Understanding the Balance of Payments

September 3rd, 2007

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Recently, in the Sydney Morning Herald (SMH), there is an article titled More exposed as deficit widens. If this article contains too many jargons for you to understand, then today’s article will be very useful to you?it will explain the concepts and definitions with regards to the Balance of Payment, which is a pre-requisite for understanding that article in the SMH. After the Balance of Payments have been explained, we will then comment about that article.

First, what is the Balance of Payments? Basically, it is a summary of Australia’s trade with the rest of the world, along with its associated flow of money. There are two components in the Balance of Payments:

  1. Current Account
  2. Capital Account

In theory, both of these components should balance because they are akin to the double entry in an accounting system. In practice, due to impossibility of perfect data collection in the real world, they never balance. Thus, there will be a third component named along the lines of ?net errors and omissions? to account for the differences.

Now, let’s tackle each of the components:

Current Account

The Current Account consists of two sub-components:

  1. Trade in goods and services Australia and the rest of the world.
  2. Payment and incomes of Australia
  3. Transfer of money to and from Australia

The first one is obvious. If Australia exports more than imports, then there will be a trade surplus. Otherwise, there will be a trade deficit. The second is the payments that Australia pays to foreigners or income that foreigners pay to Australia. Interest and dividend payments (and income) is made up of this sub-component. The third components can include foreign aid, gifts and pensions.

Capital Account

The Capital and Financial Account covers the purchases and sales of assets (e.g. stocks, bonds, property, etc). If the Capital Account is in surplus, this means that foreigners are accumulating Australian assets more than Australian accumulating foreign assets.

Why must they balance in theory?

Let’s say there is a deficit in the Current Account i.e. Australian dollars is flowing out of Australia. What will happen to the Australia dollars overseas? Since they are useless in foreign countries, they will have to eventually make their way back to Australia to be ?parked.? That means buying up assets in Australia. The converse is true if there is a Current Account surplus. Thus, in theory, the Current Account should balance with the Capital Account.

Now that you are armed with theĀ  understanding of the Balance of Payment, we will then comment about Australia’s situation in the next article.