BALANCE OF PAYMENTS ACCOUNTS

The balance of payments accounts of any country focus exclusively on the relationship of the country
with the rest of the world. Recall from the previous section that the open-economy accounts were
divided into five sub accounts, namely Firm, House- hold, Capital, Government, and Rest of the World.
The purpose of the balance of payments accounts is to examine in more detail the final, Rest of the
World account, almost like holding up a magnifying glass to it. This examination is in its own style of
accounting, however, with a terminology that is not entirely consistent with the open-economy
accounts previously discussed. Consequently, the balance of payments accounts sometimes require a bit
of patience on the part of the user.

We begin our discussion of the balance of payments accounts by considering a summary

account for Mexico in 2007. This is presented in Table 13.2. The balance of payments in this table has
five parts, each with a heading in italics. These parts are the current account, the capital/financial
account, official reserve transactions, errors and omissions, and the overall balance. The current account
of the balance of payments records transactions that create earnings and generate expenditures
between Mexico and the Rest of the World. These do not involve the exchange of assets. The
capital/financial account of the balance of payments records transactions between Mexico and the Rest
of the World that do involve the exchange of assets. The official reserve transactions also involve the
exchange of assets between Mexico and the Rest of the World, but these are governmental (central
bank and treasury)transactions rather than the private transactions of the capital / financial account.
Finally, there are inevitably errors and omissions.

The starting point for understanding the balance of payments is to recognize that the overall
balance must be zero. This is another example of the principle that

“things add up.”Consequently,we can think of the balance of payments in the following terms:

Current Account + Capital/Financial Account + Official Reserve Transactions + Errors and

Omissions = 0 (13.7)

Now let’s consider the balance of payments accounts of Table 13.2 in some detail. As we just
mentioned, the first section of the balance of payments in known as the current account and includes
items 1 through 9. Some of these items are reported in gross terms, some in net terms, and one as a
major balance.7 We consider them one at a time. Item 1 is Mexico’s total goods exports. It is reported in
gross terms at a 2007 value of US$271.9 billion. Similarly, item 2 is Mexico’s total goods imports,
reported in gross terms at a value of−$281.9 billion. You can see here that goods exports, generating a
receipt for Mexico, have a positive value, whereas goods imports, generating a payment for
Mexico,have an egative value.The net of these two items is known as the goods trade balance and is
reported in net terms of−$10.0 billion.8 Services trade is reported separately in items 4 and 5 of the
balance of payments in Table 13.2. Service exports are reported in gross terms in item 4 as $17.6 billion,

3
 and service imports are reported in gross terms in item 5 as −$24.1 billion. Again we see that
service exports, generating a receipt for Mexico, have a positive value, whereas service imports,
generating a payment for Mexico, have a negative value. Item 6 gives our second net balance, namely
the goods and services trade balance of −$16.5 billion.9 This value corresponds to the E − Z value in the
open economy accounts considered previously. Items 7 and 8 in Table 13.2 are new items that we have
not yet encountered. Furthermore, they are the two items that cause a difference between the goods
and services trade balance and the current account balance. Item 7 is net income. It requires a little
explanation. Residents of Mexico, either households or firms, own factors of production located in the
Rest of the World. That is, a Mexican firm might own a factory in a foreign country. This firm receives
income or profits from this factory during the year in question, and this is income receipts or income
credits. Alterna- tively, residents of foreign countries own factors of production located in Mexico, and
they receive payments from Mexico. From Mexico’s point of view, these are income payments or
income debits. Item 7 of Table 13.2 records the net of income receipts and income payments. Income
payments exceed income receipts, and net income is −$18.3 billion.

Item 8 is net transfers and includes foreign aid, foreign remittances (discussed in Chapter 12),
and international pension flows. For Mexico in 2007, inward transfers exceeded outward transfers by
$26.4 billion, and it is this net figure that is entered into the balance of payments.

