Balance of Payments in Global Transactions: Why Does It Matter?

Balance of Payments (BOP)

Investopedia / Paige McLaughlin

What Is the Balance of Payments (BOP)?

The balance of payments (BOP), also known as the balance of international payments, is a statement of all transactions made between entities in one country and the rest of the world over a defined period, such as a quarter or a year. It summarizes all transactions that a country's individuals, companies, and government bodies complete with individuals, companies, and government bodies outside the country.

Key Takeaways

  • The balance of payments includes both the current account and capital account.
  • The current account includes a nation's net trade in goods and services, its net earnings on cross-border investments, and its net transfer payments.
  • The capital account consists of a nation's transactions in financial instruments and central bank reserves.
  • The sum of all transactions recorded in the balance of payments should be zero; however, exchange rate fluctuations and differences in accounting practices may hinder this in practice.

The Balance Of Payments

Understanding the Balance of Payments (BOP)

The balance of payments (BOP) transactions consist of imports and exports of goods, services, and capital, as well as transfer payments, such as foreign aid and remittances. A country's balance of payments and its net international investment position together constitute its international accounts.

The balance of payments divides transactions into two accounts: the current account and the capital account. Sometimes the capital account is called the financial account, with a separate, usually very small, capital account listed separately. The current account includes transactions in goods, services, investment income, and current transfers.

The capital account, broadly defined, includes transactions in financial instruments and central bank reserves. Narrowly defined, it includes only transactions in financial instruments. The current account is included in calculations of national output, while the capital account is not. 

If a country exports an item (a current account transaction), it effectively imports foreign capital when that item is paid for (a capital account transaction). If a country cannot fund its imports through exports of capital, it must do so by running down its reserves. This situation is often referred to as a balance of payments deficit, using the narrow definition of the capital account that excludes central bank reserves. In reality, however, the broadly defined balance of payments must add up to zero by definition.

In practice, statistical discrepancies arise due to the difficulty of accurately counting every transaction between an economy and the rest of the world, including discrepancies caused by foreign currency translations. 

The sum of all transactions recorded in the balance of payments must be zero, as long as the capital account is defined broadly. The reason is that every credit appearing in the current account has a corresponding debit in the capital account, and vice-versa.

History of Balance of Payments (BOP)

Before the 19th century, international transactions were denominated in gold, providing little flexibility for countries experiencing trade deficits. Growth was low, so stimulating a trade surplus was the primary method of strengthening a nation's financial position. National economies were not well integrated, however, so steep trade imbalances rarely provoked crises. The industrial revolution increased international economic integration, and balance of payment crises began to occur more frequently.

The Great Depression led countries to abandon the gold standard and engage in competitive devaluation of their currencies, but the Bretton Woods system that prevailed from the end of World War II until the 1970s introduced a gold-convertible dollar with fixed exchange rates to other currencies.

As the U.S. money supply increased and its trade deficit deepened, however, the government became unable to fully redeem foreign central banks' dollar reserves for gold, and the system was abandoned.

Since the Nixon shock—as the end of the dollar's convertibility to gold is known—currencies have floated freely, meaning that a country experiencing a trade deficit can artificially depress its currency—by hoarding foreign reserves, for example—making its products more attractive and increasing its exports. Due to the increased mobility of capital across borders, balance-of-payments crises sometimes occur, causing sharp currency devaluations such as the ones that struck in Southeast Asian countries in 1998.

During the Great Recession, several countries embarked on competitive devaluation of their currencies to try to boost their exports. All of the world’s major central banks responded to the financial crisis at the time by executing dramatically expansionary monetary policy. This led to other nations’ currencies, especially in emerging markets, appreciating against the U.S. dollar and other major currencies.

Many of those nations responded by further loosening the reins on their monetary policy to support their exports, especially those whose exports were under pressure from stagnant global demand during the Great Recession.

Special Considerations

Balance of payments and international investment position data are critical in formulating national and international economic policy. Certain aspects of the balance of payments data, such as payment imbalances and foreign direct investment, are key issues that a nation's policymakers seek to address,

While a nation's balance of payments necessarily zeroes out the current and capital accounts, imbalances can and do appear between different countries' current accounts. The U.S. had the world's largest current account deficit in 2020, at $616 billion. China had the world's largest surplus, at $274 billion.

Economic policies are often targeted at specific objectives that, in turn, impact the balance of payments. For example, one country might adopt policies specifically designed to attract foreign investment in a particular sector, while another might attempt to keep its currency at an artificially low level to stimulate exports and build up its currency reserves. The impact of these policies is ultimately captured in the balance of payments data.

What Is a Balance of Payments (BOP) Example?

Funds entering a country from a foreign source are booked as credit and recorded in the BOP. Outflows from a country are recorded as debits in the BOP. For example, say Japan exports 100 cars to the U.S. Japan books the export of the 100 cars as a debit in the BOP, while the U.S. books the imports as a credit in the BOP.

What Is the Formula for Balance of Payments?

The formula for calculating the balance of payments is current account + capital account + financial account + balancing item = 0.

What Is BOP and Its Components?

The BOP is all transactions between entities in one country and the rest of the world over some time. There are three key BOP components, including the current account, capital account, and financial account. The current account must balance the capital and financial accounts.

Article Sources
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  1. Federal Reserve History. "Creation of the Bretton Woods System."

  2. Federal Reserve History. "Nixon Ends Convertibility of U.S. Dollars to Gold and Announces Wage/Price Controls."

  3. Peterson Institute for International Economics. "Currency Conflict and Trade Policy: A New Strategy for the United States," Pages 7–8.

  4. Peterson Institute for International Economics. "Currency Conflict and Trade Policy: A New Strategy for the United States," Pages 10–11.

  5. The World Bank. "Current Account Balance (BoP, Current US$)."

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