The balance of payments summarises the economictransactions of an economy with the rest of theworld. These transactions include exports andimports of goods, services and financial assets,along with transfer payments (like foreign aid). Thebalance of payments is an important economicindicator for ‘open’ economies like Australia thatengage in international trade because it summariseshow resources flow between Australia and ourtrading partners.
This Explainer looks at the structure of Australia'sbalance of payments.
The Structure of the Balance of Payments
Australia's balance of payments captures thetransactions between Australian ‘residents’ andthe rest of the world, in a given period. ‘Residents’are defined broadly to include people who live inAustralia, businesses that operate in Australia, theAustralian government and other organisationsthat operate here.
The balance of payments divides transactions intotwo broad accounts:
- the current account
- the combined capital and financial account
In essence, the current account captures the netflow of money that results from Australia engagingin international trade, while the combined capitaland financial accounts capture Australia's netchange in ownership of assets and liabilities. Thesebroad accounts are often referred to as the ‘twosides’ of the balance of payments.
The balance of payments are put togetheraccording to international standards (set out by theInternational Monetary Fund (IMF) and the UnitedNations) that make it easier to compare Australia'sbalance of payments with that in other countries.
The Current Account
The current account records the value of the flowof goods, services and income between Australianresidents and the rest of the world. There arethree components to the current account – the‘trade balance’, ‘primary income balance’ and‘secondary income balance’. In economic analysisor commentary, most attention is usually given tothe trade balance, which records the differencebetween the value of our exports and importsof goods and services. This is because the tradebalance forms part of gross domestic product (seeExplainer: Economic Growth).
| Current Account | |
|---|---|
| Trade balance | The value of goods and servicesthat Australian residents export lessthose that they import. |
| Primary income balance | The income that Australian residentsearn from, less that they pay to,the rest of the world from working(e.g. wages) and from financialinvestments (e.g. dividends) |
| Secondary income balance | Consists of two parts:
|
The term ‘current’ is used in describing the currentaccount because the goods, services and incomebeing traded in will be consumed or received inthe current period (specifically, within the quarter).
The Capital and Financial Account
The combined capital and financial account recordsthe capital and financial transactions betweenAustralia and the rest of the world.
The capital account component records twomain types of transactions involving capital. Thefirst is ‘capital transfers’, where one party hastransferred ownership of something to anotherparty without receiving anything in return; capitaltransfers include conditional grants for specificcapital projects (e.g. a foreign aid project to buildroads) and forgiveness of debt. The second type oftransaction involves ‘non-financial, non-producedassets’; this type of asset includes intangible assets(e.g. brand names) as well as rights to use land orwater (e.g. for mining or fishing).
| Capital Account | |
|---|---|
| Capital transfers | Transactions where one partyhas transferred ownership ofsomething to another partywithout receiving anythingspecific in return. For example:
|
| Acquisition/disposal of non-produced, non-financial assets |
|
The much larger financial account componentrecords transactions between parties that involvea change of ownership of Australia's assets orliabilities. It is structured according to the differentclasses of investment that owners of these assets orliabilities can undertake.
| Financial Account | |
|---|---|
| Direct investment | Financial transactions related to long-term capital investment in a business(e.g. purchase of machinery, buildings and factories), where the investorhas significant – 10percent or more – voting power in the business (i.e.through ownership of ordinary shares or voting stock). |
| Portfolio investment | The purchase of equity or debt(shares or bonds) in a business. In contrast to direct investment, portfolioinvestment occurs when the investor does not have an influence in theoperation of the business. |
| Financial derivative | The purchase or sale of financialderivatives (i.e. financial contractsbetween two parties where thevalue is derived from anotherfinancial instrument, such asa bond or share, or a marketindex). These transactions involvethe exchange of risk betweenparties, rather than funds. |
| Reserve assets | The purchases or sale of reserveassets held by the ReserveBank. These reserves are assetscontrolled by the Reserve Bankto meet policy objectives suchas intervention in the foreignexchange market and to assistthe Australian government inmeeting its commitments tothe IMF. |
| Other investment | Transactions that do not fit intoone of the other categories. Oneexample is ‘trade credit’ where animporter purchases goods fromoverseas and does not pay forthe goods until they are received. Another example is ‘currencyand deposits’, where moneyis deposited in or withdrawnfrom banks across borders,or banknotes and coins aretransferred between countries. |
Accounting Framework
Double Entry
Any transaction has two sides. In an economictransaction, something of economic value isprovided and something of equal value is received.This notion is reflected in the ‘double entry’accounting framework used in the balance ofpayments. In this framework, for every transactionbetween an Australian resident and the rest of theworld, the balance of payments will record twoentries. When economic value is provided a creditentry is made, and when an economic value isreceived a debit entry is made. The credit and thedebit will be for the same amount, but the creditwill be recorded as a positive entry and the debitwill be a negative entry. For example, when ashipment of wheat is exported from Australia to anoverseas buyer, a credit entry will be made in thebalance of payments reflecting the value of theshipment that has been provided to the overseasbuyer. On the other side of the transaction, theAustralian seller receives a payment for the wheatshipment and this payment is recorded as theoffsetting debit entry. Since every transactionin the balance of payments has two offsettingentries, the total balance of payments shouldbe zero.
