Background Paper 5 1996-97
Easy Guide to the Balance of Payments
Tony Kryger
Statistics Group
Summary
Introduction
What is the Balance of Payments?
The Current Account
The Capital Account
A Simple Analogy
Meaning of the Balance on Current Account
Relationship Between the Current Account Deficit and
Foreign Debt
Appendix 1 : Components of the Balance on Current
Account
Appendix 2 : Effect of Revisions on the Size of the
Current Account Deficit
Glossary
References
The balance of payments is a record of economic transactions by Australian
residents with the rest of the world. By definition the balance of payments
always balances, i.e. the sum of all debit and credit entries is zero.
The balance of payments is made up of two accounts-the current account
and the capital account. The current account records transactions between
Australian residents and non-residents in goods, services, income and
unrequited (or one-sided) transfers. The capital account records transactions
resulting in claims on the rest of the world (assets) and obligations
to the rest of the world (liabilities).
The balance on current account is the difference between a country's
aggregate investment and aggregate saving. If a country's balance on current
account is in surplus in a period, then aggregate saving exceeds aggregate
investment and the country is a net provider of investment funds to the
rest of the world. If a country's balance on current account is in deficit,
then aggregate investment exceeds aggregate saving and the country is
a net recipient of investment funds from the rest of the world.
While current account deficits contribute to a nation's foreign debt,
the current account deficit for a given period does not necessarily equal
the build up of foreign debt that occurred over that period. Rather, the
current account deficit in a given period is equal to the change in net
foreign liabilities (i.e. debt plus equity)-minus any change in the value
of those liabilities due to exchange rate variations or equity revaluations-that
occurred over the period.
Each month the balance of payments attracts considerable interest from
the media, politicians and the business community, with most attention
focusing on the size of the current account deficit. Despite this interest,
many people remain ignorant of what the balance of payments represents.
The purpose of this paper is to provide a brief explanation of how the
balance of payments is constructed. The two accounts which comprise the
balance of payments-the current account and the capital account-are described
in terms of their composition and structure. By way of analogy, the paper
discusses the different ways in which a single transaction-the purchase
of a tractor from overseas-would be represented in the accounts depending
on how the tractor is financed. The linkages between a current account
deficit and foreign debt are not well understood and therefore the paper
also looks at the relationship between these two variables and how each
affects the other.
The Australian balance of payments is a record of economic transactions
by Australian residents with the rest of the world. A transaction with
the rest of the world occurs when something of economic value is provided
by one party resident in Australia to another not resident in Australia-or
vice versa.
Three types of economic transactions are recorded in the balance of
payments:
- transactions in goods, services and income;
- special entries required to offset one-sided transactions such as
gifts, grants and funds brought into Australia or sent abroad by migrants-these
special entries are referred to in the balance of payments as 'unrequited
transfers'; and
- financial transactions involving claims on the rest of the world and
obligations to the rest of the world.
All such transactions are recorded as either credits or debits. Credits
have no arithmetic sign before them while debits are identified by a minus
sign. The provision of goods and services to non-residents, income receivable
from non-residents, unrequited transfers received from non-residents,
decreases in foreign financial assets and increases in foreign liabilities
are recorded as credit entries. The acquisition of goods and services
from non-residents, income payable to non-residents, unrequited transfers
provided to non-residents, increases in foreign financial assets and decreases
in foreign liabilities are recorded as debits entries.
Under the double-entry system for recording all balance of payments
transactions, the balance of payments always balances. It follows therefore,
that in principle, the net sum of all debit and credit entries is zero.
In practice, some transactions are not measured accurately (errors), while
others are not measured at all (omissions). Equality between the sum of
debit and credit entries is therefore brought about by the inclusion of
a balancing item.
The balance of payments is made up of two accounts-the current account
and the capital account. (The balancing item is shown outside
these accounts as it reflects the net effect of errors and omissions in
both accounts.)
The current account records transactions between Australian residents
and non-residents in goods, services, income and unrequited transfers.
(See Table 1.)
