Balance of payments
A country’s balance of payments (BoP) is simply a record of their economic transactions with the rest of the world. This short video from Investopedia provides a good overview:
While the BoP can look daunting, it is merely an application of double-entry bookkeeping to national accounts, measuring the flow of payments between one country and foreign countries. The “balance” stems from the fact that the flow of goods and services across borders must be equal to the flow of financial assets/ liabilities that finance capital accumulation. We can define it as follows:
BoP = Current Account + Capital Account (+ Financial Account)
Traditionally the BoP was simply the relationship between the current and capital accounts; however it is now common to consider the financial account as a separate item. To keep things simple, let’s merge the capital and financial accounts. A typical BoP will therefore look similar to the following:
(1) Current account
- Trade balance/net exports/(X – M) – these include goods such as oil, raw materials and clothing, and also services.
- Net investment income – on dividends and interest.
- Net transfers received – including foreign aid and money moved across border by migrants.
(2) Capital account/Financial account
- Foreign direct investment (FDI) – investment in physical infrastructure.
- Portfolio investment – equities (i.e. shares in companies) or corporate bonds.
- Other investment – more liquid assets such as government bonds.
- Reserve assets.
The BoP is not an economic theory – it’s an accounting identity. Therefore it has to balance. By definition we know that 1 = 2, however, in practice they don’t always add up. This could be because of slightly different accounting conventions, changes in exchange rates, or simply incomplete records. Therefore there is usually a final line on a BoP called “net errors and omissions”, which is simply the difference.
Looking at the current account, the first (and usually largest) item is known as the “trade balance”, or “net exports”.
Recollect the equation that we have used so far for the total spending in the economy:
AD = C + I + G
It turns out that consumption, investment and government spending, are not the only sources of demand in an economy. So are foreigners. If we export (X) more than we import (M), and have a positive trade balance, this will boost aggregate demand. The complete equation is the following:
AD = C + I + G + (X – M)
Do imports reduce GDP?
Our equation for GDP implies that more imports (M) will reduce GDP. However, as Scott Wolla explains, this is an accounting trick to offset the fact that when we buy an imported good it has also been treated as consumption (C). We subtract M not because they reduce GDP, but simply to avoid double counting them.
If a country has a trade deficit (which implies a current account deficit), it means that they are importing more than they are exporting (M>X).
How is it possible to import more than you export? There are really two ways.
Drawing down foreign reserves.
Borrow money from overseas.
If you think of yourself as a “country”, the only way you can “import” (consume) more than you “export” (produce) is either by drawing down your savings, or by borrowing from outside sources.
The capital/financial account shows these sources of financing.
FDI is typically viewed as being more favourable to the recipient country; because it is a more long-term, stable investment. But precisely because indirect investment (such as portfolio capital or bonds) is easier to reverse, this may make it more advantageous to the company doing the investing. It would be easy to think that countries should focus on attracting FDI, but in some cases being open to portfolio investment is a precursor to more longer-term commitments.
In terms of the financial crisis, Bohle and Greskovits (2012, p.225), found that the type of FDI had a big impact on the severity of the impact. In the Baltic states, Romania, Bulgaria, and Croatia, FDI flowed mostly to real estate and the financial sector. Their balance of payments were poor going into the crisis, and these sectors were particularly fragile. By contrast, the Czech Republic, Hungary, Poland and Slovakia (i.e. Visegrad countries) saw FDI flow into industry, which allowed them to increase exports and be less dependent on future capital inflows. So it isn’t only the type of financing, it’s even the type of direct investment that matters. (For more see Capitalist Diversity on Europe’s Periphery, Cornell University Press).