The financial account measures 1) changes in domestic ownership of foreign assets and 2) 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.
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.
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.
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. Why? The foreign lenders will begin to wonder whether they will get an adequate return on their investment. If demand falls off, the value of the borrower 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.
The U.S. current account deficit reached a record $803 billion in 2006. That created concern about the sustainability of such an imbalance. Even though the recession scaled it back, it appears it's on the rise again.
The warnings made by the Congressional Budget Office, and the solutions it proposed, are relevant again today. The safety of investing in the United States could once again become a concern to foreign investors. Americans have cut back on credit card spending, and the savings rate has inched up, but is it enough to fund domestic business growth? If not, it could lead to inflation and higher interest rates, lowering the U.S. standard of living.
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's helps them grow faster than they could if they maintained a surplus.
The United States traded $4.9 trillion with foreign countries in 2016. That was $2.2 trillion in exports and $2.7 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 U.S. exports is that other countries have lower standards of living. They can make things more cheaply because they pay their workers less.
Why can't we make everything at home? We could, but they 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.
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 produced overseas by a domestic company.
Therefore, a trade deficit can 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.
Balance of Payments, Its Components, and Deficit Versus Surplus
Three Ways a Country Pays for Its Growth
The balance of payments is the record of all international financial transactions made by a country's residents. 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. In the short-term, that fuels the country's economic growth. 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. Its government and residents are savers. They provide enough capital to pay for all domestic production. They might even lend outside the country.
A surplus boosts economic growth in the short term. That's because it's lending money to countries that buy its products. That boosts 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.
The balance of payments has three components. They are the financial account, the capital account and the current account.The financial account describes the change in international ownership of assets. The capital account includes any financial transactions that don't affect economic output. The current account measures international trade, the net income on investments and direct payments. Here are the balance of payments components and how they work together.