1. BALANCE OF PAYMENTS - CURRENT ACCOUNT
($ million)
1993-94 1994-95 1995-96
Current transactions -
Goods and services -
Merchandise
Exports f.o.b. 63 822 66 446 75 184
Imports f.o.b. -64 411 -74 715 -77 136
Balance on merchandise trade -589 -8 269 -1 952
Services -
Credits -
Shipment 1 487 1 533 1 682
Other transportation 4 604 4 473 4 887
Travel 7 502 8 879 10 355
Other services 4 946 5 050 5 492
Total services credits 18 539 19 935 22 416
Debits -
Shipment -3 854 -4 384 -4 358
Other transportation -4 906 -5 333 -5 721
Travel -5 157 -5 774 -6 421
Other services -5 582 -5 878 -6 017
Total services debits -19 499 -21 369 -22 517
Net services -960 -1 434 -101
Balance on goods and services -1 549 -9 703 -2 053
Income -
Credits -
Property income -
Reinvested earnings 2 434 3 866 4 016
Other 2 844 3 088 3 927
Labour and other income 511 551 609
Total income credits 5 789 7 505 8 552
Debits -
Property income -
Reinvested earnings -3 570 -6 256 -6 187
Other -17 219 -19 214 21 393
Labour and other income -283 -389 -441
Total income debits -21 072 -25 859 -28 021
Net income -15 283 -18 354 -19 469
Unrequited transfers -
Credits 2 802 3 209 3 988
Debits -2 624 -2 722 -2 764
Net unrequited transfers 178 487 1 224
Balance on current account -16 654 -27 570 -20 298
The largest items in the current account are the imports and exports
of goods. These are shown as imports f.o.b. and exports f.o.b..
The abbreviation f.o.b. stands for 'free on board' and signifies that
the value of merchandise does not include the freight and insurance
charges associated with its delivery to the country of destination.
By convention, it is assumed that these charges are met by the country
buying the goods, and are classified as services.
The difference between the total f.o.b. value of exports and that
of imports is termed the balance on merchandise trade. In 1995-96,
the value of Australia's imports exceeded the value of its exports,
giving a negative balance on merchandise trade (or balance of trade
deficit) of $1 952 million.
Net services consist of freight and insurance; the amount we
spend abroad net of what foreigners spend here; the cost of international
passenger fares; and fees for financial services, insurance services
and other miscellaneous services. Table 1 shows that in 1995-96 this
category was also in deficit by $101 million.
Net income mainly consists of interest, dividends and royalties
paid overseas, less what is received from overseas. Of total income
debits of $28 021 million in 1995-96, interest repayments on foreign
borrowings made up 46 per cent of the total.
Unrequited transfers are special entries required to offset
one-sided transactions. Examples are the money migrants bring with them,
the money migrants send to family living overseas, the money Australia
pays out in foreign aid, pensions to Australian citizens living abroad
and tax revenue received from foreigners.
The balance on current account is reached by summing the balance
on merchandise trade, net services, net income and net unrequited transfers.
In 1995-96 the current account deficit was $20 298 million, of which
almost all (96 per cent) was made up of the income deficit.
The capital account records transactions resulting in claims on the
rest of the world (assets) and obligations to the rest of the world
(liabilities). Put simply, the capital account is the other side of
the balance of payments coin to the current account. A deficit (or surplus)
on current account will be exactly offset by a surplus (or deficit)
on capital account-with the help of the balancing item.
Whereas the form of presentation of the current account is to distinguish
visible trade (goods) from services, income and transfers, the capital
account is arranged by sector (see Table 2). There are two broad sectors
called the official sector and the non-official sector.
The first of these, the official sector is made up of general government
and Reserve Bank.
