What is the Balance of Payments?

The Balance of Payments (BOP) is the place where countries record their monetary transactions with the rest of the world. Transactions are either marked as a credit or a debit. Within the BOP there are three separate categories under which different transactions are categorized:

1. the Current Account
2. the Capital Account
3. the Financial Account
   

In the current account, goods, services, income and current transfers are recorded. In the capital account, physical assets such as a building or a factory are recorded. And in the financial account, assets pertaining to international monetary flows of, for example, business or portfolio investments, are noted.

Current Acount

The Commerce Department said the current account measures the flow of goods, services and investments into and out of the United States. The current account gap for all of 2011 was 3.1% of GDP, down slightly from 3.2% in 2010. The current account is the broadest gauge of trade. It tracks not only the sale of goods and services but also investment flows.

The balance of the current account tells us if a country has a deficit or a surplus. If there is a deficit, does that mean the economy is weak? Does a surplus automatically mean that the economy is strong? Not necessarily.

But to understand the significance of this part of the BOP, we should start by looking at the components of the current account: goods, services, income and current transfers.

1. Goods - These are movable and physical in nature, and in order for a transaction to be recorded under "goods", a change of ownership from/to a resident (of the local country) to/from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in) and an import is noted as a debit (money going out).

2. Services - These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service it is recorded like an import (a debit), and if money is received it is recorded like an export (credit).

3. Income - Income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production.

4. Current Transfers - Current transfers are unilateral transfers with nothing received in return. These include workers' remittances, donations, aids and grants, official assistance and pensions. Due to their nature, current transfers are not considered real resources that affect economic production.

The current account, on a quarterly basis, measures the U.S. international balance in goods and services trade as well as unilateral transfers. (Bureau of Economic Analysis). U.S. trade with foreign countries holds important clues to economic trends here and abroad. The data can directly impact all the financial markets, but especially the foreign exchange value of the dollar.

The dollar can be particularly sensitive to changes in the chronic trade deficit run by the United States since this trade imbalance creates greater demand for foreign currencies.

The bond market is very sensitive to the risk of importing inflation or deflation. When Asian economies collapsed at the end of 1997, bond and equity investors feared that deflation in these economies would be transported to the United States. While goods inflation did decline modestly and momentarily, service inflation kept on ticking. Thus, the linkage is not so direct. A chronic current account deficit also suggests that consumers and businesses in the United States are outspending their income. We are living on credit while foreigners are paying for our profligate ways.