc. In addition, policymakers can specify a trajectory for international borrowing or lending. Third, the balance of payments helps to understand the changes in the demand and supply of the country’s currency. That is, each transaction naturally corresponds to a factor that changes the supply or demand of the country’s currency. Analyzing the balance of payments makes it possible to understand why a currency appreciates or depreciates.

In compiling the relevant statistics, countries use international standards defined in the “Balance of Payments and International Investment Position Manual” published by the International Monetary Fund (IMF). The international standards and guidelines of the IMF help to assure the compatibility of the balance of payments data among countries.

The balance of payments presents a classified record of transactions associated with the exchange of goods, services, incomes, and assets between a country’s residents and those of foreign countries to represent a country’s performance in international trade (i.e., flows of goods and services), and in international finance (i.e., flows of capital) in a given period.

The balance of payments adopts basic accounting principles. First, each transaction corresponds to a credit or debit entry. Each transaction that shows a receipt from the rest of the world is registered as a credit, and each transaction that results in a payment to the rest of the world is recorded as a debit. Also, each economic transaction is registered by two equal and opposite entries, as in the doubleentry bookkeeping system in which debits offset credits. By doing so, we allow reporting the inflow and outflow part of each transaction. For example, suppose a resident of a country sells goods to a non-resident and receives a payment from the foreign buyer in foreign currency. In that case, we can record this transaction as an export of goods as a credit item and the incurrence of a financial claim on the non-resident as a debit item.

The major transactions recorded as credits are exports of goods and services, financial inflows (foreign investments flow into the country), and interest and dividend income from earlier investments abroad. The major transactions recorded as debits are imports of goods and services, financial outflows (investments made by residents of a country in foreign countries), and interest and dividend payments from earlier investments that foreigners made in the home country. Credit items are generally payments inward to a country, while debit items are payments outward from the country. 

In the double-entry bookkeeping system, since there are two equal but opposite entries for each transaction, the total value of debits equals the total value of credits. However, it is not required that the individual accounts are balanced. The current, capital and financial accounts can be either in deficit or surplus.

The trade balance shows the net value of export and imports of goods and services. The value of exports is labeled as receipts of residents, and the value of imports is payments made to non-residents.

The primary income balance identifies net factor payments. Net factor payments are the income earned by a country’s residents employed in foreign countries and their owners of capital and land abroad minus income paid to foreign residents employed in their home country and owners of capital and land in their home. The major components in this sub-category are profits earned on capital abroad and wages earned by workers abroad.

The second category in the current account balance is the primary income balance involving net factor payments such as the net of payments made to and received from the rest of the world related to incomes of factors of production.

The third category is the secondary income balance which deals with the net unilateral transfers. Net unilateral transfers are the net of the payments made to and received from the rest of the world that are unrelated to purchasing any good, service, or asset. Thus, it is associated with the redistribution of income through current transfers.

The net unilateral transfers primarily involve donations from one country to another, international aid, gifts received or sent, personal transfers such as payments from/to immigrants, income tax paid by non-residents, etc. The home country is called a net donor when the value of net unilateral transfers is negative.

Current Account Balance= Trade Balance (X –M) + Primary Income Balance (Net Factor Payments) + Secondary Income Balance (Net Unilateral Transfers)

The capital account deals with wealth transfers between residents and non-residents in two forms: capital transfers and the acquisition/disposal of non-produced, non-financial assets. The capital account is always related to the accumulation of assets, while the current account involves current flows in a given period.

The financial account involves sales and purchases of financial assets between residents and non-residents. Transactions recorded in this account may have two forms: (i) offsetting entries of transactions recorded under the current account and the capital account and (ii) other transactions related to foreign investment. For instance, when the export or import of goods is recorded in the current account, the corresponding entry shows an increase or a decrease in financial assets in terms of deposits and trade credit and is involved in the financial account. Alternatively, there may be a transaction that is related to the exchange of one asset for another. In that case, both entries will be in the financial account. Suppose that a resident exchanges a bond for currency and deposits, the entry for the sale of the bond and its offsetting entry are both involved in the financial account.

In the financial account, the credit side shows increases in financial liabilities and decreases in financial assets, while the debit side indicates increases in financial assets and decreases in financial liabilities (see Table 4. 4). This classification can also be transformed into IMF’s terminology, defining net changes in financial assets as “net acquisition of financial assets” and net changes in financial liabilities as “net incurrence of liabilities”.

The balance in the financial account represents the net lending or the net borrowing of the country. Net lending means that the country provides funds to foreign countries, while net borrowing indicates that the country needs foreign financing. The net lending or borrowing amount can also be calculated by summing up the current and capital account balances. Because a deficit (surplus) in a total of the current and capital account balances must be compensated by a surplus (deficit) in the financial account, the total amount of the current and capital account balances is equal to the value of net lending or net borrowing. Put differently, if a country has a surplus in the total of current and capital accounts, it must balance this surplus by increasing the net acquisition of financial assets or reducing liabilities (i.e., net lending position). Suppose a country has a deficit in the sum of current and capital account balances. In that case, there must be a decrease in the net acquisition of financial assets or an increase in liabilities (i.e., net borrowing position). In sum, the balance in this account adds to our understanding of how much a country needs foreign financing or how much it can lend to foreigners.

