Balance of payments

Beginning in the 16th century, mercantilism became the dominant economic theory influencing European rulers. Local trade regulations were replaced by national rules aiming to harness the countries' economic output.[1] Measures to promote a trade surplus (such as tariffs) were generally favored.

The prevailing orthodoxy of the mercantilist age was the (now discredited) notion that the accumulation of foreign exchange or, at that time, precious metals, made countries wealthier, and so countries favored exporting their own goods to run balance of payments surpluses. This viewpoint prevails in England's Treasure by Foreign Trade (1664) by Thomas Mun.[2]

Economic growth remained at low levels in the mercantilist era; average global per capita income is not considered to have significantly risen in the whole 800 years leading up to 1820, and is estimated to have increased on average by less than 0.1% per year between 1700 and 1820.[3] With very low levels of financial integration between nations and with international trade generally making up a low proportion of individual nations' GDP, BOP crises were very rare.[3]

Gold was the primary reserve asset during the gold standard era.

The mercantilist dogma was attacked first by David Hume, then Adam Smith and David Ricardo.[2]

In the essays Of Money and Of the Balance of Trade, Hume argued that the accumulation of precious metals would create monetary inflation without any real effect on interest rates. It is the foundation of what is known in modern economic studies as the quantity theory of money, the neutrality of money and the consideration of interest rates not as a monetary phenomenon, but a real one. Adam Smith built on this foundation. He accused mercantilists of being anti-free trade and confusing money with wealth.[2]

David Ricardo based his arguments on Say's Law, developing the theory of comparative advantage, which remains the dominant theory of growth and trade in modern economics.[2]

After victory in the Napoleonic wars Great Britain began promoting free trade, unilaterally reducing its trade tariffs. Hoarding of gold was no longer encouraged, and in fact Britain exported more capital as a percentage of its national income than any other creditor nation has since.[4] Great Britain's capital exports further helped to correct global imbalances as they tended to be counter cyclical, rising when Britain's economy went into recession, thus compensating other states for income lost from export of goods.[3]

According to historian Carroll Quigley, Great Britain could afford to act benevolently[5] in the 19th century due to the advantages of her geographical location, naval power, and economic ascendancy as the first nation to enjoy an industrial revolution.[6] However, some, like Otto von Bismarck, viewed Great Britain's promotion of free trade as a way to maintain its dominant position. A view advanced by economists such as Barry Eichengreen is that the first age of Globalization began with the laying of transatlantic telegraph cables in the 1860s, which facilitated a rapid increase in the already growing trade between Britain and America.[7]

Though Current Account controls were still widely used (in fact all industrial nations apart from Great Britain and the Netherlands actually increased their tariffs and quotas in the decades leading up to 1914, though this was motivated more by a desire to protect "infant industries" than to encourage a trade surplus[3]), capital controls were largely absent. A gold standard enjoyed wide international participation especially from 1870, further contributing to close economic integration between nations. The period saw substantial global growth, in particular for the volume of international trade which grew tenfold between 1820 and 1870 and then by about 4% annually from 1870 to 1914. BoP crises began to occur, though less frequently than was to be the case for the remainder of the 20th century. From 1880 to 1914, there were approximately[8] eight BoP crises and eight twin crises – a twin crisis being a BoP crisis that coincides with a banking crisis.[3]

The favorable economic conditions that had prevailed up until 1914 were shattered by the first world war, and efforts to re-establish them in the 1920s were not successful. Several countries rejoined the gold standard around 1925. But surplus countries didn't "play by the rules",[3][9] sterilising gold inflows to a much greater degree than had been the case in the pre-war period. Deficit nations such as Great Britain found it harder to adjust by deflation as workers were more enfranchised and unions in particular were able to resist downwards pressure on wages. During the Great Depression most countries abandoned the gold standard, but imbalances remained an issue and international trade declined sharply. There was a return to mercantilist type "beggar thy neighbour" policies, with countries competitively devaluing their exchange rates, thus effectively competing to export unemployment. There were approximately 16 BoP crises and 15 twin crises (and a comparatively very high level of banking crises).[3]

Following World War II, the Bretton Woods institutions (the International Monetary Fund and World Bank) were set up to support an international monetary system, among capitalist economies, designed to encourage free trade while also offering states options to correct imbalances without having to deflate their economies. Fixed but flexible exchange rates were established, with the system anchored by the US dollar which alone remained convertible into gold. The Bretton Woods system ushered in a period of high global growth, known as the Golden Age of Capitalism. However, it came under pressure due to the inability or unwillingness of governments to maintain effective capital controls[10] and due to instabilities related to the central role of the US dollar.

