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Theoretically the capital account balance should fully offset the current account balance and the BoP should be zero for any economy. What causes the imbalance or discrepancy in the overall BoP ? What makes countries run BoP surplus or deficits ?

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  • According to the IMF's BPM6, which should be taken as the "most" standard, it is impossible for the BOP to be out of balance.

In the IMF BPM6, BOP simply refers to a statistical statement (think of it as a piece of paper or an Excel spreadsheet) that records, in summary form, all of the country's international transactions. The BOP never refers to a number. Hence, there is no such thing as a BOP surplus or a BOP deficit.

The three accounts in the BOP are the Current Account (CA), the Capital Account (KA), and the Financial Account (FA). In theory, it is always necessarily the case that: CA + KA + FA = 0. (In practice, we have to add an "errors & omissions" term.)

Hence the name balance of payments. The above balance of payments identity must always hold.

Unfortunately, not everyone follows the IMF's recommendation. This causes a lot of confusion.

  • Some countries break up the BOP in a different way and DO refer to the BOP as a number.

For example, Singapore takes out "changes in official reserves" (ΔR) from the Financial Account and combines what is left of the FA with the CA into a single account called the Capital & Financial Account (KFA).

And so for Singapore, the BOP identity can be written as: CA + KFA + ΔR = 0.

And very confusingly, Singapore then defines BOP = CA + KFA = -ΔR. Hence, in Singapore, a BOP surplus refers to when there is an increase in official reserves (yes, strangely enough, ΔR < 0 ⇔ official reserves increase). And a BOP deficit is when there is a decrease in official reserves.

Singapore's presentation of the BOP is actually not so unusual. The IMF BPM6 for example does suggest it as a possible alternative presentation of the BOP (see end of p. 224 and start of p. 225). However, I think it's pretty unusual to define the BOP as a number equal to -ΔR, as Singapore does.

  • Journalists frequently speak, mistakenly, of a BOP deficit, when they really mean a trade deficit (or, what is slightly different, a CA deficit).

This obviously adds a lot of confusion to an already confused situation.

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This depends on the exchange rate regime. For a floating exchange rate, the balance of payments is always in equilibrium, that is, the financial account always offsets the current (and capital) account. A hypothetical deficit is avoided by a depreciating exchange rate, a hypothetical surplus is avoided by appreciation.

For a fixed exchange rate regime, the central bank will offset the exchange rate adjustments that guarantee the equilibrium under floating exchange rates. In order to offset these adjustments, the CB has to intervene in the exchange markets. To prevent a currency from depreciating, the CB has to use its foreign reserves to buy its own currency. To avoid an appreciation, the CB has to buy foreign currency and icrease its foreign reserves.

To sum up, as an answer to your question: BoP imbalances only occur in a fixed exchange rate regime and are caused by foreign exchange interventions of the CB. Therefore, the imbalance is equal to the settlements balance, or the change in the CB's reserve assets.

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  • $\begingroup$ But why then almost every country has some imbalance i.e. either a BoP deficit or surplus. Even countries with highly flexible exchange rates like the United States. $\endgroup$ – Sub-Optimal Dec 5 '15 at 10:13
  • $\begingroup$ This deficit refers to a current account deficit. I haven't checked the data for US specifically, but the deficit on the current account should be offset by the capital account. Unless the Fed is intervening the exchange market, but I do not believe that this is the case. $\endgroup$ – Wecon Dec 5 '15 at 10:24
  • $\begingroup$ Maybe I was a bit confused between the definitions part. The reserve transfer transactions between central banks is not accounted in the capital account. It is added separately in the BoP . The BoP surplus or deficit that we hear about is actually the sum of Current Account balance and Capital Account balance and not the reserve transfers. Eventually, the sum of BoP surplus or deficit plus any reserve transfers plus any statistical errors will always sum to 0. Thanks a lot $\endgroup$ – Sub-Optimal Dec 5 '15 at 12:01
  • $\begingroup$ Please note my edit. I mistakenly used "capital account" instead of "financial account" in my post. I corrected this error. In my comment of Dec 5, capital account should also be changed into financial account. If you check the data, you will note that the capital account is generally very neglegible. $\endgroup$ – Wecon Mar 13 '16 at 9:36

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