International Finance Theory and Policy
by Steven M. Suranovic

Finance 5-5

The Balance of Payments Accounts: Definitions

The balance of payments accounts is a record of all international transactions that are undertaken between residents of one country and residents of other countries during some period of time. The accounts are divided into several sub-accounts, the most important being the current account and the financiall account. The current account is often further subdivided into the merchandise trade account and the service account. These are each briefly defined in the table below.

Current Account a record of all international transactions for goods and services. The current account combines the transactions of the trade account and the services account.
Merchandise Trade Account a record of all international transactions for goods only. Goods include physical items like autos, steel, food, clothes, appliances, furniture, et. al.
Services Account a record of all international transactions for services only. Services include transportation, insurance, hotel, restaurant, legal services, consulting, et. al.
Financial Account a record of all international transactions for assets. Assets include bonds, treasury bills, bank deposits, stocks, currency, real estate, et. al.

The balance on each of these accounts is found by taking the difference between exports and imports. Thus, the current account balance is defined as CA = EXG&S - IMG&S where the G&S superscript is meant to include exports and imports of both goods and services. If CA > 0, then exports of goods and services exceed imports and the country has a current account surplus. If CA < 0, then imports exceed exports and the country has a current account deficit.

Similarly, the trade balance (or goods balance) can be defined as, GB = EXG - IMG , where we record only the export and imports of merchandise goods. If GB > 0, the country would have a (merchandise) trade surplus. If GB < 0, the country has a trade deficit.

The service balance can be defined as SB = EXS - IMS, where we record only the export and import of services. If SB > 0, the country has a service surplus. If SB < 0, the country has a service deficit.

Finally, the financial account balance can be defined as KA = EXA - IMA , where EXA and IMA refer to the export and import of assets, respectively. If KA > 0, then the country is exporting more assets than it is importing and it has a financial account surplus. If KA < 0 then the country has a financial account deficit.

Occasionally, one will hear trade deficit figures reported in the US press followed by a comment that the deficit figures refer to the "broad" measure of trade between countries. In this case, the numbers reported refer to the current account deficit rather than the merchandise trade deficit. This usage is developing for a couple of reasons. First of all, at one time, around thirty years ago or more, there was very little international trade in services. At that time it was common to report the merchandise trade balance since that accounted for most of the international trade. In the past decade or so, service trade has been growing much more rapidly than goods trade and it is now becoming a significant component of international trade. (In the US service trade exceeds 30% of total trade) Thus, a more complete record of a country's international trade is found in its current account balance rather than its merchandise trade account.

But, there is a problem with reporting the current account deficit and calling it the current account deficit. The problem is that most people don't know what the current account is. There is a greater chance that people will recognize the trade deficit (although most could probably not define it either) than will recognize the current account deficit. Thus, the alternative of choice among commentators is to call the current account deficit a trade deficit and then define it briefly as a "broad" measure of trade.

A simple solution would be to call the current account balance, the trade balance since it is a record of all trade in goods and services. And, call the merchandise trade balance, the merchandise goods balance or the goods balance for short. I will ascribe to this convention throughout this text in the hope that it might catch on.

The financial account records all international trade in assets. Assets represents all forms of ownership claims in things that have value. They include bonds, treasury bills, stocks, mutual funds, bank deposits, real estate, currency and other types of financial instruments.

It is useful to differentiate between two different types of assets. First, some assets represent IOUs. In the case of bonds, savings accounts, treasury bills, etc., the purchaser of the asset agrees to give money to the seller of the asset in return for an interest payment plus the return of the principal at some time in the future. These asset purchases represent borrowing and lending. When the US government sells a treasury bill, for example, it is borrowing money from the purchaser of the T-bill and agrees to pay back the principal and interest in the future. The treasury bill certificate, held by the purchaser of the asset, is an IOU (i.e., I owe you), a promissory note to repay principal plus interest at a predetermined time in the future.

The second type of asset represents ownership shares in a business or property which is held in the expectation that it will realize a positive rate of return in the future. Assets such as common stock give the purchaser an ownership share in a corporation and entitles the owner to a stream of dividend payments in the future if the company is profitable. The future sale of the stock may also generate a capital gain if the future sales price is higher than the purchase price. Similarly, real estate purchases, say of an office building, entitle the owner to the future stream of rental payments by the tenants in the building. Owner-occupied real estate, although it does not generate a stream of rental payments, does generate a stream of housing services for the occupant-owners. In either case, if real estate is sold later at a higher price, a capital gain on the investment will accrue.

An important distinction exists between assets classified as IOUs and assets consisting of ownership shares in a business or property. First of all, IOUs involve a contractual obligation to repay principal plus interest according to the terms of the contract or agreement. Failure to do so is referred to as a default on the part of the borrower and is likely to result in legal action to force repayment. Thus, international asset purchases categorized as IOUs represent international borrowing and lending.

Ownership shares on the other hand, carry no such obligation for repayment of the original investment and no guarantee that the asset will generate a positive rate of return. The risk is borne entirely by the purchaser of the asset. If the business is profitable, if numerous tenants can be found, or if real estate values rise over time, then the purchaser of the asset will make money. If the business is unprofitable, if office space cannot be leased, or if real estate values fall, then the purchaser will lose money. In the case of international transactions for ownership shares, there is no resulting international obligation for repayment.

International Finance Theory and Policy - Chapter 5-5: Last Updated on 3/11/05