Net Errors and Omissions
While the total balance of payments should bezero, this does not always occur in practice. Thiscan be due to measurement errors, becauseit is difficult to accurately record every singletransaction between Australian residents and therest of the world. And sometimes transactions arenot measured at all – they are ‘omitted’. Becauseof this there is an additional item included in thebalance of payments, known as ‘net errors andomissions’, to ensure that it always balances.
Box: Some Examples of Credits and Debits
To help illustrate the distinction between different economic transactions and how they arerecorded in the balance of payments, consider the following examples.
An Australian mining company exports $100 million of iron ore to a private Chinese steelmaker. The Chinese steel maker will only provide payment for the shipment once it arrives inChina from Australia (which is known as a trade credit because payment is only made after thegoods are received).
The $100m shipment of iron ore from Australia is an export and is recorded as a ‘goods credit’ underthe trade balance. The trade credit payment from the Chinese steel maker is recorded in the financialaccounts as a debit under ‘other investment – trade credit’.
Australian residents, including friends Michelle and Megan, go on overseas holidays to Baliduring winter and spend a total of $5 million. The Australian residents pay for their holiday byusing money deposited in their Australian bank accounts.
The $5 million Australian residents spent on overseas travel is an import and is recorded as a‘service debit’ in the trade balance (specifically ‘import – tourism’). The payments made to overseashouseholds and businesses (for the accommodation, food, sightseeing, etc.) by the Australianresidents from their domestic bank accounts are recorded in the financial accounts as a credit under‘other investment – currency and deposits’.
Taylor, an Australian resident, buys $20 million of shares in a company listed on the New YorkStock Exchange, equivalent to less than 10 per cent of the voting rights in that company. Theshares are paid for using money from Taylor’s bank account in Australia.
The $20 million of shares purchased by Taylor is recorded in the financial account as a debit under‘portfolio investment’, because the purchase does not result in a significant degree of influence overthe firm. The payment for the shares is made from Taylor's Australian bank account and recorded inthe financial accounts as a credit under ‘other investment – currency and deposits’.
| Sample of Balance of Payments* | |||
| Credit | Debit | Net (Credit plus Debit) | |
| Current account | $100m | -$5m | $95m |
| Trade balance | $100m | -$5m | $95m |
| – Goods | $100m(1) | $100m | |
| – Services | -$5m(2) | -$5m | |
| Primary income balance | |||
| Secondary income balance | |||
| Capital account | |||
| Capital transfers | |||
| Acquisition/disposal of non-produced | |||
| non-financial assets | |||
| Financial account | $25m | -$120m | -$95m |
| Direct investment | |||
| Portfolio investment | -$20m(3) | -$20m | |
| Other investment | $5m(2) | -$100m(1) | -$75m |
| $20m(3) | |||
| Reserve assets | |||
| Net errors and omissions | |||
| Balance of payments | $125m | -$125m | $0m |
| * Example number indicated in brackets. | |||
The Relationship Between the Accounts
The current account is always offset by the capitaland financial account so that the sum of theseaccounts – the balance of payments – is zero.The logic underlying this, and represented inthe double-entry accounting framework, is thatthe value of whatever is traded (recorded in thecurrent account) is offset by a movement of someform of asset to pay for it (recorded in the capitaland financial account). Consequently, when thebalance of one account is in surplus (i.e. has apositive value, representing a credit), the balanceof the other account must be in deficit (i.e. has anegative value, representing a debit).
We can summarise the relationship betweenthe accounts with an example of Australianeconomic developments. Australia has tended toborrow from overseas, reflecting investment inthe Australian economy. The capital flowing intoAustralia is recorded as a credit in the balance ofpayments and has been associated with a capitaland financial account surplus. This surplus ismatched by a current account deficit (recorded asa debit). Part of the reason for Australia's currentaccount deficit is the interest Australia pays to therest of the world on its international borrowing.
