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Balance of Payments: Interpretation and Exercise

Article · June 2009

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Petra Christmann
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UVA-BP-0473
Balance of Payments: Interpretation and Exercise

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BALANCE OF PAYMENTS: INTERPRETATION AND EXERCISE

The balance of payments is a statement of a country’s economic transactions with the rest
of the world. In order to analyze the balance of payments and identify potential balance of
payments problems, the calculation of balances, in which certain components are grouped
together and subtotals of partial totals are calculated, is helpful. A balance of payments problem
can occur if a country does not have sufficient foreign capital inflows in the capital and financial
accounts to finance a deficit in the current account. In this case a country needs to use its foreign
currency reserves to finance the deficit not covered by capital inflows. If the country’s stock of
foreign exchange reserves is not sufficient to make up the shortfall, the country has to resort to
other means such as obtaining financing from the International Monetary Fund.

The current account balance is obtained by adding up all the items included in the
current account (goods, services, income, and transfers). A country needs to finance a current
account deficit through transactions in the capital and financial accounts. A country that is
running a current account deficit is borrowing from abroad. Within the current account other
balances can be calculated. These include: the trade balance, the balance on goods and services,
and the balance on goods, services, and income.

The basic balance adds long-term capital flows to the current account. This balance is
useful to evaluate whether a current account deficit is financed by long-term capital flows. Since
short-term capital flows are highly sensitive to relative interest rates and tend to be very volatile,
a country that needs to rely on short-term capital flows to finance parts of its current account
deficit (i.e., a country with a negative basic balance) is more likely to experience balance of
payments problems.

The capital account narrowly defined (which more accurately should be referred to as the
capital and financial account narrowly defined) is another useful balance to evaluate the health of
a country’s balance of payments. The capital account narrowly defined is the sum of the capital
account, the financial account, and net errors and omissions. This balance indicates the amount
of nonofficial financial flows that is available to cover a current account deficit.

The overall balance is the balance most frequently referred to as the balance of payments.
The overall balance is the sum of the balances of the current account, the capital account, the

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financial account, and net errors and omissions. The overall balance measures the imbalance
between the sources of foreign exchange (such as exports and capital inflows) and uses of foreign
exchange (such as imports and capital outflows). For example, a country may run a current
account deficit that is larger than the capital inflows that the country receives in the capital and
financial accounts. In this case the overall balance would show a deficit that needs to be financed
through a loss of foreign exchange reserve. Alternatively, a country that is running a surplus in the
overall balance is accumulating foreign exchange reserves. The overall balance is especially
important for countries that have fixed exchange rate systems, where the level of and the changes
in foreign exchange reserves play a critical role for the sustainability of the exchange rate.

The overall balance is the inverse of the line “reserves and related items.” Please note
that a negative sign in the reserves and related items line indicates that the country is increasing
its foreign exchange reserves, while a positive sign means that the country is losing foreign
exchange reserves. This counterintuitive sign is an accounting artifact (the balance of payments
needs to balance).

Exercise

Use the Brazilian balance of payments in Exhibit 1 (also available as an electronic file)
to answer the following questions:

1. Calculate and interpret the following balances for Brazil’s Balance of Payments in 1994
and 1998:
ƒ Merchandise trade balance
ƒ Current account
ƒ Basic balance
ƒ Capital account narrowly defined
ƒ Overall balance
Are there any indications of a balance of payments problem?

2. What are the most significant changes in the Brazilian Balance of Payments between
1994 and 1998? Which factors might have contributed to these changes? As a foreign
investor how would you evaluate these changes?
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