The Structure of the Balance of Payments

For many A level students this is their least favourite topic. Don't panic! All will be made clear! The key point is to understand the distinction between the current account and the capital account and understand the link between them. Here goes then!

The balance of payments measures all flows of money between the UK and the rest of the world. The current account records the movements of all goods and services into and out of the UK. The capital account measures all capital flows carried out by individuals, firms and governments (usually for investment purposes). Before we look at these two sections individually, the diagram below gives you an overall picture of what is going on. Click on the buttons below to see the summaries of the different accounts.

 

Note that figures have been added for the full year 1999 to give you an idea of how the UK fairs internationally. All figures are in billions of pounds. All positive figures (+) refer to money flowing into the UK as payment for UK exports (on the current account) or simply as investments (in the capital account). All negative figures (-) refer to money flowing out of the UK as payment for imports (on the current account) or simply for investments (on the capital account). Now for the details of the two main sections.

The current account records the movement of all goods and services into and out of the UK. Some of you may be thinking, "what happened to the visibles and invisibles?" While some examiners might let you get away with using these terms, these old terms have not been used officially for almost five years!

Trade in goods

The visible section is now called the trade in goods section. Both names are equally easy to remember. This section records all trade in goods, hence the name! Another way of thinking about it is that all goods are visible, hence the old name.

There are hundreds of different items that fall under this category. Oil is one of the biggest, especially given that the UK has been a net exporter of oil for the last 20 years. All manufactured goods are included, like cars, all household appliances, computers and anything else you can think of. Textbooks often refer to 'semi-manufactures'. These are items that have not quite become finished manufactures. Car parts might be an example. All raw materials that are needed for any production process are also included, as are all food items.

If the UK sells a Rover car (made in Britain) to someone in a French car showroom, then this is called an export and appears as an inflow of money (+) in the 'trade in goods' section of the current account. If Renault (the French car company) sell a car to someone in a British car showroom, then this is called an import and appears as an outflow of money (-) in the same section.

It is very important to follow the money. When the UK exports a car, the car may well go abroad, but the payment for the car flows into the UK, hence the plus sign (+) in the current account. When the UK imports a French Renault, the car comes into the UK, but the payment flows out of the country, hence the minus sign (-) in the current account.

The 'trade in goods' balance is often referred to as the trade balance. Adding up the total value of exports of goods and subtracting the total value of imports of goods calculate this. In the case of the UK, this balance is nearly always negative, so it is known as the trade deficit; the UK always imports more goods than it exports.

Trade in services

In the days of 'visible' and 'invisible', services, investment income and transfers were all lumped in together in the 'invisibles' section. The current account only had two sections: visible and invisible.

Trade in services is now a separate section, as are the other two categories (see next two sub-sections). Although it is not quite so easy to picture international trade in services (only about 20% of all services are potentially tradable), good examples include financial services (e.g. banking and insurance), transport services (particularly shipping), law, accountancy, management consultancy and tourism.

Again, it is important to follow the money. Unlike the 'trade in goods' section, where the good goes one way and the money goes the other, with the 'trade in services' section the money tends to follow the service. If a British person goes on holiday to France flying with Air France, all payments will count as imports because the money flows out of the UK (-). The payment for the flight goes back to France, and any money actually spent on food, drink and hotels ends up in France.

Again, you can see why these items were referred to as 'invisible'. Unlike, say, a car, you can't 'see' a holiday or a financial service. You experience a holiday, or a financial service, and probably get a lot of benefit from them, but they are not tangible.

Investment income

This also used to be under the old 'invisibles'. You may know it as 'IPDs' or interest, profit and dividends. The new title of investment income makes sense because interest, profit and dividends are all forms of income earned on investments. Interest is earned on bank deposits and government bonds, profit is earned from investments in a business enterprise and dividends are earned annually on shares.

The key point to note here is that these incomes (annual flows of money) are derived from invested capital (stocks of wealth) that appears in the capital account. This is the crucial link between the current and the capital accounts. Interest is earned on money invested in the 'other investment' section of the capital account, and the bonds in the 'portfolio investment' section of the capital account (see the green line on the diagram above). Profit is earned on money invested in businesses in the 'direct investment' section of the capital account (see the red line of the diagram above). Dividends are earned from the investment in shares that appear in the 'portfolio investment' section of the capital account (see the blue line on the diagram above).

Transfers

This also used to be under the old 'invisibles'. Transfers are now separated into a separate section because they are different in the sense that they do not reflect any actual trade. This section is split into two; government transfers and transfers made by other sectors.