2. BALANCE OF PAYMENTS - CAPITAL ACCOUNT
($ million)
1993-94 1994-95 1995-96
Net capital transactions -
Official -
General government -
Foreign investment in Australia -
Borrowing 7 597 9 569 2 837
Other 83 73 -190
Total 7 680 9 642 2 647
Australian investment abroad -553 544 -140
Total general government 7 127 10 185 2 507
Reserve Bank -
Foreign investment in Australia -49 23 -16
Australian investment abroad -
Reserve assets -1 037 1 971 -817
Other - - -
Total -1 037 1 971 -817
Total Reserve Bank -1 086 1 994 -833
Total official 6 041 12 179 1 674
Non-official -
Foreign investment in Australia -
Direct investment -
Reinvestment of earnings 3 570 6 256 6 187
Other 2 243 2 322 9 231
Portfolio and other investment 14 715 4 744 23 084
Total foreign investment in Australia 20 528 13 322 38 503
Australian investment abroad -
Direct investment -
Reinvestment of earnings -2 434 -3 866 -4 015
Other -4 197 -210 -6 332
Portfolio and other investment -7 919 1 970 -10,859
Total Australian investment abroad -14 550 -2 107 -21 206
Total non-official 5 978 11 215 17 297
Balance on capital account 12 019 23 394 18 971
General government includes the transactions made by the Commonwealth
government, the states, local government and statutory authorities-but
not those of public business enterprises which are included in the
non-official sector. It lists funds borrowed and repayments of foreign
loans. General government thus shows the change in net liabilities
of our various levels of government to non-residents which have resulted
from their financial transactions during a particular period.
The second sub-sector of the official sector is Reserve Bank which
shows the net effect of increases (debits) and decreases (credits)
in those foreign exchange assets that are controlled and available
for use by the central authorities to meet their needs (called reserve
assets). It includes such items as the use of International Monetary
Fund credit and the changes in our reserves of gold and foreign currencies.
Changes in our reserve assets provide an important indication of the
Reserve Bank's activities in the foreign exchange market. For example,
by buying Australian dollars the Reserve Bank can put upward pressure
on the foreign value of our currency; or it can exert downward pressure
on the currency by selling Australian dollars.
Non-official capital covers all other transactions not included
in the official sector. These include transactions by banks; private
and government businesses; and households. These, in turn, are divided
into direct and portfolio and other investment. Direct
investment is defined as a situation in which there is a degree of
influence by the investor over the investee, i.e. whether the investor
owns 10 per cent or more of the ordinary shares or voting stock of
the investee. Portfolio and other investment describes all other investment
activity not classified as direct investment or reserve assets.
The interaction between current account transactions and capital
account outcomes can be usefully explored with the following analogy.
Consider a wheat farmer who wishes to purchase a tractor. In the
analogy the farm represents Australia and the tractor an imported
good. Four simple options for purchasing the tractor will be considered,
each option differing in its place in the record of transactions of
the farm with the outside world (the farm's balance of payments record).
The options are:
- Raise the Cash by Selling Wheat
- Borrow the Money
- Draw on Money in the Farmer's Overseas Bank Account
- Sell off Part of the Farm to Raise the Cash to Buy the Tractor
The tractor purchase may therefore be financed in a number of ways,
each of which will appear in the 'balance of payments' record of the
farm. Similarly, a nation's imports must be financed and the source
of the finance will appear somewhere in the balance of payments record
of the nation. If you want a tractor you have to provide something
in exchange-either exports, bonds (borrowing money) or assets (selling
equity or reducing foreign bank account balances)-and what you sell
will appear in the balance of payments record. Exports appear in the
current account, bonds and assets in the capital account.
A current account deficit requires a balancing capital inflow which
may take the form of borrowing (foreign debt) or equity investment
(selling off the farm). In terms of the analogy, selling off the farm
is only one means of paying for the tractor. The farmer could also
pay for the tractor by selling materials or labour to a non-resident
to build a new factory or mine on the farm.
In the farm story, a single individual was responsible for the import
of the tractor and for the decision about the means of financing that
import. This is not true for a nation's imports, however, in which
different individuals are involved in the activities of importing,
exporting, borrowing overseas and selling assets to foreign residents.
The balance on current account represents the difference between
a country's level of national investment (public and private) and
its level of national saving (public and private).
If a country's balance on current account is in surplus in a period,
then national saving exceeds national investment and the country is
a net provider of investment funds (loan and equity funds) to the
rest of the world. That is, it will have a capital account deficit.
If, on the other hand, a country's balance on current account is in
deficit, then national investment exceeds national saving and the
country is a net recipient of investment funds from the rest of the
world. That is, it will have a capital account surplus.
Australia has almost always run a deficit on its current account;
since 1950, Australia has run a surplus on its current account in
only four years (see chart below). A common concern has been the rise
in the current account deficit from between 2 and 3 per cent of GDP
in the 1960s and 1970s to between 4 and 6 per cent of GDP in the 1980s
and 1990s.