Imbalances caused gold to flow out of the US and a loss of confidence in the United States ability to supply gold for all future claims by US dollar holders resulted in escalating demands to convert US dollars, ultimately causing the US to end the convertibility of the US dollar into gold, thus ending the Bretton Woods system.[3] The 1945–71 era saw approximately 24 BoP crises and no twin crisis for advanced economies, with emerging economies seeing 16 BoP crises and just one twin crisis.[3]

Manmohan Singh, former PM of India (2004-2014), showed that the challenges caused by imbalances can be an opportunity when he led his country's successful economic reform programme after the 1991 crisis, as the minister of Finance.

The Bretton Woods system came to an end between 1971 and 1973. There were attempts to repair the system of fixed exchanged rates over the next few years, but these were soon abandoned, as were determined efforts for the U.S. to avoid BoP imbalances. Part of the reason was displacement of the previous dominant economic paradigm – Keynesianism – by the Washington Consensus, with economists and economics writers such as Murray Rothbard and Milton Friedman[11] arguing that there was no great need to be concerned about BoP issues.

In the immediate aftermath of the Bretton Woods collapse, countries generally tried to retain some control over their exchange rate by independently managing it, or by intervening in the foreign exchange market as part of a regional bloc, such as the Snake which formed in 1971.[12] The Snake was a group of European countries who tried to retain stable rates at least with each other; the group eventually evolved into the European Exchange Rate Mechanism (ERM) by 1979. From the mid-1970s however, and especially in the 1980s and early 1990s, many other countries followed the US in liberalizing controls on both their capital and current accounts, in adopting a somewhat relaxed attitude to their balance of payments and in allowing the value of their currency to float relatively freely with exchange rates determined mostly by the market.[3][12]

Developing countries who chose to allow the market to determine their exchange rates would often develop sizable current account deficits, financed by capital account inflows such as loans and investments,[13] though this often ended in crises when investors lost confidence.[3][14][15] The frequency of crises was especially high for developing economies in this era – from 1973 to 1997 emerging economies suffered 57 BoP crises and 21 twin crises. Typically but not always the panic among foreign creditors and investors that preceded the crises in this period was usually triggered by concerns over excess borrowing by the private sector, rather than by a government deficit. For advanced economies, there were 30 BoP crises and 6 banking crises.

A turning point was the 1997 Asian BoP Crisis, where unsympathetic responses by western powers caused policy makers in emerging economies to re-assess the wisdom of relying on the free market; by 1999 the developing world as a whole stopped running current account deficits[16] while the U.S. current account deficit began to rise sharply.[17][18] This new form of imbalance began to develop in part due to the increasing practice of emerging economies, principally China, in pegging their currency against the dollar, rather than allowing the value to freely float. The resulting state of affairs has been referred to as Bretton Woods II.[19] According to Alaistair Chan, "At the heart of the imbalance is China's desire to keep the value of the yuan stable against the dollar. Usually, a rising trade surplus leads to a rising value of the currency. A rising currency would make exports more expensive, imports less so, and push the trade surplus towards balance. China circumvents the process by intervening in exchange markets and keeping the value of the yuan depressed."[20] According to economics writer Martin Wolf, in the eight years leading up to 2007, "three-quarters of the foreign currency reserves accumulated since the beginning of time have been piled up".[21] In contrast to the changed approach within the emerging economies, US policy makers and economists remained relatively unconcerned about BOP imbalances. In the early to mid-1990s, many free market economists and policy makers such as U.S. Treasury secretary Paul O'Neill and Fed Chairman Alan Greenspan went on record suggesting the growing US deficit was not a major concern. While several emerging economies had intervened to boost their reserves and assist their exporters from the late 1980s, they only began running a net current account surplus after 1999. This was mirrored in the faster growth for the US current account deficit from the same year, with surpluses, deficits and the associated buildup of reserves by the surplus countries reaching record levels by the early 2000s and growing year by year. Some economists such as Kenneth Rogoff and Maurice Obstfeld began warning that the record imbalances would soon need to be addressed from as early as 2001, but it was not until about 2007 that their concerns began to be accepted by the majority of economists.[22][23]

The balance of payments takes into account payments for a country's exports and imports of goods, services, financial capital, and financial transfers.[28][27] It is prepared in a single currency, typically the domestic currency for the country concerned. The balance of payments accounts keep systematic records of all the economic transactions (visible and non-visible) of a country with all other countries in the given time period. In the BoP accounts, all the receipts from abroad are recorded as credit and all the payments to abroad are debits. Since the accounts are maintained by double entry bookkeeping, they show the balance of payments accounts are always balanced. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.