Government transfers include contributions to the EU (most of which is used for the Common Agricultural Policy or CAP) and foreign aid. These are flows of money out of the UK (-). The 'other sectors' section many highlights the transfer of assets by individuals to foreign bank accounts.

The Capital account measures all the short term and long term monetary transactions between the UK and the rest of the world. Generally, these flows of money are associated with saving and investment, but speculation has become a big part of the account in recent years. Officially, the name has changed to 'Capital and Financial Accounts', but examiners seem to be happy for you to use 'capital account', probably because it is a lot less hassle to write down under exam conditions! Here are the four main sections.

Direct investment

This refers to money that flows across national boundaries for the purpose of investing in a business enterprise. Essentially, it records the transfer of ownership of UK or foreign businesses. It also records money invested abroad for a new business venture. When Marks & Spencer build a new store in, say, Hong Kong, this will count as an outflow of money from the UK (-) in the direct investment section of the capital account. When Nissan built its factory in Sunderland, this counted as an inflow of money (+) in the same section.

Note that earnings from these investments (profit) appear in the investment income section of the current account. The initial investment by M & S in Hong Kong will appear as a one off outflow of money from the UK (-) in the capital account, but each subsequent year M & S should make profits (hopefully!). These will appear as inflows of money into the UK (+) in the investment income section of the current account.

Portfolio investment

This is money that flows across national boundaries for the purpose of investing in shares and bonds. If someone in the UK buys some shares in an American company, this will count as an outflow of money from the UK (-) in the portfolio investment section of the capital account. If an American buys some shares in a British company, this will count as an inflow of money into the UK (+) in the same section

Again, note that the earnings from these shares and bonds (dividends and interest) will appear, in subsequent years, in the investment income section of the current account. For as long as the UK citizen holds onto the American shares, he will receive an annual dividend, which will represent an inflow of money into the UK (+) on the investment income section of the current account.

Other investment

This section can be quite hectic because it includes short-term 'hot money' banking flows. It also includes net government borrowing from foreigners.

Official reserves

This refers to the reserves of gold and foreign currencies held by the Bank of England for use by the government. The government might use some of their reserves to artificially manipulate the value of the pound; although this rarely happens any more because the pound is freely floating and the government do not seem particularly keen to intervene in currency markets. After the last government's horrific experience of trying to defend the pound within the Exchange Rate Mechanism, all governments since have left the pound alone to find its own level in the currency markets.

You may know this as the balancing item. I'm afraid this name has changed as well. The new name actually makes more sense. The term 'balancing item' suggests that this entry is an actual 'item'. This is misleading. The balancing item was only ever a number stuck into the account to represent mistakes, so the new name is entirely appropriate.

As you will see in the next section of this Learn-It, the balance of payments always balances, so, theoretically, the net errors and omissions item should always equal zero. That it rarely does reflects the fact that it is very difficult to collect all of the data required for the balance of payments in a totally accurate fashion. Millions of pieces of information have to be collected from around the world. There is often a time lag as well. It is interesting to note that when past figures for the balance of payments are revised as the years go by, the figures for 'net errors and omissions' get smaller and smaller as the errors are found and corrected.

Before we start, here is the relevant formula for the balance of payments.

Current account balance + Capital account balance + net errors and omissions = 0

As we said above, net errors and omissions simply reflect mistakes. Assuming no mistakes are made, then the formula will look like this.

Current account + Capital account = 0, hence Current account = Capital account.

In other words, if a country has a deficit on the current account (more imports than exports) then it must have an equal and opposite surplus on the capital account (and vice versa).

Let's think about this. If you buy a Mercedes car, what are the flows of monies involved? You go to the Mercedes showroom and buy the car using pounds. This money will end up back in Germany. But the German owners of Mercedes do not want the money in pounds. They will want Euros.

How are the pounds changed into Euros?

In the currency market, which forms part of the capital market.

Where will this transaction appear in the balance of payments?

In the capital account, probably under 'other investment'.

So, as you can see, any transaction that takes place in the current account must have an equal and opposite transaction somewhere in the capital account. Of course, in the real world, countries that run large current account deficits (like the UK) have to attract this foreign currency in the first place. This is not such a problem in the UK; we are lucky that we have successful and sophisticated capital markets. Go to the next Learn-It to find out more about how the UK manages to attract foreign investment to keep the capital account in surplus.

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