The balance of payments
Maintaining a balance of payments with the rest of the world is a macro-economic objective. In simple terms, if the balance of payments balances, then the combined receipts from selling goods and services abroad, and from the return on investments abroad, equals the combined expenditure on imports of goods and services, and investment income going abroad.
The balance of payments is also an official account of international payments, published in a document called the ‘Pink Book’. Statistics on UK imports and exports have been gathered in the UK since 1687.
As an official record, the balance of payments is divided into two accounts - the current account and the capital and financial account.
The current account
The current account is made up of the following payments:
Trade in goods
These items include the import and export of finished goods, such as cars, and computers; semi-finished goods, such as parts and components for assembly, and commodities, such as oil, tea and coffee.
Trade in services
Trade services include financial services, tourism, and consultancy.
Investment income, which
includes overseas profits, such as those from business activities of
subsidiaries located abroad; interest received from UK financial
investment and loans abroad and; dividends from owning shares in
overseas firms .
Transfers in items such as gifts, donations to charity and overseas aid
The current account - 2009 (£b)
The Current Account for 2009 showed that the UK had a deficit of £18b.
The Capital and Financial Account
The Capital and Financial Account records the flows of capital and finance between the UK and the rest of the world. Types of flow include the following:
Real foreign direct investment (FDI), such as a UK firm setting up a manufacturing plant in South Africa.
Portfolio investment, such as UK citizens buying shares in an overseas firm in anticipation of a long term return.
Short-term speculative flows, called hot money, where speculators invest abroad in order to obtain the highest return in the short run. For example, a UK fund manager working for a major UK investment bank may buy shares in a US hi-tech firm in the hope of making a fast return. Speculators may quickly sell shares and other financial assets if a short-term profit has been made.
Official financing, which occurs when governments, or their agents, buy or sell currencies, securities and other assets to create an inflow or outflow in the balance of payments accounts. For example, when a deficit occurs it may be financed through the Bank of England acting for the government. In an accounting sense the Bank of England must ensure that the account balances – the bottom line of the account must always equal zero.
Financing deficits and surpluses
The financing of a deficit is achieved by:
Selling gold or holdings of foreign exchange, such as US dollars, yen or euros, or:
Borrowing from other Central Banks or the International Monetary Fund (IMF).
A surplus will be disposed of by:
Buying gold or currencies.
Paying off debts.
The Balancing Item
In theory, the Capital and Financial Account balance should be equal and opposite to the Current Account balance so that the overall Account balances, but in practice this is only achieved by the use of a balancing item. The balancing item is defined as the device used to compensate for errors and omissions in the balance of payments data, and which brings the final balance of payments account to zero.
Recent Current Account balance