When all components of the BoP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned from its foreign investments (but not the investments themselves, since foreign investments are deficit items), by running down currency reserves or by receiving investments or loans from other countries.

While the overall BoP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BoP, such as the current account, the capital account excluding the central bank's reserve account, or the sum of the two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted. The term "balance of payments" often refers to this sum: a country's balance of payments is said to be in surplus (equivalently, the balance of payments is positive) by a specific amount if sources of funds (such as export goods sold and bonds sold) exceed uses of funds (such as paying for imported goods and paying for foreign bonds purchased) by that amount. There is said to be a balance of payments deficit (the balance of payments is said to be negative) if the former are less than the latter. A BoP surplus (or deficit) is accompanied by an accumulation (or decumulation) of foreign exchange reserves by the central bank.

Economics writer J. Orlin Grabbe warns the term balance of payments can be a source of misunderstanding due to divergent expectations about what the term denotes. Grabbe says the term is sometimes misused by people who aren't aware of the accepted meaning, not only in general conversation but in financial publications and the economic literature.[26]

A common source of confusion arises from whether or not the reserve account entry, part of the capital account, is included in the BoP accounts. The reserve account records the activity of the nation's central bank. If it is excluded, the BoP can be in surplus (which implies the central bank is building up foreign exchange reserves) or in deficit (which implies the central bank is running down its reserves or borrowing from abroad).[27][26]

The term "balance of payments" is sometimes misused by non-economists to mean just relatively narrow parts of the BoP such as the trade deficit,[26] which means excluding parts of the current account and the entire capital account.

Another cause of confusion is the different naming conventions in use.[29] Before 1973 there was no standard way to break down the BoP sheet, with the separation into invisible and visible payments sometimes being the principal divisions. The IMF have their own standards for BoP accounting which is equivalent to the standard definition but uses different nomenclature, in particular with respect to the meaning given to the term capital account.

The International Monetary Fund (IMF) use a particular set of definitions for the BoP accounts, which is also used by the Organisation for Economic Co-operation and Development (OECD), and the United Nations System of National Accounts (SNA).[30]

The main difference in the IMF's terminology is that it uses the term "financial account" to capture transactions that would under alternative definitions be recorded in the capital account. The IMF uses the term capital account to designate a subset of transactions that, according to other usage, previously formed a small part of the overall current account.[31] The IMF separates these transactions out to form an additional top level division of the BoP accounts. Expressed with the IMF definition, the BoP identity can be written:

${\displaystyle {\text{current account}}\,+\,{\text{financial account}}\,+\,{\text{capital account}}\,+\,{\text{balancing item}}\,=\,0.\,}$

The IMF uses the term current account with the same meaning as that used by other organizations, although it has its own names for its three leading sub-divisions, which are:

• The goods and services account (the overall trade balance)
• The primary income account (factor income such as from loans and investments)
• The secondary income account (transfer payments)

There are conflicting views as to the primary cause of BoP imbalances, with much attention on the US which currently has by far the biggest deficit. The conventional view is that current account factors are the primary cause[40] – these include the exchange rate, the government's fiscal deficit, business competitiveness, and private behaviour such as the willingness of consumers to go into debt to finance extra consumption.[41]

An alternative view, argued at length in a 2005 paper by Ben Bernanke, is that the primary driver is the capital account, where a global savings glut caused by savers in surplus countries, runs ahead of the available investment opportunities, and is pushed into the US resulting in excess consumption and asset price inflation.[42]

The US dollar has been the leading reserve asset since the end of the gold standard.

In the context of BoP and international monetary systems, the reserve asset is the currency or other store of value that is primarily used by nations for their foreign reserves.[43] BoP imbalances tend to manifest as hoards of the reserve asset being amassed by surplus countries, with deficit countries building debts denominated in the reserve asset or at least depleting their supply. Under a gold standard, the reserve asset for all members of the standard is gold. In the Bretton Woods system, either gold or the U.S. dollar could serve as the reserve asset, though its smooth operation depended on countries apart from the US choosing to keep most of their holdings in dollars.