The sum of the net items 6 through 8 composes the current account balance and is entered into
the accounts as a major balance in item 9 of Table 13.2. In 2007, Mexico had a current account deficit of
$8.4 billion. Because the accounts between Mexico and the rest of the world must balance(“things add
up,”once again),it must be the case that there were other transactions in the balance of payments
offsetting the current account deficit. As mentioned previously, whereas the current account records
earnings and expenditure transactions that do not involve the exchange of assets, the capital / financial
account has the distinguishing feature of consisting of transactions that involve the exchange of
assets.10 The type of asset exchanged and who exchanges them determine the capital / financial
account item in which a transaction is recorded. For example, item 10 in Table 13.2 is direct investment,
which is just the foreign direct invest- ment (FDI) we discussed in previous chapters.

As we discussed in Chapter 1, the assets involved in direct investment contain an element of

management influence reflected in shares amounting to at least 10 percent of the enterprise in
question. In the case of Mexico in 2007, there was a net inward flow of direct investment of $18.8
billion. The second capital account item is portfolio investment. Portfolio investment includes
government bonds of various maturities, corporate equities, and corporate

bonds. Unlike direct investment, portfolio investment does not involve an element of
management influence.11 As we see in item 11 in Table 13.2, in the case of Mexico in 2007, there was a
net inward flow of portfolio investment of $11.3 billion. The third capital / financial account item is
other investment.This includes commercial bank lending and other residual items. As we see in item 12
of Table 13.2, in the case of Mexico in 2007, there was a net outward flow with an entry of −$10.6
billion.12 The sum of the net items 10 through 12 composes the capital / financial account balance and
is entered into the accounts as a major balance in item 13 of Table 13.2. In 2007, Mexico had a capital
account surplus of $19.5 billion, more than offsetting the current account deficit of $8.4 billion. This
value corresponds most closely to the SF value in the open-economy accounts considered earlier. The
third component of the balance of payments accounts is official reserve transactions, reported in net
terms as a major balance in Table 13.2. It is an item that did not appear in the open-economy accounts
relationship of the preceding balance of payments equation. The official reserves balance is recorded as
item 14 at a value of −$10.3 billion in 2007. The official reserves balance reflects the actions of the
world’s treasuries and central banks. Central banks need to hold reserves of foreign exchange. They hold
these in the form of other countries’ government bonds and in accounts at foreign central banks.
Transactions on the official reserves balance occur in four instances:

1. When Mexico’s central bank sells foreign exchange holdings, this generates an inward flow of
funds and income or receipts on Mexico’s official reserves balance (positive entries).

2. When Mexico’s central bank buys foreign exchange holdings, this generates outlays or
expenditures on the official reserves balance (negative entries).

3. When foreign central banks sell their reserves of Mexico’s currency,this generates an
outward flow of funds and an outlay or expenditure on Mexico’s official reserves balance (negative
entries).

4. Finally, when foreign central banks buy reserves of Mexico’s currency, this generates an
income or receipts on Mexico’s official reserves balance (positive entries).

Let’s take stock of our balances up to this point:the current account balance is −$8.4 billion, the
capital/financial account balance is $19.5 billion, and the official reserves balance is −$10.3 billion.
Adding these three balances gives us $0.8 billion. The balance of payments accounts address this kind of
difference through the errors and omissions entry. This entry, item 15 in Table 13.2 of −$0.8 billion,
ensuresthat the overall balance of payments in item 16 is indeed zero. “Things add up.”

ANALYZING THE BALANCE OF PAYMENTS ACCOUNTS

With this understanding of the balance of payments accounts in hand, we can now turn to how
we might use the accounts in a more analytical fashion. As we saw in Equation 13.7, the sum of the
current account, the capital/financial account, official reserve transactions, and errors and omissions
must be zero. In practice, and as we saw in Table 13.2, errors and omissions are small. Analytically then
(but not in actual accounts), we can ignore the errors and omissions. This gives us:

Current Account + Capital/Financial Account + Official Reserve Transactions = 0 (13.7)

This is the analytical application of “things add up” for the balance of payments accounts.We
have also seen that the current account contains the trade balance and the capital account contains
foreign savings. So Equation 13.7 is similar to Equations 13.5 and13.6 of our open economy macro
economic accounts.However,it is more inclusive than those accounts and allows for official reserve
transactions.
 What does Equation 13.7 tell us? There are many ways of going about describing this, but
perhaps the easiest is to recognize that, if two of the items in Equation 13.7 have the same sign (positive
or negative), then the third must have the opposite sign (negative or positive). To be more specific, we
can state that:

If the current and capital/financial accounts are both positive (negative), then official reserve
transactions must be negative (positive).

