The Structure of the Balance of Payments
Expert reviewed • 14 August 2024 • 9 minute read
Understanding Australia's Balance of Payments
The Balance of Payments (BOP) is a comprehensive record of the country's economic transactions with the rest of the world, including a country's trade and financial flows. The structure of the BOP is divided into two main accounts: the current account and the capital and financial account.
One of the most fundamental aspects of the BOP is understanding how debits and credits work. Debits and credits are fundamental to the balance of payments, as they help track all economic transactions between Australia and the rest of the world. Credits refer to inflows of money into Australia. They increase the country's foreign exchange reserves and are recorded as positive entries. Conversely, debits represent outflows of money from Australia to other countries. They decrease the country's foreign exchange reserves and are recorded as negative entries.
The BOP is based on the fundamental principle of double-entry bookkeeping, ensuring that the sum of all credit entries equals the sum of all debit entries. This means that, in theory, the overall balance of payments should always be zero (current account should always equal the capital and financial account). However, in practice, statistical discrepancies and measurement challenges can lead to imbalances. Any of these discrepancies are thus recorded in a section of the balance of payments: "net errors and omissions." This section balances out the BOP to ensure the sum of both accounts equals zero.
What is the Current Account?
The current account is primarily composed of three major components:
- Trade in Goods and Services: This includes all the exports and imports of goods and services. In this category, exports are considered credits (there is an inflow of money as something is being sold) and imports are considered debits (money is leaving the country).
- Primary Income: This covers income from investments and employment, such as dividends from foreign investments and wages earned by workers from abroad. Investment income received from abroad is a credit, while investment income paid to foreigners is a debit. As such, the primary income component often shows a deficit, as Australia pays out more in investment income than it receives.
- Secondary Income: This includes transfers where no quid pro quo (money is given out of compassion) is expected, such as foreign aid, personal remittances, and other transfers from non-residents to residents or vice versa.
What are the Capital and Financial Accounts?
Often the capital and financial accounts are considered two separate accounts. However, when it comes to balancing the BOP, they are combined to be weighed against the current account.
As such, the capital account includes capital transfers and the acquisition or disposal of non-produced, non-financial assets, such as intellectual property rights. For example, if an Australian pharmaceutical company sells the patent for a new drug to a foreign company, the transaction is recorded as a credit in Australia's capital account because it represents an inflow of funds to Australia in exchange for a non-produced asset.
Furthermore, the financial account captures transactions in financial assets and liabilities. These are included under the following sectors:
- Direct Investment: Movements of capital associated with control or significant influence over enterprises. Examples of this could be direct international investment in a domestic company, for the acquisition of capital or stake in said company. Remember when money comes into the country it is considered a credit, and when money leaves it is considered a debit.
- Portfolio Investment: Transactions in equity and debt securities, where the purpose is not to exert control over the entity. Examples of this involve the purchasing of company stocks in the ASX.
- Other Investment: Includes trade credits, loans, currency deposits, and other asset and liability forms.
- Reserve Assets: Australia's reserve assets are used to manage the value of the nation's currency and contribute to stabilising the economy's external sector. For example, if the Reserve Bank of Australia is to ever purchase or sell a specific currency, it would be reflected in this section of the financial account.