Balance of Payments - Description and Relationship Between it's Three Main Accounts

Defining the term “balance of payments” and describe the relationship between its three main accounts. How might the balance of payments be impacted by fluctuations in the value of the Australian dollar.

The balance of payments is a measure of Australia’s economic relationship with the rest of the world. The balance of payments (BOP) summarises the transactions between Australia and the rest of the world over a given period of time. The BOP is defined as record of transaction between Australia and the rest of the world during a given period, which a recorded in various accounts. Funds flowing into Australia are recorded as credits and those flowing out as debits. The accounts of the balance of payments are the current account and the capital and financial account.

The Current Account

The current account in the balance of payments is a summary of Australia’s non reversible transactions with the rest of the world. The first section is the balance on goods and services. It refers to the net result of transactions of goods and services. Simply, it is the difference between what Australia pays for its imports and receives for its exports. Net income, the next section refers to the difference between what Australia receives from its overseas investments and money it has lent abroad, with return from foreign investments in Australia and debts servicing cost on money borrowed by Australians. Net current transfers are the last section and are relatively small. It refers to the transfer of financial resources without any good or service in return e.g. insurance payouts. The balance of the current account is achieved by adding the aforementioned components.

The Capital and Financial Account

The capital and financial account (CFA) is a record of reversible transactions between Australia and the rest of the world. It records the purchasing, lending, borrowing and sale of assets that occur between Australia and foreigners. The capital account is the smaller section. It accounts for the net transfer of migrants, foreign aid and non-products non-financial assets such as intellectual property. The financial account refers to the transaction of financial assets and liabilities between Australia and the rest of the world. It records the various types of investment which include, direct investment, portfolio investment, derivatives, reserve assets and other assets. The balance on the capital and financial account is achieved by adding the categories of the account together.

In order to achieve the balance of payments the balance on the current account and the balance on the capital and financial account are added together. These should add together and if there is a slight imbalance this is accounted for in the net errors and omissions section. Then these accounts are added together they balance to $0. Thus we have the balance of payments.

Relationship Between Current Account and the Capital and Financial Account

The two accounts when added together equal zero. Essentially, in Australia’s case, the deficit on the current account is equal to the surplus on the capital and financial account. The financial inflow on the capital and financial account is needed to finance the deficit on the current account. Additionally, financial inflows coming into Australia increase the size of our net income deficit. This is the case as financial inflows require some sort of return, which is recorded as an outflow on the net income section of the current account. Loans from overseas require the amount to be paid back as well as debt servicing costs. Foreign assets holdings in Australia require return such as dividends or rent. Thus as financial inflows increase the amount of money flowing out on the net income section increases as well. This results in a larger deficit on the current account.

Another relationship between the two accounts is the levels of saving and investment in Australia. Australia has a historically low level of savings and a small population. Additionally, we have a vast amount of investment opportunities due to Australia’s abundant natural resources. Thus we require a large financial inflow to finance investment.

Balance of Payments and Exchange Rates

The balance of payments will be affected by the exchange rate. Appreciations and depreciations of the rate will both have positive and negative effects.
Appreciations and the Balance of Payments

When the value of the $A increases, Australia’s exports become more expensive. Other things being equal this would cause a fall in demand. Thus, the balance on goods and service would deteriorate worsening the CAD. As imports become cheaper, consumption of these goods will increase. This deteriorates balance on goods and services as well as the CAD. A rise in the value of $A would also cause the returns of foreign investment to be worth less in $A terms. This reduces income inflows, deteriorating the CAD. The value of foreign assets will also fall in $A terms. This is known as the valuation effect. Positively, Australia’s payments on foreign debt will also fall as the dollar can buy more foreign currency, thus improve the net income component of the current account. Additionally, the overall value of foreign debt will also fall.

Depreciation and the Balance of Payments

If the value of the dollar is reduced, the cost of debt servicing as well as the overall value of foreign debt is increased. This constitutes in larger income outflows, which increase the CAD. On the other hand, exports become cheaper for foreigners. This, other things being equal will cause export revenue to rise which improves the balance of goods and services and Australia’s current account deficit. Imports will become more expensive, which reduces import spending, and improves the CAD. The value of returns from foreign investment is increase in $A terms improving net income and CAD.
All in all, a depreciation in the dollar herald more benefits for the balance of payments. However, the fact that Australian Dollar often faces heavy speculation can result in a destabilisation of the currency. As we can see from above, the currency has a strong effect on the balance of payments and volatility in the currency can also transfer to volatility in the balance of payments.