While current account deficits contribute to a nation's net foreign
debt, the deficit for a given period does not have to equal the build
up of net foreign debt that occurred over that period. For example,
in 1995-96 the current account deficit totalled $20.3 million while
net foreign debt increased by only $5.8 million. The discrepancy between
these figures can be explained by looking at the way in which current
account deficits are financed.
A current account deficit can be financed in two ways-by increased
borrowing from overseas and by increased equity investments by foreigners
in Australia. In theory, a current account deficit could be entirely
financed by foreign equity investments in which case there would be
no need to borrow any overseas funds at all. In practice however,
deficits are financed by a combination of borrowing and equity investments.
While it may be thought that the increase in overseas borrowing has
to equal the increase in net foreign debt, this need not be the case.
Consider for example a situation in which Australia has a current
account deficit in a particular quarter and borrows funds from overseas
to cover the deficit. At the same time the Australian dollar appreciates
in value against other currencies which causes the Australian-dollar
value of our debt to fall (so-called valuation effect-see below).
If the value of our foreign debt falls far enough, it may offset the
additional funds borrowed during the quarter so that net foreign debt
is lower at the end of the quarter than it was at the start. That
is, valuation effects may outweigh the effects of transactions.
A current account deficit in a given period is therefore equal to
the change in net foreign liabilities (i.e. debt plus equity)-minus
valuation effects-that occurred over that period (plus or minus the
balancing item). Valuation effects, which can be substantial, are
those changes in the value of net foreign liabilities that are due
to exchange rate movements and equity revaluations (mainly revaluations
of issued shares and securities purchased by overseas investors).
The table below illustrates the relationship between the current account
deficit in the June quarter 1996 and the change in net foreign liabilities
that occurred during this quarter.
In the June quarter 1996 therefore, Australia had a current account
deficit of $4 796 million. While in theory the current account deficit
should equal the capital account surplus, in practice these items
are rarely in balance and equality has to be achieved by the balancing
item. If we make the current account deficit equal the capital account
surplus by subtracting the balancing item, the deficit for the June
quarter 1996 is $6 103 million. In order to finance a deficit of $6
103 million, Australia borrowed $3 631 million in overseas funds and
allowed foreigners to make $2 473 million worth of equity and 'other'
investments in Australia ($2 439 million plus $34 million). Note that
although Australia borrowed $3 631 million during the June quarter,
the overall level of net foreign debt did not rise by this amount
but rather rose by only $2 649 million. This was due to favourable
valuation effects which reduced the value of our debt by $981 million.
It should also be noted that just as current account deficits can
affect the level of Australia's net foreign debt, so the cost of servicing
this debt can add directly to our current account deficit by increasing
the income deficit. In 1995-96 for example, 10 per cent of all Australia's
current account debits (and almost half its income debits) consisted
of interest payments on foreign debt.
While Australia has nearly always had a deficit on its current account,
it wasn't until the 1980s that these deficits were associated with
a build up of foreign debt. Earlier deficits were not associated with
a build up of debt because the deficits were generally lower and the
capital inflow to finance these deficits was largely long-term equity.
In the 1980s however, Australia experienced persistently high current
account deficits and almost all the capital inflow needed to finance
these deficits was in the form of overseas borrowings.
In the 1990s, a high proportion of the capital inflow to Australia
has been coming in the form of foreign equity investment. In 1993-94
for example, the inflow of net foreign equity investment was $24 billion,
more than sufficient to cover the $17 billion current account deficit
in that year. This was a major factor contributing to the $4 billion
decrease in Australia's net foreign debt between 1992-93 and 1993-94,
despite an increase in the current account deficit during the period.
(The appreciation in the Australian dollar over the period also contributed
to the fall in our net foreign debt).
