Introduction

The balance of payments reports all financial flows of a country vis-à-vis the rest of the world. It is a farly complicated balance sheet but, in this short text, we shall present it in quite simplified way for the absolute beginner.

An aggregate view

In very aggregate terms, let's consider all "money" entering into a country (for whatever reason and transaction) and all "money" exiting from it.

The difference between the two is the change in the official currency reserves of the central bank.

In other terms, people from abroad bring their currency to the central bank, obtaining the local currency in exchange. The local people buy foreign currency in the central bank. All these transactions can have intermediaries (as banks) but at the end, there is a place (the "reserves" of the central bank [1]) that accomodate for the differences between inflows and outflows.

Since reserves are usually small in comparison with the flows - and their systematic decrease or increase create problems, as we shall see in a moment - to a large extent, inflows and outflows tend to be equal.

In fact, if outflows are larger than inflows, the reserves are going down, until the central bank reacts (e.g. by devaluating the currency). If outflows are smaller than inflows, reserves pile up. Since they could be profitably used, there is a pressure to reduce them (e.g. by stimulating an outflow in terms of outgoing FDI).

In absence of tight currency control and central bank activities, the exchange rate tends to react with a spontaneous devaluation in the first case, and with a revaluation in the second one, helping reducing the unbalance.

The items

Now, let's see the reasons that move money out and in. They are the same in the two direction, since they relate to:

• trade of goods;
• trade of services;
• income transfers (remittances from emigrants, dividends, profits, rents from assets abroad,...);
• purchases of assets (real estate, shares, bonds,...)
• loans;
• non-refundable aid.

Sometimes one distinguishes short term speculative assets ("portfolio investments" as shares bought and sold daily in stock exchange markets) from long term productive assets (as Foreign direct investments).

The net flows

Indeed, we are now in the condition to introduce definitions for the following net flows (resulting from a difference between "out" and "in"):

• merchandise balance
• trade balance
• current-account balance
• core balance
• basic balance
• the balance for official financing.

These balances are included one in another as Russian matrioshka nesting dolls. In particular:

• exports less imports of physical goods = merchandise balance;
• by adding the net trade of services (exports less imports) to the merchandise balance, one get the trade balance
• trade balance plus net current transfer (as workers' remittances out of wages and payments of international aid) plus net rent, interest, profits and dividends = the current-account balance.

All other items constitute the capital account.

The capital account is always equal to the current-account, since it includes the accomodating items as changes in official currency reserves.

However, the nested doll structure continues:

• the current-account balance plus net direct foreign investment = the core balance
• the core balance plus other net long-term capital movements (as investments in foreign equity markets) = the basic balance;
• the basic balance plus net short-term capital movements (e.g. bank deposits and short-term loans) = the balance of total currency flows = the balance for official financing.

The net official financing comprehends changes in official currency reserves.

Difficulties

Statisticians collecting data face many empirical difficulties in tracking all these flows, to the effects that

1. statistical discrepancies can be quite large;

2. disaggregated bilateral statistics are often lacking, apart for merchandise balance;

3. data about tax-sensitive items (as profits) are often inaccurate.

But, at the end, the dynamics of bank reserves is the key to understand the aggregate.

Data

An example of Balance of Payments: the case of Luxembourg

Bilateral merchandise balance for 99 countries

Bilateral remittances flows worldwide

Remittances inflows and outflows: a time-series

Foreign direct investment: a long time-series

NOTES

[1] These reserves can be located in the country or in an account at the International Monetary Fund.