If the current and official reserve transaction accounts are both positive (negative), then the
capital/financial account must be negative (positive).

If the capital/financial and official reserve transaction accounts are both positive (negative),
then the current account must be negative (positive).

Let’s examine two cases of this with reference to the first of these bullet points. Suppose that
the current and capital / financial accounts were both positive.This roughly means that Mexico is selling
more goods, services, and assets in the private realm from the Rest of the World than it is buying. The
official transactions must make up for the difference. The central bank must buy additional assets to
generate an offsetting expenditure with a negative entry and bring the overall balance of payments back
to zero.Alternatively, suppose that the current and capital/financial accounts were both negative. This
roughly means that Mexico is buying more goods, services, and assets in the private realm from the Rest
of the World than it is selling. Again, the official transactions must make up for the difference. The
central bank must sell additional assets to generate an off setting receipt with a positive entry and bring
the over all balance of payments back to zero.

Another way to look at Equation 13.7 is in terms of financing current account deficits. This often
has relevance to countries in deficit positions and is a focal point for many types of analysis. Perhaps
Mexico has a negative goods and services trade balance that is not offset by income and transfer
receipts. Consequently, there is a current account deficit. Perhaps, however, the capital/financial
account, even with a positive balance, is insufficient to finance the current account deficit. The central
bank must step in to sell assets and generate additional receipts. As we will see in subsequent chapters,

this entails drawing down foreign exchange reserves. There is a limit to central banks’ abilities to
do this, however, because foreign exchange reserves cannot fall below zero. That is why, in some
instances, a current account deficit with an insufficient capital account surplus draws so much attention:
it can precipitate a crisis. The balance of payments accounts are thus an important diagnostic tool for
interna- tional economists.13 They help to identify patterns of relationships of the country in question
with the rest of the world that might not be sustainable. For example, in the case just described, an
international economist might begin considering potential cor- rective measures. The current account
deficit, for example, may need to be suppressed through increases in government tax revenues that
allow an increase in government savings.

GLOBAL IMBALANCES

The discussion in this chapter on open-economy and balance of payments accounts helps to
provide a window onto one of the most central aspects of the current world economy. There is a
tradition in international economics that suggests that it is nat- ural for developed countries to have
capital/financial account deficits or outflows and for developing countries to have capital/financial
account surpluses or inflows. As a result, developing countries would receive net inflows of capital that
would yield relatively high rates of return, the capital being supplied from developed countries where
rates of return are relatively low. This reflects the fact that, at early stages of development, the need for
capital is high, whereas domestic saving is low. As devel- opment proceeds, the need for capital slowly
declines, whereas domestic saving slowly increases.14 Let’s examine whether this proposition holds in
the current world economy. We do this from the developed country perspective first, considering the
United States. Figure 13.3 plots the capital/financial and official reserves account transactions of the U.S.
balance of payments from 1960 to 2008.15 These are the two accounts that involve the exchange of
assets. Between 1960 and 1983, the United States was not a significant
borrower(positiveentries)orasignificantlender(negativeentries).Beginningin1984,
however,andincontraindicationtothedevelopedcountryaslenderstoryjustdescribed, the United States
began to borrow from abroad on the capital/financial account as part of the Reagan Administration’s
expansive fiscal policies and consequent decline of U.S. government savings. The concurrent expansion
of government deficits and current account deficits became known as the “twin deficits.” This borrowing
began to decline in 1989. A second episode of foreign borrowing on the capital/financial account began
in 1993. Unlike the decade of the 1980s, this was due to a collapse of household savings rather than
government savings. Beginning in 2001, an entirely new episode of foreign