Following the ending of Bretton Woods, there has been no de jure reserve asset, but the US dollar has remained by far the principal de facto reserve. Global reserves rose sharply in the first decade of the 21st century, partly as a result of the 1997 Asian Financial Crisis, where several nations ran out of foreign currency needed for essential imports and thus had to accept deals on unfavourable terms. The International Monetary Fund (IMF) estimates that between 2000 and mid-2009, official reserves rose from $1,900bn to $6,800bn.[44]

Global reserves had peaked at about $7,500bn in mid-2008, then declined by about $430bn as countries without their own reserve currency used them to shield themselves from the worst effects of the financial crisis. From Feb 2009 global reserves began increasing again to reach close to $9,200bn by the end of 2010.[45][46]

As of 2009, approximately 65% of the world's $6,800bn total is held in U.S. dollars and approximately 25% in euros. The UK pound, Japanese yen, IMF special drawing rights (SDRs), and precious metals[47] also play a role. In 2009, Zhou Xiaochuan, governor of the People's Bank of China, proposed a gradual move towards increased use of SDRs, and also for the national currencies backing SDRs to be expanded to include the currencies of all major economies.[48][49]

While the current central role of the dollar does give the US some advantages, such as lower cost of borrowings, it also contributes to the pressure causing the U.S. to run a current account deficit, due to the Triffin dilemma. In a November 2009 article published in Foreign Affairs magazine, economist C. Fred Bergsten argued that Zhou's suggestion or a similar change to the international monetary system would be in the United States' best interests as well as the rest of the world's.[50] Since 2009 there has been a notable increase in the number of new bilateral agreements which enable international trades to be transacted using a currency that is not a traditional reserve asset, such as the renminbi, as the settlement currency.[51]

A BoP crisis, also called a currency crisis, occurs when a nation is unable to pay for essential imports or service its external debt repayments. Typically, this is accompanied by a rapid decline in the value of the affected nation's currency. Crises are generally preceded by large capital inflows, which are associated at first with rapid economic growth.[3] However a point is reached where overseas investors become concerned about the level of debt their inbound capital is generating, and decide to pull out their funds. It sometimes takes only one or two large investors pulling out to trigger a mass panic due to herd effects. The resulting outbound capital flows are associated with a rapid drop in the value of the affected nation's currency. This causes issues for firms of the affected nation who have received the inbound investments and loans, as the revenue of those firms is typically mostly derived domestically but their debts are often denominated in a reserve currency. Once the nation's government has exhausted its foreign reserves trying to support the value of the domestic currency, its policy options are very limited. It can raise its interest rates to try to prevent further declines in the value of its currency, but while this can help those with debts denominated in foreign currencies, it generally further depresses the local economy.[3][16][7] Lower-income countries are more exposed to suffer this type of crisis, while economic growth and foreign-exchange piling are particularly useful to prevent them.[52]

An upwards shift in the value of a nation's currency relative to others will make a nation's exports less competitive and make imports cheaper and so will tend to correct a current account surplus. It also tends to make investment flows into the capital account less attractive so will help with a surplus there too. Conversely a downward shift in the value of a nation's currency makes it more expensive for its citizens to buy imports and increases the competitiveness of their exports, thus helping to correct a deficit (though the solution often doesn't have a positive impact immediately due to the Marshall–Lerner condition).[55]

Exchange rates can be influenced by governments. In the early years of the Bretton Woods System international markets were heavily constrained by capital controls, managing the exchange rate has often been problematic as the markets often want the currency to move in the opposite direction to governments. Developing countries in particular would often experience difficulties, though even advanced economies like Britain had issues, with Black Wednesday an example when she had insufficient reserves to counter the market.</ref> in a rules based or managed currency regime, and when left to float freely in the market they also tend to change in the direction that will restore balance. When a country is selling more than it imports, the demand for its currency will tend to increase as other countries ultimately[56] need the selling country's currency to make payments for the exports. The extra demand tends to cause a rise of the currency's price relative to others. When a country is importing more than it exports, the supply of its own currency on the international market tends to increase as it tries to exchange it for foreign currency to pay for its imports, and this extra supply tends to cause the price to fall. BoP effects are not the only market influence on exchange rates however, they are also influenced by differences in national interest rates and by speculation.