Balance on Net Net income Net Balance
merchandise services unrequited on
trade transfers current
account
$m $m $m $m $m %GDP
1950-51 533 -171 -121 8 249 3.5
1951-52 -679 -276 -126 -7 -1088 -14.3
1952-53 723 -184 -119 -31 389 4.5
1953-54 332 -145 -159 -32 -4 0.0
1954-55 -90 -190 -164 -33 -477 -4.8
1955-56 -29 -189 -189 -41 -448 -4.1
1956-57 605 -156 -189 -43 217 1.8
1957-58 122 -206 -187 -38 -309 -2.6
1958-59 92 -191 -254 -33 -386 -3.0
1959-60 78 -218 -305 -26 -471 -3.3
1960-61 -176 -249 -301 -22 -748 -4.9
1961-62 460 -186 -262 -20 -8 -0.1
1962-63 88 -201 -333 -22 -468 -2.8
1963-64 522 -219 -360 -13 -70 -0.4
1964-65 -138 -268 -355 -19 -780 -3.8
1965-66 -171 -292 -388 -38 -889 -4.1
1966-67 113 -314 -414 -44 -659 -2.8
1967-68 -196 -360 -551 -24 -1131 -4.4
1968-69 35 -403 -603 -9 -980 -3.4
1969-70 437 -416 -697 -12 -688 -2.2
1970-71 438 -455 -704 -28 -749 -2.1
1971-72 932 -491 -708 -26 -293 -0.7
1972-73 2210 -584 -783 -88 755 1.7
1973-74 987 -990 -738 -180 -921 -1.7
1974-75 847 -1118 -723 -200 -1194 -1.8
1975-76 1546 -1247 -1393 -326 -1420 -1.9
1976-77 1096 -1627 -1605 -298 -2434 -2.8
1977-78 857 -1801 -1770 -257 -2971 -3.1
1978-79 687 -1773 -2179 -340 -3605 -3.3
1979-80 2758 -1868 -2727 -135 -1972 -1.6
1980-81 -459 -2076 -2759 -140 -5434 -3.9
1981-82 -3013 -2378 -3208 -192 -8791 -5.5
1982-83 -795 -2729 -2788 -195 -6507 -3.8
1983-84 186 -2717 -4883 115 -7299 -3.7
1984-85 -350 -3733 -6792 198 -10677 -4.9
1985-86 -3543 -3797 -7940 683 -14597 -6.1
1986-87 -1114 -2995 -8745 1183 -11671 -4.4
1987-88 1129 -2450 -10528 1633 -10219 -3.4
1988-89 -3118 -2676 -13563 2173 -17184 -5.1
1989-90 -2428 -4139 -17180 2290 -21460 -5.8
1990-91 2911 -2553 -18060 2373 -15329 -4.0
1991-92 3797 -1899 -15656 2185 -11573 -3.0
1992-93 591 -2188 -13949 662 -14884 -3.7
1993-94 -589 -960 -15284 178 -16655 -3.9
1994-95 -8269 -1434 -18354 487 -27570 -6.1
1995-96 -1952 -101 -19470 1224 -20299 -4.2
The monthly balance of payments estimates attract considerable attention
from the media and the business community. This is despite the fact
that these estimates are often subject to considerable revision-the
more recent estimates generally being subject to the greatest revisions.
In its monthly publication Balance of Payments (Cat. No. 5301.0)
the Australian Bureau of Statistics warns :
... estimates are preliminary and subject to revision. Particular
care should be taken in interpreting monthly movement ... Certain
items have been estimated using extrapolation techniques until source
data become available.
Revisions may occur for a number of reasons. Some of the main reasons
are:
- revisions to estimates provided by a data source;
- estimates from a more timely but less accurate data source are
replaced by estimates from a different, less timely but more accurate
data source;
- improvements in the method of compiling the balance of payments
estimates from the data source; and
- changes in the concepts underlying the estimates.
The size of the revisions made to the balance of payments estimates
may in some cases be quite considerable. The figure below shows the
size and direction of the difference between first estimates of the
current account deficit (the estimate the first time the current account
deficit for a particular month is published) and the latest estimates
(in this case the revised estimate as at July 1996). Of the monthly
current account deficit figures published over the past 10 years,
initial estimates were lower than the latest estimates on 55 occasions
and greater than the latest estimates on 66 occasions. There is not
a great difference therefore in the frequency with which first estimates
of the current account deficit are either underestimates or overestimates.
