The balance of payments is a calculation that reflects the transactions an individual country makes with the rest of the world. It is a detailed record of the trading that a country such as the UK engages in with global markets, and it is divided into different types of account:
The current account
The financial account
The capital account
These accounts can be broken down as follows.
The balance of payments current account
The current account reflects the trade a country has made in goods and services and any income flows that come into the country. The amounts for all of these are measured in both directions – funds moving both in and out of the country. The current account can be divided into the following aspects:
Balance of trade in goods – this accounts for visible, tangible items being imported and exported between the UK and other countries.
Balance of trade in services – this accounts for invisible, intangible aspects of trade such as tourism and financial services.
Net income flows – this accounts for income flowing into the country from primary sources such as wages and investment.
Net current transfers – this accounts for so-called secondary income flows such as government transfers to bodies such as the UK and the EU
The balance of payments financial account
This records transactions based around financial investment, such as the following:
Direct investment – this is investment coming into the UK from other countries. An American firm building a headquarters in the UK would count as a credit item on the UK financial account, for example.
Portfolio investment – this is financial income flowing in and out of the country, and can include factors such as savings placed into bank accounts or investments in bonds and gilts. This section of the financial account might also include short-term money flows, such as foreign investors saving money in UK bank accounts when interest rates are more advantageous.
The balance of payments capital account
This covers the funds that come into the country for the purchase of fixed assets such as land and property.
What factors might impact on the balance of payments?
A deficit on the current account, which means more money leaving the country than coming in, could be caused by a number of factors including:
Consumers spending more money on imports. This could be triggered by an economic boom, during which people feel they have more disposable income available, and more of this disposable income is spent on goods manufactured overseas.
If a country such as the UK experiences higher levels of inflation than overseas competitors then this will make UK exports less competitive, leading to lower demand and a smaller flow of money.
If the exchange rate shifts so that the pound becomes stronger, exports become more expensive and imports cheaper, and this can have a detrimental effect on the balance of payments. In simple terms, more money will be leaving the UK for other countries on affordable imports than will be entering the UK from other countries on less affordable exports.
Shifts in the balance of payments
In general terms, the balance of payments tends to shift in a cyclical manner. When the UK economy is strong, more spending on imports leads to a current account deficit, while during periods of low economic growth spending on imports drops and the deficit on the current account gets smaller.
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