When exchange rates are fixed by a rigid gold standard,[57] or when imbalances exist between members of a currency union such as the Eurozone, the standard approach to correct imbalances is by making changes to the domestic economy. To a large degree, the change is optional for the surplus country, but compulsory for the deficit country. In the case of a gold standard, the mechanism is largely automatic. When a country has a favourable trade balance, as a consequence of selling more than it buys it will experience a net inflow of gold. The natural effect of this will be to increase the money supply, which leads to inflation and an increase in prices, which then tends to make its goods less competitive and so will decrease its trade surplus. However the nation has the option of taking the gold out of economy (sterilising the inflationary effect) thus building up a hoard of gold and retaining its favourable balance of payments. On the other hand, if a country has an adverse BoP it will experience a net loss of gold, which will automatically have a deflationary effect, unless it chooses to leave the gold standard. Prices will be reduced, making its exports more competitive, and thus correcting the imbalance. While the gold standard is generally considered to have been successful[58] up until 1914, correction by deflation to the degree required by the large imbalances that arose after WWI proved painful, with deflationary policies contributing to prolonged unemployment but not re-establishing balance. Apart from the US most former members had left the gold standard by the mid-1930s.

A possible method for surplus countries such as Germany to contribute to re-balancing efforts when exchange rate adjustment is not suitable, is to increase its level of internal demand (i.e. its spending on goods). While a current account surplus is commonly understood as the excess of earnings over spending, an alternative expression is that it is the excess of savings over investment.[59]

That is:

${\displaystyle {\text{CA}}={\text{NS}}-{\text{NI}}\,}$

where CA = current account, NS = national savings (private plus government sector), NI = national investment.

If a nation is earning more than it spends the net effect will be to build up savings, except to the extent that those savings are being used for investment. If consumers can be encouraged to spend more instead of saving; or if the government runs a fiscal deficit to offset private savings; or if the corporate sector divert more of their profits to investment, then any current account surplus will tend to be reduced. However, in 2009 Germany amended its constitution to prohibit running a deficit greater than 0.35% of its GDP[60] and calls to reduce its surplus by increasing demand have not been welcome by officials,[61] adding to fears that the 2010s would not be an easy decade for the eurozone.[62] In their April 2010 world economic outlook report, the IMF presented a study showing how with the right choice of policy options governments can shift away from a sustained current account surplus with no negative effect on growth and with a positive impact on unemployment.[63]

Nations can agree to fix their exchange rates against each other, and then correct any imbalances that arise by rules based and negotiated exchange rate changes and other methods. The Bretton Woods system of fixed but adjustable exchange rates was an example of a rules based system. John Maynard Keynes, one of the architects of the Bretton Woods system had wanted additional rules to encourage surplus countries to share the burden of rebalancing, as he argued that they were in a stronger position to do so and as he regarded their surpluses as negative externalities imposed on the global economy.[64] Keynes suggested that traditional balancing mechanisms should be supplemented by the threat of confiscation of a portion of excess revenue if the surplus country did not choose to spend it on additional imports. However his ideas were not accepted by the Americans at the time. In 2008 and 2009, American economist Paul Davidson had been promoting his revamped form of Keynes's plan as a possible solution to global imbalances which in his opinion would expand growth all round without the downside risk of other rebalancing methods.[55][65][66]

By September 2010, international tensions relating to imbalances had further increased. Brazil's finance minister Guido Mantega declared that an "international currency war" has broken out, with countries competitively trying to devalue their currency so as to boost exports. Brazil has been one of the few major economies lacking a reserve currency to abstain from significant currency intervention, with the real rising by 25% against the US dollar since January 2009. Some economists such as Barry Eichengreen have argued that competitive devaluation may be a good thing as the net result will effectively be equivalent to expansionary global monetary policy. Others such as Martin Wolf saw risks of tensions further escalating and advocated that coordinated action for addressing imbalances should be agreed on at the November G20 summit.[45][86][87]

Commentators largely agreed that little substantive progress was made on imbalances at the November 2010 G20. An IMF report released after the summit warned that without additional progress there is a risk of imbalances approximately doubling to reach pre-crises levels by 2014.[88]

• Comprehensive international BOP statistics from the IMF
• BOP for Hong Kong Archived 29 June 2010 at the Wayback Machine
• US statistics (See "External Sector")
• Detailed historical BOP data from the US Bureau of Economic Analyses
• European Central Bank (ECB, as source of euro area) (1 March 2017). "Balance of payments, capital account, monthly data". Eurostat. Archived from the original on 16 May 2018. Retrieved 17 May 2018.

• Report to Congress on International Economic and Exchange Rate Policies Feb 2011 US treasury report with sections on BOP issues for major trading blocs and countries.
• Paper from the Bank of Canada on challenges for 2010 regarding current imbalances, in context of international monetary system history Archived 30 October 2010 at the Wayback Machine
• European Central Bank paper on the accumulation of reserves and imbalances since 1995