Moreover, the size of the revision is about the same, being on average
$219 million for a revision upward to the current account deficit
and $212 million for a revision downward to the current account deficit.
balance on current account. The difference between receipts
and payments as the result of transactions in goods, services, income
and unrequited (or one-sided) transfers between Australia and the
rest of the world. A current account deficit means that total payments
exceed total receipts, while a current account surplus means the reverse.
balance on merchandise trade. The difference between the
total free on board value of exports and that of imports. If the value
of imports exceeds the value of exports a nation is said to have a
balance of trade deficit. If the reverse is true, a nation has a balance
of trade surplus.
balance of payments. A record of all transactions between
one particular country and all foreign countries. It is made up of
two accounts-the current account and the capital account.
balance of trade deficit (or surplus). See balance on merchandise
trade.
balancing item. That item which brings about equality between
the sum of credit and debit entries in the balance of payments. Since,
by definition, the balance of payments must always balance, the balancing
item thus reflects the net impact of transactions that have not been
measured accurately (errors) or have not been measured at all (omissions).
capital account. The record of transactions resulting in
financial claims on the rest of the world (assets) and obligations
to the rest of the world (liabilities).
current account. The record of transactions in goods, services,
income and unrequited transfers between one particular country and
the rest of the world.
current account deficit (or surplus). See balance on current account.
direct investment. Capital invested in an enterprise by an
investor having a significant influence-currently defined as at least
10 per cent equity-over the key policies of the enterprise.
equity. Another name for ownership.
free on board (f.o.b.). A term used to signify that the value
of merchandise does not include the freight and insurance charges
associated with its delivery to the country of destination.
gross foreign debt. The level of foreign borrowings by Australian
residents.
liabilities. Obligations to make payments or render service
in the future as the result of a past transaction.
merchandise trade. Movable goods (with a few exceptions)
that change ownership from residents to non-residents (exports) and
from non-residents to residents (imports).
net foreign debt. The level of borrowings by Australian residents
less the sum of Australian lending abroad and official reserve assets.
net income. The difference between income earned by Australian
residents from non-residents and by non-residents from residents.
It consists of investment income (e.g. dividends and interest), other
property income (e.g. royalties) and labour income (e.g. wages and
salaries).
net services. The difference between services rendered by
Australian residents to non-residents and by non-residents to residents.
It consists of freight and insurance charges; the amount Australians
spend abroad net of what foreigners spend here; the cost of international
passenger fares; and fees for financial services, insurance services
and other miscellaneous services.
non-official sector. That part of the capital account that
comprises banks (apart from the Reserve Bank), non-bank financial
enterprises, trading enterprises and households.
official sector. That part of the capital account that comprises
general government institutions and the Reserve Bank.
portfolio and other investment. All foreign investment activity
not classified as direct investment or reserve assets.
reserve assets. Foreign financial assets that are effectively
controlled and available for use by the central authorities for meeting
balance of payments needs.
unrequited transfers. One-sided transactions where resources
are provided without something of economic value being received in
return, by non-residents to Australian residents and by residents
to non-residents. Examples are foreign aid, migrants' transfers, gifts,
donations, pensions and taxes.
Australian Bureau of Statistics, Balance of Payments, Australia
(Cat. Nos. 5301.0, 5302.0, 5303.0)
Australian Bureau of Statistics, Balance of Payments, Australia-Concepts,
Sources and Methods (Cat. No. 5331.0)
Australian Bureau of Statistics, International Investment Position,
Australia (Cat. No. 5306.0)
Clark, D., 'Understanding the Balance of Payments', Student Economic
Briefs 1989-90, Sydney, The Financial Review Library
Dippelsman, R., Australia's Foreign Debt, Parliamentary Library
Current Issues Paper Number 4, September 1989
Fraser, B., 'Some Aspects of Australia's Foreign Debt', Reserve
Bank of Australia Bulletin, March 1990
Fraser, B., 'Understanding Australia's Foreign Debt and the Solutions',
Reserve Bank of Australia Bulletin, August 1990
Gittins, R., 'Foreign Frozen Debt Not a Warm Feeling', Sydney
Morning Herald, 4 March 1995
Lawson. M., Foreign Debt-BOP Till it Drops?, Parliamentary Library
Background Paper, May 1988
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