The balance of payments equals the transactions between a country and the rest of the world. The balance of payments is made up of two divisions – the current account and the capital account.
Transactions that occur due to export and import activity are entered into the current account.
Transactions that occur due to the sale or purchase of assets are entered into the capital account. When economists talk of assets they mean any kind of form in which wealth can be stored, for instance, money, shares, building or land. The capital account records all international sales and purchases of assets. When a German company buys a UK factory that transaction is entered as a negative on the German capital account and a positive on the UK capital account. Why? Think of the purchase of the UK factory as an import of an asset and the selling to a German firm as an export of an asset.
The two divisions of the balance of payments must add up to zero. This is because, just as in company accounts, every transaction is entered twice: once as a credit and once as a debit.
Current account + capital account = 0
What goes into the current account?
We learned before that the current account is the net of a country’s exports of goods and services. These come in three categories:
- Merchandize trade, the import and export of goods.
- Investment income, interest and dividend payments from abroad and repatriated profits
- Other services, trade in services such a tourism, consultancy, etc.
An additional type of international transaction is also included in the current account. This is called net unilateral transfers. Net unilateral transfers are international gifts, international aid and workers’ remittances (wages that workers earned abroad and then sent home).
What goes into the capital account?
The capital account measures the difference between sales of assets to foreigners and purchase of assets in foreign countries. If a German were to lend money to a UK resident this is buying a promise of interest payment. Therefore, the German investor is buying a UK asset so the purchase goes into the capital account under assets. We can say that there is an inflow of capital to the UK and an outflow from Germany. You should note that the interest payment generated from the loan is counted in the current account.
Difficulties and differences in data collection and definition mean that there can be differences in the capital account and the current account. This difference, balancing item, is called the statistical discrepancy.
Governments as well as private firms and individuals also hold internationally tradable assets. These are usually in the form of gold and currencies. The US dollar is the main currency held, however in recent years the euro has gained popularity. These government holdings of gold and currency are called the official reserve assets. Governments hold these reserves for two reasons; emergency assets for times of economic problems, and foreign exchange intervention.