In our example, the representative economy runs a trade surplus. The net primary income is positive, implying that the economy’s factor income receipts are larger than the factor income payments. According to the secondary income balance, the economy’s unilateral transfer payments to the rest of the world are higher than its receipts. By summing up these three balances, we can find the amount of the current account balance. According to Table 4.5, the country is running a current account surplus. When the capital account is added, the net lending or borrowing position comes out with a positive sign, which implies that the country will lend to the rest of the world. This lending position can also be seen in the financial account. Given that the change in the acquisition of financial assets exceeds the incurrence of liabilities, this country becomes a lender.

We will extend the national income accounting to open economies by adding the current account balance.The goods market equilibrium condition for an open economy is as follows.Y= C+I+G+NX   

(1)  Y denotes GDP, C, I, and G are consumption, investment, and government expenditures, respectively, and NX refers to the trade balance (X-M). Now, subtract net taxes T from both sides of Equation (1) to get:

Y-T=C+I+G-T+NX (2)

Then, subtract C from both sides of Equation (2)

Y-T=C+I+G-T+NX

Finally, add net income from abroad (the primary income balance, NI) and net transfers from abroad (the secondary income balance, NT) to both sides of Equation (3)

Y+NI+NT-T-C=I+G-T+(NX+NI+NT)

Equation (4) shows that private savings denoted by (Y+NI+NT-T-C) are equal to the sum of domestic investment, government budget deficit, and the current account balance as follows:

S=I+(G-T)+ Current Account Balance (CA)

By rearranging the terms of Equation (5), we can get

CA=(S+(T-G))-I

When domestic investment exceeds national saving, this implies a current account deficit. When national saving is larger than domestic investment, it is considered a current account surplus. This also underlines an important relationship for open economies: an open economy can save domestically and acquire foreign savings to build up capital stock. In other words, an open economy can simultaneously increase investments and foreign borrowing. For example, a country whose national saving falls short of domestic investment borrows from foreigners (acquires foreign wealth). Alternatively, a country whose national saving exceeds the domestic investment lends to another country to finance investments. Here, deficit countries borrow from the rest of the world, and surplus countries lend to the rest of the world. 

Current account (CA) + capital account (KA) + Financial account (FA)=0   (7)

This accounting identity given in Equation (7) is the fundamental identity of the balance of payments.

To make a further interpretation, we can express the identity above as follows: CA + KA=-FA (8) or CA=-KA-FA (9)

Equation (8) associates CA and KA with international lending/ borrowing. According to this association, the amount of net lending or net borrowing is determined by the sum of CA and KA, i.e., a country’s net capital flows must balance the net flows of goods, services, and income payments/receipts to/from other countries.

The financial account balance also reflects the changes in the net indebtedness of a country. Using Equation (9), we can conclude that if CA<0, it requires international borrowing and the financial account must be in surplus. Suppose this country is already in debt; the surplus needed in the financial account represents an increase in foreign indebtedness. However, if this country is already a net creditor, the surplus represents a decline in international lending. Therefore, when CA<0, a debtor country’s indebtedness increases, or the creditor country’s lending to foreigners reduces. The opposite is true for the case of CA>0.

In the capital account, when the total value of debit items exceeds the total value of credit items, the capital account is in deficit, and the opposite is a surplus. In many countries, the capital account deficit or surplus amount is a relatively small part of the balance of payments. The financial account can also be in deficit and surplus. When it is in surplus, it means that the purchases of domestic assets by the rest of the world are higher than those of foreign assets by the country’s residents. The deficit in the financial account is the opposite. Recall that the fundamental identity of the balance of payments forces the surplus (deficit) in the sum of the current and capital account deficit to be balanced by a deficit (surplus) in the financial account.

To see the trade deficit/surplus history of Türkiye, we illustrate the trends of trade and the current account balances (as a percentage of GDP) between 1974 and 2021 in Figure 4.1. As seen in Figure 4.1, Türkiye has been suffering from high trade and current account deficits over the past decades. After the capital account liberalization in 1989, Türkiye experienced large ups and downs in trade and the current account deficits. The 2001 crisis led to temporary trade and current account surpluses induced by the bust cycle in economic activity. Then, deficits continued to increase until the 2008 Global Financial Crisis hit the Turkish economy. In the global recession, the trade and the current account deficits as a percentage of GDP dropped to 1-2%. However, after the recovery of the global economy, deficits continued to increase. For instance, in 2012, which we deal with, the trade deficit as a percentage of GDP reached more than 4%, and the current account deficit was reported as more than 5%