AS Economics Revision – Balance of Payments

Below are some notes and a mindmap on the Balance of Payments with a New Zealand bias.

Balance of Payments consists of 3 accounts – Current Account, Capital Account and Financial Account:

1. Current Account – this consist of 4 accounts:

• Balance of trade in Goods  – also know as visibles. E.G. Manufactured goods, Semi-finished goods, energy products, raw material, consumer goods and capital goods. The difference between visible exports (+) and  imports (-) is sometimes known as the ‘Balance of Trade’.
• Balance of trade in Services – Invisibles. E.G. Tourism, Banking, Shipping and Transport, Education, etc. The difference between invisible exports (+) and  imports (-) is Balance on Services.
• Balance on Primary Income – measures two main flows of income into and out of NZ: the compensation of employees – wages and salaries and investment income – Interest Profits and Dividends coming into NZ from NZ assets owned overseas matched against the outflow of profits and other income from foreign owned assets located within NZ.
• Balance on Secondary Income – relates to transfers of money between countries by central government and other economic agents – remittances sent back to NZ from overseas workers and overseas development aid. Also a financial commitment if your country is a member of an organisation like the EU, APEC etc.

2. Capital Account – this account is of minor consequence relative to the NZ Balance of Payments as a whole. The transactions recorded here involve transfers of ownership of fixed assets and also migrants transfers. Funds brought into NZ by new immigrants are recorded as capital account credits, whilst any funds sent by NZ residents who are emigrating to other countries are debits in the capital account.

3. Financial Account – there are 2 main components of this account:

• Direct Investment Flows – relates to FDI – Foreign Direct Investment. E.G. if Toyota invest money in a car plant in NZ this would be an inflow of direct investment. Similarly, when Carter Holt Harvey invest money overseas this will result in an outflow of direct investment from NZ.
• Portfolio Investment Flows – consider the sale and purchase of NZ shares and government securities. E.G. when an overseas investor buys shares on the NZ stock market, there will be an inflow of portfolio investment. When overseas investor sell shares or securities, there is an outflow.

Source: CIE A Level Economics Revision. Susan Grant

Lockdown sees NZ current account deficit narrow

Source: ASB Bank: Economic Note NZ Q1 Current Account Review17 June 2020

The current account deficit narrowed over the year to March 2020, to $-8.4 billion (-2.7% of GDP) – see graph from ASB. This was expected especially as the fall in tourism was offset by the solid trade in goods. Tourist spending was down 8.3% whilst transport services declined by 9.4%. Travel spending overseas by New Zealander’s (imports) was down 9.7% for travel services and 5.1% for transport. The narrowing of the deficit often coincides with a downturn in the economy as there is weaker domestic demand for foreign products and services by consumers and the business sector. Covid-19 has magnified the downturn and there is more pain to come for the domestic economy. Below are some notes on the Balance of Payments which is part of NCEA Level 2 and CIE AS/A2 courses

Balance of Payments consists of 3 accounts – Current Account, Capital Account and Financial Account:

1. Current Account – this consist of 4 accounts:

• Trade in Goods  – also know as visibles. E.G. Manufactured goods, Semi-finished goods, energy products, raw material, consumer goods and capital goods. The difference between visible exports (+) and  imports (-) is sometimes known as the ‘Balance of Trade’.
• Trade in Services – Invisibles. E.G. Tourism, Banking, Shipping and Transport, Education, etc. The difference between invisible exports (+) and  imports (-) is Balance on Services.
• Net Income – measures two main flows of income into and out of NZ: the compensation of employess – wages and salaries and investment income – Interest Profits and Dividends coming into NZ from NZ assets owned overseas matched against the outflow of profits and other income from foreign owned assets located within NZ.
• Net current transfers – relates to transfers of money between countries by central government and other economic agents. E.G. Germany is a net contributor to European Union (EU) Institutions. Other items include foreign aid, military grants and money transfers.

2. Capital Account – this account is of minor consequence relative to the NZ Balance of Payments as a whole. The transactions recorded here involve transfers of ownership of fixed assets and also migrants transfers. Funds brought into NZ by new immigrants are recorded as capital account credits, whilst any funds sent by NZ residents who are emigrating to other countries are debits in the capital account.

3. Financial Account – there are 2 main components of this account:

• Direct Investment Flows – relates to FDI – Foreign Direct Investment. E.G. if Toyota invest money in a car plant in NZ this would be an inflow of direct investment. Similarly, when Carter Holt Harvey invest money overseas this will result in an outflow of direct investment from NZ.
• Portfolio Investment Flows – consider the sale and purchase of NZ shares and government securities. E.G. when an overseas investor buys shares on the NZ stock market, there will be an inflow of portfolio investment. When overseas investor sell shares or securities, there is an outflow.

Balance of Payments and Current Account

In theory the BOP should always balance. The sum of the current account, capital account and financial account balances should be zero. In reality however, this is never the case as it is impossible to record accurately every single transaction that takes place. An additional item known as net errors or omissions, or balancing item, is added to the BOP to ensure that the accounts balance. You can see below that a further $2,600m is required to make the accounts balance – this is referred to as “Net errors and omissions”

Teaching why the Balance of Payments equals zero.

A HT to colleague Nick Lloyd for this great explanation of the relationship between the current account and the capital and financial accounts. In theory the balance of payments should equal zero and this is one area that students find hard to comprehend. Hope you find it as useful as I did.

The Relationship between the Current Account and the Capital and Financial Account

A few starting points:

1. Gross Domestic Product (GDP) = C + I + G + (X – M)
2. Gross National Product (GNP) = GDP plus Net Income (Income Credits (Yc) – Income Debits (Yd))
3. Saving/Investment Gap (S – I) = Balance on Capital and Financial Account (Capital Outflows (Ko) – Capital Inflows (Ki))
4. Current Account Balance = Trade Balance (X – M) + Net Income (Yc – Yd)
5. National Savings = GNP – (Private Spending (C) + Government Spending (G))

Now:

GNP                                      =               GDP + (Yc – Yd) =  C + I + G + (X – M) + (Yc – Yd)

GNP – (C + I + G)                 =               (X – M) + (Yc – Yd)

GNP – (C + G) – I                 =               (X – M) + (Yc – Yd)

S – I                                    =               (X – M) + (Yc – Yd)

Balance on Capital & Financial Account               =               Balance on Current Account

 

Another way to arrive at the same conclusion:

Assuming freely floating exchange rate is in equilibrium:

Demand for Currency = Supply of Currency

Demand comes from:     X + Yc + Ki

Supply comes from:        M + Yd + Ko

Thus when the forex market is in equilibrium:

Demand                         =               Supply

X + Yc + Ki                    =               M + Yd + Ko

(Ki – Ko)                        =               (M – X) + (Yd – Yc)

Balance on CFA               =               Balance on Current Account

 

So, if as a nation you earn more than you spend (current account surplus), you are in effect lending to the rest of the world (exporting savings) by accepting IOUs in the form of your increased holdings of foreign assets (shares, land, government bonds, etc.)

If as a nation you spend more than you earn (current account deficit), you must borrow from the rest of the world (import savings) in the form of increased foreign holdings of your domestic assets (shares, land, government bonds, etc.)