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Balance of Payments

Definition, Description of Accounts, Impact of Deficit


A country's balance of payments is made up of the current account, financial account and the capital account. The current account meaasures international trade and the net income on investments, as well as direct payments. The financial account describes the change in international ownership of assets. The capital account includes miscellaneous financial transactions that don't affect economic output.

The balance of payments is important because it will tell you whether a country has enough savings and other financial transactions to pay for its consumption of imports. It will also tell you if it's producing enough economic output to pay for its growth.

A country with a balance of payments deficit probably imports more goods, services and capital than it exports. It is also borrowing from other countries to pay for its imports. This can be good for a while, so the country can fuel economic growth. However, if it continues for years, then the country may be seen as a net consumer, not producer, of the world's economic output. It may have to sell off its assets, such as natural resource and commodities, to pay for its consumption. Eventually, other countries may wonder if their investments will pay off.

A country with a balance of payments surplus is probably exporting much of its production. In addition, its government and residents are savers, providing enough capital to finance this production and even lend to other countries. This is a great scenario to boost economic growth, in the short term. However, in the long term, this country needs to encourage its residents to spend more and build a larger domestic market. This will keep it from being too dependent on export-driven growth. It will also allow its companies to refine goods and services, using the domestic population as a giant test market. Finally, a large domestic market can also inoculate the country from the volatility of exchange rate fluctuations.

Current Account

foreign exchange
Credit: Peter Dazeley/Getty Images
The current account includes a country's trade balance. In addition, it adds in the effects of net income and direct payments. When the activities of a country's people provide enough income and savings to fund all their purchases, business activity and government infrastructure spending, then the current account is in balance.

Financial Account

Financial Account
The financial account measures 1)changes in domestic ownership of foreign assets and 2)foreign ownership of domestic assets. If domestic ownership increases more than foreign ownership does, it creates a deficit in the financial account. This means the country is selling off its assets, like gold, commodities and corporate stocks, faster than it is acquiring foreign assets.

Capital Account

The capital account measures a variety of miscellaneous financial transactions. The important thing to remember is that they don't affect income, production or savings. For example, it records international transfers of drilling rights, trademarks, and copyrights. Many capital account transactions are intermittent, such as a cross-border insurance payment. The capital account is usually pretty small compared to the other two component of the balance of payments.

Causes and Consequences of a Current Account Deficit

Current Account Deficit
A current account deficit is created when a country's residents would rather spend on imports than save. In addition, the country's businesses are seen as a good investment to foreign lenders. It also helps if the lender country's businesses profit from exports. It's a win/win for both countries. However, if the current account deficit continues for a long time, it can be a drag on economic growth. Why? Because the foreign lenders may eventually wonder whether they will get an adequate return on their investment. If demand falls off, the value of the borrower country's currency can start to fall. This can lead to inflation as import prices rise. It can also lead to higher interest rates as the government must pay higher yields on its bonds.

U.S. Current Account Deficit -- Threat or Way of Life?

U.S. Current Account Deficit
The U.S. current account deficit reached its all-time highest level of $803 billion in 2006, causing concern about the sustainability of such an imbalance. Even though the recession scaled it back, it appears it's on the rise again. The warnings made by the Congressional Budget Office, and the solutions it proposed, seem as relevant today as when they were made. The safety of investing the U.S. could once again become a concern to foreign investors. Americans have cut back on credit card spending, and the savings rate has inched up, but is it enough to fund domestic business growth? If not, it could lead to inflation and higher interest rates -- just when the U.S. economy appears to be leaving behind the worst recession since the Great Depression of 1929.

What's Measured in a Trade Deficit?

Trade Deficit
A trade deficit results when a country's imports of goods and services is greater than its exports. Imports are any goods and services produced in a foreign country, even if produced overseas by a domestic company. Therefore, a trade deficit can occur even if all the imports are being sold by, and sending profit to, a domestic firm. With the rise of multinational corporations, and jobs outsourcing, trade deficits are on the rise.

The Current U.S. Trade Deficit

U.S. Trade Deficit
The U.S. trade deficit hit a record $753 billion in 2006. The recession lowered the deficit, but it is rising again. A large part of the U.S. trade deficit is caused by America's reliance on foreign oil. When oil prices rise, so does the trade deficit. America also imports a lot of automobiles and consumer products. The U.S. exports a lot of the same things, as well as services such as financial and travel-related services. However, it's not enough to balance the deficit in goods. Find out the primary trading partners, why an ongoing deficit weakens the economy, and how the deficit affects the dollar's value -- and vice versa.
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