Balance of Payments in Global Transactions: Why Does It Matter? (2024)

What Is the Balance of Payments (BOP)?

The balance of payments (BOP),also known as the balance of international payments, is a statement of all transactions made between entities inonecountry and the rest of the worldover a defined period, such as a quarter or a year. It summarizes all transactions thata country's individuals, companies, and government bodies complete with individuals, companies, and government bodiesoutside the country.

Understanding the Balance of Payments (BOP)

The balance of payments (BOP) transactions consist of imports and exports of goods, services, and capital, as well as transfer payments, such as foreign aid and remittances. A country'sbalance of payments and its net international investment positiontogether constitute its international accounts.

The balance of payments divides transactions into two accounts:the current accountand the capital account.Sometimes the capital account is called the financial account, with a separate, usually very small, capital account listed separately. The current account includes transactions in goods, services, investment income,and current transfers.

The capital account, broadly defined,includes transactions in financial instrumentsand central bankreserves. Narrowly defined, it includes only transactions in financial instruments. The current account is includedin calculations of national output, while the capital account is not.

If a country exports an item (a current account transaction), it effectively imports foreign capital when that item is paid for (a capital account transaction). If a country cannot fund its imports through exports of capital, it must do so by running down its reserves.This situation is often referred to as abalance of payments deficit, using the narrow definition of the capital account that excludescentral bank reserves. In reality, however, the broadly defined balance of payments must add up to zero by definition.

In practice, statistical discrepancies arise due to the difficulty of accurately counting every transaction between an economy and the rest of the world, including discrepancies caused by foreign currency translations.

History of Balance of Payments (BOP)

Before the 19th century, international transactions were denominated in gold, providing little flexibility for countries experiencing trade deficits. Growth was low, so stimulating a trade surplus was the primary method of strengthening a nation's financial position. National economies were not well integrated, however, so steep trade imbalances rarely provoked crises. The industrial revolution increased international economic integration, and balance of payment crises began to occur more frequently.

The Great Depression led countries to abandon the gold standard and engage in competitive devaluation of their currencies, but the Bretton Woods system that prevailed from the end of World War II until the 1970s introduced a gold-convertible dollar with fixed exchange rates to other currencies.

As the U.S. money supply increased and its trade deficit deepened, however, the government became unable to fully redeem foreign central banks' dollar reserves for gold, and the system was abandoned.

Since the Nixon shock—as the end of the dollar's convertibility to gold is known—currencies have floated freely, meaning that a country experiencing a trade deficit can artificially depress its currency—by hoarding foreign reserves, for example—making its products more attractive and increasing its exports. Due to the increased mobility of capital across borders, balance-of-payments crises sometimes occur, causing sharp currency devaluations such as the ones thatstruckin Southeast Asian countries in 1998.

During the Great Recession, several countries embarked on competitive devaluation of their currencies to try to boost their exports. All of the world’s major central banks responded to the financial crisis at the time by executing dramatically expansionary monetary policy. This led to other nations’ currencies, especially in emerging markets, appreciating against the U.S. dollar and other major currencies.

Many of those nations responded by further loosening the reins on their monetary policy to support their exports, especially those whose exports were under pressure from stagnant global demand during the Great Recession.

Special Considerations

Balance of payments and international investment position data are critical in formulating national and international economic policy. Certain aspects of the balance of payments data, such as payment imbalances and foreign direct investment, are key issues that a nation's policymakers seek to address,

While a nation's balance of payments necessarily zeroes outthe current and capital accounts, imbalances can and do appear between different countries' current accounts. The U.S. had the world's largest current account deficit in 2020, at $616 billion. China had the world's largest surplus, at $274 billion.

Economic policies are often targeted at specific objectives that, in turn, impact the balance of payments. For example, onecountry might adopt policies specifically designed to attract foreign investmentin a particular sector, while anothermight attempt to keep its currency at an artificially low level to stimulate exportsand build up its currency reserves. The impact of these policies is ultimately captured in the balance of payments data.