Balance of Payments, Its Components, and Deficit Versus Surplus

Three Ways a Country Pays for Its Growth

Image by Theresa Chiechi © The Balance 2019

The balance of payments is the record of all international trade and financial transactions made by a country's residents. 

The balance of payments has three components. They are the current account, the financial account, and the capital account. The current account measures international trade, net income on investments, and direct payments. The financial account describes the change in international ownership of assets. The capital account includes any other financial transactions that don't affect the nation's economic output.

Key Takeaways

  • A country’s balance of trade refers to the difference of how much a country is importing versus exporting.
  • The three components of the balance of payments are the current account, financial account, and capital account. 
  • The U.S. economy’s reliance on consumption and low prices has created a large deficit in the balance of payments. 
  • Unchecked, a long-term rising deficit can lead to inflation and a lower standard of living.

What It Means

A country's balance of payments tells you whether it saves enough to pay for its imports. It also reveals whether the country produces enough economic output to pay for its growth. The BOP is reported for a quarter or a year. 

A balance of payments deficit means the country imports more goods, services and capital than it exports. It must borrow from other countries to pay for its imports.

It's like taking out a school loan to pay for education. Your expected higher future salary is worth the investment.

In the long-term, the country becomes a net consumer, not a producer, of the world's economic output. It will have to go into debt to pay for consumption instead of investing in future growth. If the deficit continues long enough, the country may have to sell off its assets to pay its creditors. These assets include natural resources, land, and commodities.

A balance of payments surplus means the country exports more than it imports. It provides enough capital to pay for all domestic production. The country might even lend outside its borders.

A surplus boosts economic growth in the short term. There's enough excess savings to lend to countries that buy its products. The increased exports boost production in its factories, allowing them to hire more people. In the long run, the country becomes too dependent on export-driven growth. It must encourage its residents to spend more.

A larger domestic market will protect the country from exchange rate fluctuations. It also allows its companies to develop goods and services by using its own people as a test market.

Current Account

The current account measures a country's trade balance plus the effects of net income and direct payments. When the activities of a country's people provide enough income and savings to fund all their purchases, business activity, and government infrastructure spending, then the current account is in balance.

Current Account: Deficit

A current account deficit is when a country's residents spend more on imports than they save. To fund the deficit, other countries lend to, or invest in, the deficit country's businesses. The lender country is usually willing to pay for the deficit because its businesses profit from exports to the deficit country. In the short run, the current account deficit is a win/win for both nations.

But if the current account deficit continues for a long time, it will slow economic growth. Foreign lenders will begin to wonder whether they will get an adequate return on their investment. If demand falls off, the value of the borrowing country's currency may also decline. This leads to inflation as import prices rise. It also creates higher interest rates as the government must pay higher yields on its bonds.

Current Account: U.S. Deficit

The U.S. current account deficit reached a record $806 billion in 2006. That created concern about the sustainability of such an imbalance. It fell during the recession but is now growing again.

The Congressional Budget Office warned about the danger of the current account deficit. It also proposed several solutions. First, Americans should cut back on credit card spending and increase their savings rate enough to fund domestic business growth. Second, the government must reduce its health care spending. The best way to do that is lower the cost of health care. That was the goal of the Affordable Care Act.

If these solutions don't work, it could lead to inflation, higher interest rates, and a lower standard of living.

Current Account: Trade Balance

The trade balance measures a country's imports and exports. This is the largest component of the current account, which is itself the largest component of the balance of payments. Most countries try to avoid a trade deficit, but it's a good thing for emerging market countries. It helps them grow faster than they could if they maintained a surplus.

Trade Balance: U.S. Imports and Exports

In 2019, the United States traded $5.2 trillion with foreign countries. That was $2.5 trillion in exports and $2.9 trillion in imports. It's the third-largest exporter but the top importer.

With its size and wealth, it should be exporting more. One of the major challenges to increasing U.S. exports is that other countries have lower costs of living. They can make things more cheaply because they pay their workers less.

Making everything domestically would cost a lot more. Most people aren't willing to pay more just to save U.S. jobs.  U.S. imports cost less than domestically-made products. America imports more than half of its goods from just five countries.

Current Account: Trade Deficit Definition

A trade deficit results when a country's imports more than it exports. Imports are any goods and services produced in a foreign country, even if these are produced overseas by a domestic company.

A trade deficit can then occur even if all the imports are being sold by, and sending profit to, a domestic firm. With the rise of multinational corporations and job outsourcing, trade deficits are on the rise.

Current Account: U.S. Trade Deficit

A large part of the U.S. trade deficit is caused by America's reliance on foreign oil. When oil prices rise, so does the trade deficit. America also imports a lot of automobiles and consumer products. U.S. exports include many of the same things, but not enough to outweigh the deficit

In 2017, the United States outranked 20 countries by racking up the highest trade balance deficit by far, approximating $862.21 billion. Dependence on foreign oil, high import consumption, increase in multinational corporations, and job outsourcing is increasing that trade deficit.

Financial Account

The financial account measures changes in domestic ownership of foreign assets and foreign ownership of domestic assets. If foreign ownership increases more than domestic ownership does, it creates a deficit in the financial account. This means the country is selling off its assets, like gold, commodities, and corporate stocks, faster than it is acquiring foreign assets.

Capital Account

The capital account measures financial transactions that don't affect a country's income, production, or savings. For example, it records international transfers of drilling rights, trademarks, and copyrights. Many capital account transactions happen infrequently, such as cross-border insurance payments. The capital account is the smallest component of the balance of payments.